MF Global, LCH and the LSEG

Sunday, November 6, 2011 7:00 PM

The collapse of MF Global serves a timely reminder of the importance of infrastructure for clearing and settlement. While it will take time to sort through the wreckage of reckless and possibly criminal behavior, the relative ease - so far, at least - with which markets have digested the situation speaks volumes to the importance of risk controls in the plumbing behind modern trading.

At the same time, though, the relative uncertainty that still prevails a week after the fact attests to how much more must be done to truly safeguard financial markets. These issues reach far beyond MF Global: too much dealing still is not centrally cleared; high speed trading proliferates despite its mismatch against days-long settlement cycles; regional and asset class-specific variations inhibit trading and hedging, while introducing costly inefficiencies. Maybe most of all, when there are problems, a clear accounting takes too much time to reach.

A more secure financial system - the system required sooner rather than later to maintain order in perilous markets - will require significant improvements in clearing and settlement infrastructure, which will need to move closer to real time, to adopt standards for interoperability, and to facilitate cross-platform and cross-asset class margining, both to reduce friction and to harmonize systems so that when regulators and users need answers, they get them without delay.

These are global issues, but they are particularly timely here in the UK and in Europe, as the London Stock Exchange Group (LSEG) nears acquiring control of LCH.Clearnet. This transaction warrants close scrutiny by regulators, politicians, and market participants, including the LCH owners who support the LSEG bid.

Naturally, it’s easy to understand why the sellers would warm to the LSEG offer, with reports suggesting it was twice as high as the next best bid. When you’re selling, it’s always great to find such an eager buyer, which commentators ascribe to beleaguered management desperate to do a deal, any deal, hot on the heels of resounding failure at their last attempt.

The windfall from such a sale must be tempting, but when the sellers are also users, they need to think longer term.

In the not-distant future we can be sure that trading businesses and their associated economic activity will go where the most robust clearing and settlement systems are offered. That means steady-state and status quo aren’t enough: to be competitive and to foster an environment that will benefit their customers, clearing and settlement facilities will have to innovate and deliver real business solutions.

So how goes the LSEG track record for delivering innovative business solutions? Management trumpeted bond and derivatives trading as being strategic priorities, but these initiatives appear to be failing comprehensively, even if in a kind of slow motion. Baikal? Best soon forgotten. All good ideas (if also perfectly obvious) which, given the resources and the dominant position of the LSEG, one would expect to reach fruition. But, no; even when the goal is easier to hit than to miss, there’s never a ball in the back of the net.

How about the LSE’s migration to new technology? Seems to be okay now, but the transition was deeply flawed, impacting market participants for weeks, at times severely.

And why did the LSEG braintrust decide to move the whole market at once to their new technology? That struck many market pros as unnecessarily risky, a kind of Lehman-esque roll of the dice, and one that appeared to compound problems as the migration ran into trouble. Try that approach with a clearing and settlement infrastructure and you might as well warn users to fasten safety harnesses and don crash helmets: it will be total business shutdown.

Operators of clearing and settlement platforms need to have the confidence of all market participants - the platforms’ users, large and small - because credibility in this domain of financial markets is sacrosanct. After all, people and organizations on the clearing and settlement side of the trading equation are privy to exceptionally sensitive data, and the requirements for robust policy and procedures are paramount to protect client confidentiality.

Does the LSEG have a track record that would give users rock-solid confidence? How about their dedication to standards of governance that form the bedrock confidentiality? I made my reservations clear in a letter to the FSA; FSA letter.jpg

When the user-owners of LCH consider their core businesses of banking, broking and trading, all of which depend on reliable, credible facilities for clearing and settlement, they know they are deeply exposed to bad outcomes: if these facilities end up mismanaged, the lost business will make any windfall from the sale of LCH pale in comparison.

Maybe the sellers think that portability is just around the bend, so it doesn’t matter if the community loses faith in LCH because customers could soon all just migrate to a different platform. After all, they know that the LSEG acquisition of LCH constitutes a kind of vertical silo which, historically, customers would probably have opposed as a callous attempt to lock in business, protect declining market share and steal back lost pricing power.

The reality is, though, that portability isn’t just around the corner. The open architecture will come, but it will take time and will be obstructed by vested interests. LCH sellers may underestimate this; if so, they do so with real risk. In the interim, any dent to the integrity of clearing and settlement infrastructure will stifle trading businesses and associated capital markets activity. Users don’t need to decide that management are comprehensively unscrupulous or incompetent, just a hint of either is enough to destroy confidence in markets and lead risk managers to convene triage meetings.

Here’s a radical idea: how about dropping LCH.Clearnet into the ECB or the Bank of England or some combination of the two? When stability returns to markets and to the wider financial system, it could spin back out into user ownership and control. User-owners may forfeit their imminent windfall, but they won’t be held to flames they will surely feel if their current plan goes dreadfully awry.