We Must Break Down Vertical Silos, Says Senior EU Lawmaker

Terry Flanagan

A senior European Union lawmaker has criticized attempts by some in the industry to lobby against European Commission proposals in MiFID II to put an end to the ‘vertical silo’ approach, which many of the region’s incumbent exchanges currently operate under.

A vertical silo refers to a structure whereby an exchange owns its own clearing house in one integrated business, allowing the exchange to lock in clearing revenue that otherwise would go to an external provider.

However last October, the European Commission, in its updated Markets in Financial Instruments Directive (MiFID II) proposals, announced plans to introduce a more horizontal approach—allowing “open access” to competitors’ exchanges—whereby clearing structures would be able to centrally clear products for various exchanges and execution facilities.

“[There must be] open and fair access to trading venues and central counterparties,” said Sharon Bowles, a Liberal Democrat MEP, who is the first Briton to chair the parliament’s influential Economic and Monetary Affairs Committee.

Examples of vertical silos for futures and derivatives include InterContinental Exchange through ICE Clear Europe, CME Group with CME Clearing Europe and Deutsche Börse with Eurex Clearing, as well as various national clearing houses for the equities markets. Horizontal clearing structures, which encourage market competition and supports new market entrants, include LCH.Clearnet, SIX x-clear, the Options Clearing Corporation and the Depository Trust & Clearing Corporation in the U.S..

“The CME Group and ICE, which both operate vertical silos, have just been designated systemically important and too big to fail by U.S. regulators,” said Bowles. “I do not think we want the same for our institutions in Europe. We do not want taxpayers to be on the hook for bailing them out 10 years down the line, just as they are today for banks.

“Europe will be speaking with forked tongue on growth if it insists on promoting ‘national’ or ‘European champions’ over the principle of an ‘open market economy with free competition’ which is embedded in the Treaty [that originally established the European Economic Community in 1958].”

Clearing is a crucial part of the post-trade process that helps guarantee securities and derivatives trades are completed even if one party defaults. And with the G20’s drive to have a large chunk of the $700 trillion global over-the-counter derivatives market pushed on to exchanges and cleared by a central counterparty by the end of this year, to safeguard the financial system against large defaults, clearing houses have become a key battleground in the exchange space due to the potential revenues on offer.

However, one transatlantic exchange operator, Nasdaq OMX, is set to offer an alternative to the vertical silo approach with the launch today of a London-based derivatives platform that will trade interest rate products.

Called Nasdaq OMX NLX, it is set to increase competition in derivatives trading and clearing in Europe. Most fixed income trading in the region is currently done through NYSE Euronext’s NYSE Liffe and Deutsche Börse’s Eurex, both vertical silos, but Nasdaq’s new venue, which will build its presence in London, will separate trading from the clearing, which will be done by LCH.Clearnet.

“The buy side are looking for solutions that can help alleviate the collateral burden resulting from financial market reform and they will welcome this initiative by Nasdaq OMX,” said Will Rhode, a principal and director of fixed income research at TABB Group, a capital markets consultancy.

“European regulators will likely be pleased to see a horizontal clearing structure come to market where trade flow from NLX, other exchanges and platforms and the OTC market will be able to co-mingle within a single clearing house. This will be a significant trading and clearing alternative to the incumbent solutions that currently dominate the marketplace.”

Charlotte Crosswell, chief executive of NLX, added: “This new trading venue will be very exciting as it will have the potential to realize significant cost savings for customers. The combination of strong technology, risk management and the market presence of Nasdaq OMX and LCH.Clearnet has allowed us to build a very competitive offering and we have a system ready for customer testing. This puts us in a prime position to capitalize on market structure changes in this space.”

Nearly all of the major incumbent European equity exchanges have their own clearing houses but some alternative venues, such as Chi-X Europe and Turquoise, have been pushing for a competitive clearing model in cash equities, known as interoperability, with European regulators now cautiously backing their plans. Many of these exchanges offer traders a choice of as many as four clearers as the costs of clearing are reduced.

However, earlier this year Nasdaq OMX Europe, an operator of seven Baltic and Nordic exchanges, decided to postpone its decision to allow interoperability in its cash equities markets and is waiting on the final outcome of the European Market Infrastructure Regulation (Emir), another financial diktat from Brussels that is due to become law at the end of the year, before committing to any new clearing model.

“We are convinced that a competitive cash clearing model will act to drive liquidity and lower investor costs, thus benefiting our clients and the European capital market as a whole,” said Hans-Ole Jochumsen, president of Nasdaq OMX Nordic at the time.

“However, there is still uncertainty regarding the detailed requirements for interoperability even though there is a political agreement regarding Emir. There needs to be clarity and a level playing field in this area, before we can introduce interoperability.”

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