Review of Participation Requirements in Central Counterparties – March 2009 4. Impact of the Change^[1]

A market participant's capacity to provide competitive broking services need not be dependent upon its ability to access the central counterparty directly. If the market for third-party clearing is sufficiently deep and competitive, individual participants (particularly those that are small) may well find use of a third-party clearer attractive. Indeed, since a third-party clearer can take advantage of scale economies – because fixed costs are high relative to variable costs – it may be able to offer services at a lower cost than could a small broker if performing this role itself.

If, however, the third-party clearing market is not deep and competitive, increases in minimum capital requirements could potentially have an adverse impact on the market. In the case of the increase in ACH's minimum capital requirement to $10 million, for example, there are two possible effects:

there could be an impact on the business of those brokers that currently hold less than $10 million in ‘core liquid capital’ and, to the extent that they service particular constituencies, potentially a reduction in access to trading services for some consumers; and
depending on the responses of those with less capital than required, there could be implications for the structure of participation and the distribution of exposures across participants.

While the second of these effects would not appear to be material in this case, there is potentially a significant impact on a number of existing small brokers.

4.1 Impact on existing participants

The proposed increase in ACH's minimum capital requirement from $2 million to $10 million would directly affect 17 of the 57 existing participants subject to minimum ‘core liquid capital’ requirements as at the end of 2008. Of these 17, 10 have ‘core liquid capital’ of less than $5 million. Graph 2 shows the distribution of ‘core liquid capital’ among ACH's participants.

Participants with insufficient ‘core liquid capital’ to meet higher threshold requirements would have three choices: (i) inject additional capital; (ii) move to third-party clearing; or (iii) merge or exit the business. Each of these choices has different implications for the participants themselves and the market.

4.1.1 Injecting capital

In the current market environment, raising additional capital may be challenging for a number of affected participants. Furthermore, since participants consider that they already hold adequate capital to support their businesses, they would deem any additional capital injected ‘lazy’ capital. They argue that, were they unable to achieve an adequate return on capital, their parent entities, banks or other capital providers might reconsider the value of their investment in the business. In December 2008, ASX proposed a broader definition of ‘core liquid capital’ (so-called ‘core capital’) to ease the transition to a higher capital requirement.^[2] While this proposal is still subject to the rule-change disallowance process, this broader definition includes, in addition to the components of ‘core liquid capital’, acceptable mark-to-market revaluation reserves, and the following assets (up to a value of $5 million):

approved subordinated debt;
additional cash collateral cover lodged with ACH; and
unconditional third-party bank guarantees.

Notwithstanding this additional flexibility, affected brokers claim that injecting additional ‘capital’ could still have an adverse impact. Specifically, if subordinated or other debt was raised, perhaps to fund additional cash collateral lodged with ACH, there could be a direct reduction in profitability given that the cost of the debt would likely exceed the return that could be earned on the funds. For example, Table 4 considers the impact under the assumption that participants make maximum use of the additional flexibility in raising debt-like ‘core capital’, and that the cost of raising such funds is 2 percentage points higher than the return on investing them.

In this case, the calculated impact of a $10 million requirement across the sample of affected brokers would range from a decline in profits of less than 3 per cent, to a drop of 39 per cent.

4.1.2 Third-party clearing

Developments in the third-party clearing market have not played out as expected at the time ACH made its decision to increase minimum capital requirements. There are relatively few providers of third-party clearing services, possibly reflecting very little demand for these services in the past. But it may also be that the cost of direct participation has to date been lower than would be appropriate were it to reflect more accurately the risk to the central counterparty. As such, third-party providers may not yet have reached the optimal scale, and relative pricing is not yet at a level that attracts brokers away from direct participation.

Whatever the reasons for the lack of development of the market, it has resulted in a fairly concentrated third-party clearing market with limited choice of services for participants. As at the end of 2008, a total of 48 of the 94 trading participants on the ASX market used third-party clearing for at least a portion of their business: 37 of these channelled all of their trades via a third-party clearer; a further 11 participants used a third-party clearer for only a sub-set of their trades. There are two dominant providers of third-party clearing services, one primarily serving retail brokers; the other serving wholesale paticipants in the options market (Table 5).

Furthermore, the difficulties in the global financial system over recent months have affected (the parent firms of) some current and prospective providers of third-party services, leaving them under new ownership or subject to government support arrangements. This uncertainty is likely to make it difficult for small brokers to commit to such a model at this time.

Contributing to this reluctance to commit is the high level of transition costs in moving to a third-party clearing model, or indeed in shifting between third-party clearers. These costs entail systems and operational costs as well as administration costs associated with establishing contracts between the third-party clearer and a broker's clients.^[3] The high cost of transition could effectively lock a broker into its existing third-party clearing arrangement, or at least make it difficult to change, even if a cheaper alternative became available.

Several respondents to the consultation provided projections of the impact of third-party clearing on their profitability, with the general message being that third-party clearing would substantially increase operating costs and undermine competitiveness. In one case, a shift to third-party clearing was projected to wipe out profits entirely. Such projections are, however, very dependent upon the model of third-party clearing adopted and hence the potential fixed-cost savings over time. In principle, there are a number of potential alternative third-party clearing and access models, each carrying different costs and risks and with different implications for the broker's underlying business model. Table 6 provides an overview of a subset of the alternative third-party clearing models.

Model 1 is most commonly applied currently in the retail market. In this model, the third-party clearer does not directly control the trade flow, but carries the broker's trades through clearing and settlement and assumes the broker's obligations as though they were its own. Model 2, of which there are currently no live examples in Australia, is the de minimus outsourcing model. Here, the third-party clearer only takes on the broker's exposures with the central counterparty, while the broker maintains client relationships and is responsible for both trading and settlement. Under Models 3 and 4, the trade flow is controlled by the third-party clearer, which allows it to better control the exposures it assumes on behalf of the broker. The only difference between these two models is that, in Model 4, the broker retains full control over its client relationships by continuing to sponsor their securities holdings in CHESS.^[4] For many brokers, this is extremely important, since ‘client service’ is an integral part of their product offering. Furthermore, the third-party clearer may be a competitor in its brokerage business.

Therefore, a broker should in principle be able to find a model to meet its specific preferences. However, the lack of depth in the marketplace and uncertainty as to the commitment of incumbent providers means that, for some brokers, use of third-party clearers poses some difficulties at the present time.

4.1.3 Merge or exit the business

Should a broker be unable to raise additional capital at an economical cost or to find a viable third-party clearing relationship, it may be forced to merge or exit the business. In such circumstances, brokerage markets in smaller Australian cities could be disproportionately affected. Indeed, several of the submissions from smaller brokers affected by the change were from brokers based in cities other than Sydney and Melbourne. Withdrawal of such regional operators could diminish competition for brokerage services in these areas.

Smaller brokers specialise mainly in retail brokerage, often providing tailored services to smaller companies and individual clients, or servicing a geographically concentrated group of financial planners (who may in turn support thousands of retail clients). They also sometimes provide niche research on smaller regional companies. Larger inter-state brokers providing a standardised service in multiple markets may not find it economical to replicate the tailored and specialised services provided by an exiting regional broker, leaving some constituencies with reduced access to brokerage services.

4.2 Concentration of exposures

Depending on the initial participation structure and the responses of participants, one possible outcome of an increase in minimum capital requirements is an increase in exposures of the remaining participants and hence increased concentration risk for the central counterparty. The analysis below considers whether such concentration could emerge following the change proposed by ACH.

Both the normal-course and stress-test exposures brought to the central counterparty by participants with less than $10 million in capital are relatively low in absolute terms (Table 7). Interestingly, however, notwithstanding that only seven of the 17 participants directly affected by the minimum capital change generate exposures in the derivatives market, some of the highest exposures are generated by the brokers with the lowest capital.

Given the relatively low level of exposures generated by these participants, the effect on risk concentration from a widespread shift to third-party clearing would not be material. The small number of affected participants active in the derivatives market account for less than 1 per cent of total initial margin posted, while in the cash equity market, affected participants account for approximately 2 per cent of total notional margin. With this level of exposures, even in the extreme case that all affected participants in the cash equity market moved to a third-party clearing arrangement with the principal third-party clearer for retail business, the distribution of exposures across ACH participants would change only marginally. Under this scenario, 80 per cent of exposures would be shared among 13 as opposed to 14 participants (Graph 3).

Nevertheless, it is important that those offering third-party clearing services are sufficiently robust and well capitalised. To the extent that a number of trading participants are dependent on their services, there is a case for third-party clearers to be required to be of higher credit quality and meet high operational and risk-management standards. Indeed, many international central counterparties set higher capital requirements for third-party clearers, and SFECC also plans to do so.

Footnotes

To assist in the analysis of potential impacts, ASX provided the Reserve Bank and ASIC with data on 62 ACH participants that were subject to minimum ‘core liquid capital’ requirements as at end-November 2008. Of these, 22 participants had less than $10 million in ‘core liquid capital’. Four participants had less than $2 million in ‘core liquid capital’, three of which have subsequently resigned (and have been excluded from the analysis), while the fourth has injected additional capital. Since end-November 2008, a further two participants with ‘core liquid capital’ between $2m and $10m were acquired by, or transferred their business to, other ACH participants with ‘core liquid capital’ greater than $10m. These participants are also excluded from this analysis, and their positions transferred to the appropriate parties (assuming no netting). [1]

See <http://www.asxonline.com/intradoc-cgi/groups/derivatives/documents/communications/asx_022665.pdf> [2]

These include statutory disclosure and anti-money-laundering provisions. This process could be particularly burdensome for a broker offering a service to financial-planning intermediaries, who collectively might have tens of thousands of end-clients. [3]

CHESS is the Clearing House Electronic Subregister System, the electronic book-entry register of holdings of approved securities managed by ASX Settlement and Transfer Corporation Pty Limited. [4]

Review of Participation Requirements in Central Counterparties – March 2009 4. Impact of the Change[1]