My blog published on Finextra in April this year, outlined the huge value to the finance industry of a combined DTCC and LCH Clearnet business. Now, what was rumour looks like it’s an odds on certainty that this deal will go through, once the details have been agreed. The disaster that has befallen the markets this year now makes this merger almost a necessity and an important start that will bring about many changes in the structure of international markets.

Arguably one of the biggest problems that the banks have had is their inability to assess effectively their counterparty risks. It is this concern about counterparties within the banking system that had a part to play in the credit crunch, which morphed into the virtual meltdown of the securities markets and the destabilisation of financial services and then the economy. This systematic breakdown would have been less painful and easier to rectify if the merger had already happened.

Measuring counterparty risk and fulfilling accurate ‘know your customer’ (KYC) processes has become more difficult over the years as globalisation and complex products disguise the financial viability of the counterparty. Counterparties nowadays are in many international markets, with clients and their assets in many other disparate systems so that bringing them altogether is virtually impossible. The merger now condenses a huge chunk of the international market into one system producing far greater control and security.

With so many of a counterparties assets in so many different systems and with complex derivative and OTC trades invisible on the balance sheets, much of the counterparty risk assessment will have had to resort to using third party suppliers like rating agencies and credit checking entities. The current crisis in the finance industry has proven these to be inadequate and superficial in providing the security required by the bank to deal. The merger of the DTCC and LCH Clearnet will mean that more counterparties in more international markets will be included and there will subsequently be more margined trades, which should bring a higher degree of comfort for the banks and their investors.

The problems of cross asset margining in multiple international markets have been a fundamental weakness in the financial system, which have been exposed by this crisis. Mainly caused by the massive increase in OTC products the silo depositories of assets have masked the true asset collateral and values. In short the market has been unaware of the increasing number of naked short positions. The switching of assets between different depositories to collateralise positions or trades has been like a merry-go-round that got everyone dizzy and which on a day to day basis made it impossible to gain an exact understanding of the exposures of the banks in the wholesale markets and the institutions in the retail. The volume and speed of order/executions and the constant movement of collateral made it impossible for risk managers to gage the true position.

This merger will bring about a centralisation of assets and enable collateral to be moved more efficiently against international positions. The netting and margining across asset classes will be both a cost benefit and a significant reduction of risks for the financial services firm and the investor.  

By dealing with these risks this merger goes a long way in providing banks and investors with the increased confidence so desperately needed by the markets and one of the root causes of the financial crisis. The value of confidence that your counterparty is secure and their assets are under wraps with an independent third party cannot be understated.

The merger will increase the transparency of a huge percentage of international business allowing central banks to measure more accurately the exposures within the financial system and take necessary action when required. The merger will create a central point of certainty within the financial system, which will provide more assurance for the financial services firms. Counterparty risks will instantly become more robust and the financial world that much safer.

The ability to margin cross assets should not be underestimated it has cost savings for firms but more importantly will provide reduced operational risk that will have a immediate positive impact on the balance sheet. As balance sheets have become stressed over this last year any relief will be welcome.

The reduced risks of international trading that would emerge from this merger will begin to address many of the systemic risks of globalisation that have been in evidence during this current crisis. There are two ways to look at systemic risk. One is the fragmentation of risk reduces systemic risk and the second is that the more risk is centralised increases systemic risk but does provide mechanisms for taking actions to mediate and therefore reduces the impact. The way that the global finance industry now operates makes the second method preferable and therefore the DTCC/LCH Clearnet merger is a vital solution.

In the USA the costs of clearing and settlement are a fraction of that in other international markets, due to their ability to net and margin across assets, this alone has a direct beneficial line to the financial services firm and the end investor. Cost savings within the financial system have an important part to play in the recovery of the financial markets, as the investor will not pay more after this crisis especially as the finance industry has shown itself to be inept with prices high and risks matching them. For the first time international markets costs are likely to begin to be reduced all as a direct result of this merger.

Another interesting aspect of this merger is that for the first time there will be a link between the London Stock Exchange and NYSE Euronext. Both Exchanges will now share the same Clearer and this has to decrease the costs of any potential merger and therefore increase the possibility of them merging. This would be the merger of all mergers in the exchange business. But is it a fanciful notion in these times, as once cornerstone financial institutions disappear? Or is it one of the likely structural changes that will be part of the new world order, certain to be created, as governments look to rectify the mistakes of past markets?

There has to be a possibility that the DTCC and LCH Clearnet merger will trigger another round of consolidation within the European Exchanges and Clearers. For example would the Deutsche Börse and Clearstream be more aggressive in the future and be forced to go hunting for new partnerships if not mergers?

OM and NASDAQ have been showing signals for years that they are one of the most aggressive in this market, although their corporate building policies have not yet born much fruit, they will certainly be a player. They are making a good fist of creating an international exchange and clearing capability, which in these times of change, could be a useful partner for the Deutsche Börse. Anyway they will certainly be in the mix when merger opportunities arise.

The MTFs have all signed up with a Clearer and the merger of DTCC and LCH Clearnet makes the possibility that a stock exchange will mop them all up, more likely. It will be a simple integration of front end technology, as the back end will already be achieved with this merger. 

It’s impossible to see any reason why this merger should not materialise and begin to provide the benefits I have described and more. The shift of market infrastructure that this merger causes will reverberate across international markets and produce a chain reaction that will bring about consolidation of key market co-operatives. The cost and risk reduction to the financial services firms that occur from this merger must be passed onto the investor, to aide the industry recovery process. It looks like the merger of the DTCC and LCH Clearnet will be an historical and world changing event that will be an important feature in the redesigning of the financial system and the securities market in particular. Isn’t that what we all need and want?           

By Gary Wright, M.S.I