The merger between Deutsche Börse and the London Stock Exchange should be blocked
AT THE peak of the financial crisis, in 2008, the Office of Fair Trading objected to a merger between Lloyds TSB and HBOS, two big British banks, saying that competition would suffer. The finding was overruled by the British government (on advice from the Bank of England, among others), which judged that a merger would increase financial stability. The ideal response to the proposed friendly merger between Deutsche Börse (DB) and the London Stock Exchange (LSE) would be a mirror image of the treatment of the Lloyds-HBOS tie-up. If Europe’s trustbusters bless the deal, governments should block it unless its backers allay concerns about financial stability.
Much of the opposition to the mooted DB-LSE merger draws on predictable arguments: fear of foreigners taking over national stockmarkets and concerns about the new outfit’s pricing power. But the real objection to uniting Europe’s two largest stock exchanges is more alarming. The fees charged for listing and trading stocks accounted for less than a tenth of the total revenue of the two firms combined last year. The mainstay of both is clearing trades, notably interest-rate derivatives. Clearing-houses, like LSE’s LCH.Clearnet and DB’s Eurex, stand in the middle of trades, acting as a buyer to every seller and a seller to every buyer. If one party goes bust, the clearer will make the trade good.
Since the financial crisis, when a load of bilateral derivatives trades blew up AIG, an insurer, clearing has become a pillar of the regulatory architecture. Traders in Europe will, for example, be obliged to clear most interest-rate swaps from June. Putting trades through a clearing-house means that a default by a single counterparty is unlikely to ripple through the system. But it also concentrates more risk in the clearing-house itself. If any of the big clearing-houses were to fail, the consequences would be horrendous. Lehman Brothers was a midsized investment bank, yet its failure helped turn a local bust into a once-in-a-century crisis because it was so tightly connected to the rest of the system. The world’s big clearing-houses are even more enmeshed: the notional value of interest-rate swaps cleared by LCH.Clearnet in 2015 was $533 trillion.
Too big for sale
Consolidating the big clearing-houses would further concentrate this risk. As if that were not reason enough to give financial regulators pause, one of the benefits for customers that the LSE-DB team is touting should rule a deal out. Clearing-houses require each party to a derivatives trade to make an upfront payment, which rises or falls in size as the market moves for or against each party. This payment, or margin, is part of the defences that a clearer calls upon to make a trade good if either counterparty fails to pay: DB and LSE combined hold €150 billion ($170 billion) in such collateral. If a client goes bust and its margin payments are insufficient, the clearer still has other funds to call on. But it is a step closer to failure.
The exchanges say their clearing-houses will remain separate, but customers of both will be able to offset some classes of derivatives bets that tend to move in opposite directions, and put up less margin as a result (see article). Rivals, such as America’s CME, already allow this but that is no reason to replicate its risks. In a crisis, the offsetting correlations between different sorts of bets tend to break down.
Regulators have relentlessly jacked up the amount of equity with which big banks must fund themselves so as to protect them from losses. Clearing-houses should be treated with even more care. Unless the LSE and DB pledge to keep their clearing-houses truly separate, with ring-fenced default funds and no skimping on margin, their tie-up should be blocked.
This article appeared in the Leaders section of the print edition under the headline "Don’t clear the clearers"
