Clearing and Settlement of Derivatives: Is a Code of Conduct Advisable?

• Date: 01 July 2010
• Published date: 01 July 2010
• DOI: http://doi.org/10.1111/j.1468-0386.2010.00519.x
• Author: Ulf Nielsson

eulj_519477..500

Clearing and Settlement of Derivatives:

Is a Code of Conduct Advisable?

Ulf Nielsson1

Abstract: This article is a first step to assess whether a self-regulatory ‘Code of Conduct’,

which has been in effect for European equities, should also be extended to derivatives. The

aim of the code is to increase competition and customer choice in the European transaction

process (trading, clearing and settlement). The article examines whether such a code is

advisable for derivatives by evaluating potential market failures and inefficiencies in

European derivatives markets. More specifically, the article: a) highlights the main

differences in the clearing and settlement procedures of derivatives versus equities; b)

outlines current and alternative market infrastructures in derivatives post-trade markets;

and c) evaluates the current level of competition among derivatives exchanges and also

between the on- and off-exchange trading segments.

The article concludes that if imminent initiatives taken to increase the competitiveness

of over-the-counter (OTC) derivatives markets vis-à-vis the incumbent derivatives

exchanges—such as increased clearing house usage and new entry of multilateral trading

facilities—are not effective in the near future, a code of conduct could be envisaged. This

should entail promoting faster automation of OTC post-trade processes and ensuring price

comparability is maintained between derivatives exchanges.

I Introduction

In recent years stock exchanges have expanded into multiple areas, such as offering

derivatives trading and clearing house services. Given these changes, along with

entries of so-called multilateral trading facilities, it is not surprising that The Economist

(2007) remarked that ‘over that past decade financial exchanges have changed out

of all recognition’.2Also, the post-trade market segment—namely clearing and

settlement—is undergoing considerable transition. Most notably, part of the European

post-trade industry has committed itself to a so-called self-regulatory ‘Code of

Conduct’, which aims to facilitate competition in post-trade markets. This code only

applies to equity markets, but might be extended to derivatives market as well. For

1School of Business, Reykjavik University (email: ulf@ru.is). Thanks to the European Commission (spe-

cifically DG MARKT, G2 unit) and an anonymous referee for many useful comments, and to the

Federation of European Securities Exchanges (specifically Rafael Plata) for data assistance. It should be

emphasised that the article reflects only the views, explicitly stated or implied, of the author. All remaining

errors are my own.

2The Economist, ‘Marketplaces on the move’, 13 September 2007, online version, available at

http://www.economist.com.

European Law Journal, Vol. 16, No. 4, July 2010, pp. 477–500.

© 2010 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford, OX4 2DQ, UK

and 350 Main Street, Malden, MA 02148, USA

example, Clara Furse, the Chief Executive of London Stock Exchange, recently stated

that ‘the code currently applies only to cash equity...[but] ironically, the user benefits

of such a code would be much greater in derivatives markets’.3

This article evaluates whether this is indeed the case, ie whether there are market

failures or inefficiencies in European derivatives markets which justify a regulatory

intervention in the post-trade market segment. This is done by addressing three central

issues. First, the article outlines the key differences in the clearing and settlement of

derivatives as opposed to equities. This discussion highlights the special features of the

derivatives post-trade process. Second, the article outlines the currently prevalent

infrastructure of derivatives markets. The pros and cons of this market structure—as

well as its potential alternatives—are assessed. Third, the article evaluates the nature

and degree of competition between derivatives exchanges. The size and scope of deriva-

tives exchanges is also compared to the over-the-counter (OTC) market in order to

examine the level of competition between these two market segments.

Despite its importance, the post-trade industry has received limited attention in the

academic literature. This may perhaps be due to limited data availability in the clearing

and settlement stage, which limits econometric analysis and leaves studies to be mostly

descriptive in nature. The relevant studies will be mentioned periodically throughout

the article. However, to the author’s best knowledge, this article is the first to bring

together the different arguments for and against (self-)regulatory intervention in Euro-

pean post-trade derivatives markets. This implies pin-pointing the potential market

failures and inefficiencies in the current system and the means to address them. The

different arguments and available empirical data on derivatives markets are evaluated

to assess whether action should be taken. This should therefore not only be of value to

managers of the industry infrastructure, but also to end users who are directly affected

by the post-trade market structure (through transaction costs and ability to choose

their preferred service provider).

The article finds that there are warning signs which point to constrained competition

in derivatives transactions. There are merely two major derivatives exchanges in

Europe which are built on a vertical market structure, implying that once the user has

entered into a trade she has limited freedom when it comes to choosing a clearing

counterparty. Although this does not necessarily call for regulatory action in itself, it

can be viewed as a warning sign because the vertical market structure often goes hand

in hand with limited price comparability between business units. Further, the signifi-

cantly bigger OTC derivatives market could, in principle, provide competition to the

incumbent exchanges. But as this market segment is mostly concentrated on providing

non-standardised derivatives products (not traded on exchanges), it restricts the degree

of competition it can provide. However, the ongoing streamlining of OTC markets—

due to increased clearing house usage and potential entry of electronic trading plat-

forms in derivatives trading—means that OTC markets may gradually become more

competitive to organised exchanges. Thus, the article concludes that it may be wise to

see if these initiatives bear fruit in the near future. Otherwise, a (self-)regulatory

intervention could be envisaged which would strive to promote faster automation of

OTC post-trade processes and would ensure price comparability is maintained between

derivatives exchanges.

3Financial Times, ‘Speak up to keep clearing houses competitive’, 16 April 2008, online version, available

at http://www.ft.com.

European Law Journal Volume 16

478 © 2010 Blackwell Publishing Ltd.