Competition in U.S. Clearing Has its Cost, Risk and Challenges

Clearance is relevant again, says Robert Iati, TABB Group partner, global head of consulting and author of a new 24-page research note titled, “Competition in US Clearing: Cost, Risk & Challenges,” which investigates the growing importance of clearance in the US markets, its impact on processing costs, and the changing paradigm that may lead to the emergence of a more competitive business.

Following years of taking a back seat to the front-office drivers, such as commission management platforms and low-latency execution systems that are more closely linked to revenue generating activities, the importance of core transaction processing is top of mind for the decision makers in the industry.

Like any infrastructural backbone, people often do not feel the need to understand such a complex system unless prices go up or something goes wrong. It is no wonder, then, that the industry is starting to sit up and take notice. With firms focusing more closely on cost and customer retention, clearing is beginning to capture the attention of market participants in many ways.

However, any new competitor in the US clearing business will be swimming upstream to some extent, says Robert Iati, facing the prospect of challenging a firmly entrenched incumbent in the NSCC. “The potential competitors are a mix of horizontal and vertical models and ownership structures that includes existing utilities, exchanges, clearing entities or quite possibly a combination of two or all three.” European entities are also part of this group, “since they’re eyeing the clearing space as new fodder for their businesses.”

Market structure is changing as exchanges merge across both geographic borders and asset classes. As exhibited by the mergers of NYSE, Euronext and Amex; and of Nasdaq, OMX and PHLX; the trading markets of today are quite different from those of the recent past and will alter the way transactions are processed, costs are assessed and risk is managed. So after a period when both the market and the process were simple, there is pressure to focus our efforts on improving clearance.

While this whirlwind of change and competition plays out, trade and share volumes continue to rise with no indication of tempering. Although these higher volumes are good news for trading firms, they also come at a price. Ever since the adoption of decimalization and the utilization of trading algorithms, trade sizes are being chopped into smaller pieces with the average sizes declining to around 250 shares per trade. Smaller trade sizes in combination with increased volumes are generating more trades to process.

The US clearing industry has experienced a 300-percent increase in clearing volume of US equities over the past four years. This is having a profound effect on brokers’ costs and cutting into their bottom line, even despite the fact that exchange costs have lessened because of competition in trading.

As long as markets are constrained by geographic borders and distinct regulatory oversight—as in the past—the clearing paradigm faces little industry-wide pressure. Local markets, overseen by provincial regulatory authorities, faced little pressure to change, restricted to issues related to their own specific market. Now, as exchanges merge and align across borders, the core of market structure will be permanently altered and, with it, challenges the tenets upon which clearance processes have operated.

Recent market issues have made all participants more sensitive than ever to their exposure to counterparties and credit. Institutions need greater certainty of their counterparties’ ability to fulfill.