81 Defining the core issues – efficiency and network strategies Direct Costs Service Provider Charges Indirect Costs Cost of Capital Risk Management Costs Information Technology Costs Back-Office Costs COST CATEGORIES Clearing House Charges COST TYPES Figure 3.3 Cost types and categories Source: Author’s own. Clearing House Clearing Members 1ST LEVEL 2ND LEVEL Costs of Production Profit Margin CCP CCP Charges Direct Costs Indirect Costs + Costs of Production RESEARCH FOCUS Non-Clearing Members GCM Charges Costs of Production Direct Costs Indirect Costs + Profit Margin GCM Direct Costs Indirect Costs + ++ Chapter 5Chapter 6 TRANSACTION COSTS IN THE VALUE PROVISION NETWORK LEVEL OF DIRECT ACCESS TO CCP LEVEL OF INDIRECT ACCESS TO CCP Figure 3.4 Transaction costs in the Value Provision Network Source: Author’s own. 82 Clearing Services for Global Markets The ‘first level’ of costs refers to those occurring on the first level of the VPN, i.e. those borne by the producer of the service, the clearing house and its direct customers, the clearing members. As outlined above, this research examines both the direct and indirect costs that clearing members have to bear in order to clear their transactions. To analyse these costs, it is crucial to include the clearing house’s costs of production, as these translate into direct costs for the clearing members. 34 Costs of production have divergent meanings for different clearing members. For a clear ing member with a pro- prietary focus, costs of production refer to the costs of doing business, i.e. the total costs related to clearing its own transactions. Costs of production from the perspective of a clearing member with agency focus, on the other hand, mean the internal costs for producing the service it provides to its customers. 35 This study focuses on the first level of transaction costs for different reasons. Firstly, this analysis serves to assess the efficiency impact of different network strategies. Secondly, a detailed and comprehensive analysis of the second level of transaction costs exceeds the scope of this study. 36 Although the research focus lies on the first level of costs, it is important to have a basic understanding of both cost levels to truly comprehend the full impact network strategies can have on the efficiency of clearing and the struc ture of the VPN. Throughout the research, information on and analysis of the second level will thus be provided, albeit with a more narrow scope. 3.2.1 Direct transaction costs Direct transaction costs are clearing-related costs that are monetarily quan- tifiable and can be measured explicitly. T his cost type comprises two cost categories – clearing house charges and service provider charges (see Figure 3.5). Service providers for clearing members, as defined for the purpose of 34 An analysis of the costs of production for clearing houses is provided in Chapter 6;ananalysisofthe direct and indirect costs for clearing members is provided in Chapter 5. 35 Both perspectives are e laborated in more detail in the following chapters. 36 As non-clearing members need to establish an account relationship through another party to effect clearing, the transaction costs they have to bear significantly depend on the fees charged by their respective GCM(s). Because these costs are highly dependent on the internal calculations and pricing policy of the clearing intermediary involved, they are difficult to analyse. The same applies to other customers, i.e. individuals or firms that are not members of the clearing house’s affiliated exchange(s), whose view is not included in this study for similar reasons. Again, it is more relevant here to analyse the costs of production for clearing members, i.e. the first level of costs, because such an analysis serves to provide insight into the costs that these other customers have to bear. 83 Defining the core issues – efficiency and network strategies Clearing House Charges One-Off Costs Fixed annual/monthly membership fees Fixed annual/monthly infrastructure fees Transaction-driven fees Event-driven fees Fees charged for additional services Penalties Charges for service level upgrades or other changes DIRECT COSTS Service Provider Charges Fixed Costs Variable Costs One-off admission fees/purchase of shares or seat at clearing house Initial one-off payments to service providers Fixed Costs Fixed annual/monthly fees Variable Costs Transaction-driven fees Event-driven fees Fees charged for additional services Penalties Charges for service level upgrades or other changes One-Off Costs Figure 3.5 Categorisation of direct transaction costs Source: Based on Eurex Clearing price list; LCH.Clearnet website; and FOW (ed.) (2006). this study, include back-office vendors, telecommunications companies, (cor- respondence) banks, 37 settlement institutions and other GCMs; all of these entities sell different clearing-related (supporting) services. Clearing members usually have to bear one-off costs for establishing their initial relationship to a clearing house and service providers, together with any recurring fees charged by clearing houses and service providers. These charges commonly have fixed and variable components. 38 37 Clearing members are required to operate accounts for settlement. The accepted banks are predefined in the rules and regulations of the respective clearing house. 38 Direct costs, which are not taken into account in this study, result from the charges from acquiring hardware and paying software licence fees and regulatory fees. 84 Clearing Services for Global Markets 3.2.1.1 Clearing house charges Depending on their institutional structure, some clearing houses impose a one-off admission fee on members; others require the upfront purchase of a certain number of shares, memberships or seats at the clearing house. One- off admission fees can vary according to the clearing membership level, i.e. according to whether clearing members can clear their own transactions and those of their customers (GCMs) or are allowed to clear only their own transactions (ICMs). Fixed costs include all recurring annual or monthly fees charged by clear- ing houses, such as minimum transaction charges, membership or clearing licence fees. Another fixed fee component charged by clearing houses relates to infrastructure fees (which are often also referred to as ‘communication’ fees). Infrastructure fees are paid for connecting a specific clearing member location to the clearing house – either through the internet or via dedicated telecommunication lines. These lines are commonly leased to clearing mem- bers for the duration of their particular clearing member status. Charges for line fees can depend on the bandwidth size, connection type, i.e. internet versus dedicated lines, or geographical location. Line fees commonly cover the usage and initial installation of the line(s). Some clearing houses out- source this service to designated telecommunications companies, which then charge clearing members directly. 39 Infrastructure fees can also include addi- tional charges for workstations, servers, back-office and information services link-ups. Clearing house charges that translate into variable costs to clearing mem- bers can be itemised as follows: transaction-driven fees, event-driven fees, fees charged for additional services, penalties and fees charged for service level upgrades, other services or infrastructure changes. Among the most com- monly observed and discussed direct costs associated with the use of a CCP are the transaction-driven fees. Clearing house fees are commonly charged to each side (i.e. both the buy and sell sides) of a contract. Different fee lev- els are usually set for each exchange or execution platform or venue eligible for clearing at the respective CCP. The most significant difference among transaction-driven fees is their varying base of reference. Vertically integrated clearing houses often charge so-called ‘all-in’ fees, which cover both the trad- ing and clearing fee per contract, rather than charging a separate clearing 39 In such cases, line fees are part of the service provider charges and not part of the clearing house charges. 85 Defining the core issues – efficiency and network strategies fee. 40 Fees may further vary according to product or product groups (e.g. individual equity, stock index, interest rate, etc.), member type 41 or business type (prop. versus agency business). Finally, transaction-driven fees may be eligible for discount schemes or rebates. A tiered fee structure allows fees to be discounted on an aggregated basis, i.e. according to the trade size (number of contracts per t rade) or volume thresholds. 42 Depending on the institutional structure, clearing houses may employ a policy that entails the refunding of par t of the transaction-driven fees to members at the end of a financial year. Event-driven fees result from any ‘event’ affecting an open position. These fees may thus be charged for option exercises, 43 assignments and adjust- ments or futures contracts tendered, assigned or cash settled. Therefore, the amount of event-driven fees clearing members have to bear heavily depends on the product portfolio they clear. Clearing houses also charge v ariable fees for additional services, 44 which c an, for example, include the service provi- sion for give-up executions, allocations, claims, transfers, specialised account structures or reports. Clearing houses may also charge penalties, e.g. for delayed payments or deliveries. The fees commonly involve the refunding of the costs covered by a clearing house when a clearing member issues a late payment or delivery. Additionally, clearing houses sometimes charge a fixed fee per product and day late, requiring a daily interest payment on the outstanding amount to be paid or delivered. 45 Last but not least, variable costs may include possible charges for service level upgrades, such as non-gratuitous network or bandwidth upgrades (insofar as this service has not been outsourced to another service provider). These fixed and variable components represent a catalogue of various pos- sible clearing house charges; the ultimate scope and type of fees depend on 40 In Europe, Eurex Clearing and OMX Clearing charge an all-in fee, whereas LCH.Clearnet, MEFF and CC&G charge a separate clearing fee. 41 US clearing houses typically categorise different member types; each member type usually corresponds to individual fee levels. See, e.g. www.cme.com. 42 Volume thresholds may, for example, refer to daily volume levels, accounting months or yearly cleared contracts. 43 Not e that when exercising an option, the exercise fee is only paid by the buyer. 44 The definition of which services command additional charges and which are included in the tr ansaction fee differs from one clearing house to another. 45 This daily interest payment can be calculated on top of a standard reference interest rate, such as the European Central Bank’s overnight lending interest rate, or the commercially available money market interest rate. 86 Clearing Services for Global Markets several factors, such as the clearing house’s regulatory environment, institu- tional structure and general pricing policy. 3.2.1.2 Service provider charges Service provider charges also consist of one-off, variable and fixed costs. As outlined above, service providers comprise back-office vendors, telecommu- nications companies, (correspondence) banks, settlement institutions and other GCMs. The number and type of service providers employed usually depend on the relative size of a clearing member. Isolating the clearing-related amount from the overall service provider charges is often difficult, as service providers are co mmonly employed to provide a variety of internal support services for their clients and not merely those related to clearing. Back-office vendors are firms providing the financial community with spe- cialised software solutions. 46 Clearing members commonly require their ser- vices to integrate the different IT structures from various clearing house interfaces and to customise applications. The back-office solutions provided by these vendors are designed to facilitate processing with various interfaces. Clearing members often employ vendor technology to consolidate their back- office applications into a single user interface, which can lead to improved risk monitoring and scalability. 47 Adaptation of internal systems also becomes nec- essary when clearing members perform a broad range of clearing services. 48 Such services can include the replication of certain clearing house processes for their clients when data and repor ts provided by a CCP are incompatible with a clearer’s internal processing system. GCMs in particular often require a more detailed internal risk reporting or account structure to serve their clients better, and thus incur costs for this replication. Back-office vendors provide for the necessary system adaptation. 49 They usually charge initial one-off, fixed annual or monthly payments, as well as fees for additional services. 46 A general distinction differentiates front- and back-office vendors. Technology from front-office vendors allows, for example, the loading of various exchanges’ screens on to a single platform, and enables customers to search electronically for the best price (best execution) for a trade and choose the exchange with the lowest fees. Cf. Cohen (2005), p. 20. 47 Scalability refers to the ability of a hardware or software system to adapt to an increase in size or capability. 48 Cf. Bank for International Settlements (ed.) (2004), p. 6. 49 Additionally, vendor technology supports the automatic management of services, such as give-ups, reducing manual intervention through monitoring the clearing status of transactions and monitoring margins via a single interface. At the same time, clearing houses update and replace their software and systems periodically, typically on a replacement cycle of five to seven years. Cf. Group of Thirty (ed.) (2003), p. 5. Vendors can facilitate these updates and replacements to clearing members. 87 Defining the core issues – efficiency and network strategies Additional charges from service providers may stem from the aforemen- tioned outsourcing of technical infrastructure provision to telecommuni- cations companies, which may charge recurring fixed fees as well as pos- sible fees for service level upgrades or other changes and infrastructure adaptations. Dealing with a CCP also entails costs for the banking intermediaries. Clearing houses usually demand that all clearing members hold dedicated accounts for the physical delivery of an underlying and cash payments. This requirement entails administrative costs stemming from the maintenance of margin accounts and the calling and calculation of margin requirements. 50 Clearing members that choose not to open an account at such a dedi- cated bank can utilise the services of a so-called ‘correspondence’ bank. The clearing member can use the correspondence bank’s account at a central bank; the correspondence bank in turn charges fees for this intermediary service. A fourth category of clearing-related service provider concerns those involved with custody and enabling settlement. As outlined above, these insti- tutions most importantly comprise CSDs and ICSDs. Clearing members need to hold accounts with CSDs/ICSDs and custodians in order to hold and man- age collateral, which is employed for margin payments, or physical delivery of positions. Holding accounts and moving collateral translates into fixed and variable costs for clearing members. Due to the limited scope of this study, costs related to settlement and custody serv ices will not be explored and analysed in detail. 51 Finally, service providers for clearing members can also include other GCMs. As outlined in section 2.3.2, not all clearing members are necessarily members of all the clearing houses relevant for the markets in which they are active. In such cases, clearing members employ the service of other GCMs to clear their transactions, thus acting as NCMs in these other markets. However, clearing members can also employ third-party GCMs as service providers for functions and processes they would otherwise perform internally. This kind of outsourcing can relate to single services, such as regulatory reporting, or complete functional areas, such as back-office functions. Utilising the ser- vices of other clearers translates into fixed and variable costs for clearing members. 50 Cf. NERA Economic Consulting (ed.) (2004), p. 11. 51 Refer to Kr ¨ opfl (2003) for an in-depth analysis of transaction costs related to settlement and custody services. 88 Clearing Services for Global Markets 3.2.2 Indirect transaction costs Clearing services costs entail not only those fees directly charged by clearing houses or service providers, but also any additional internal costs related to the use of the CCP infrastructure and services. These costs are difficult to isolate and measure explicitly; they are therefore referred to as indirect transaction costs. Because these costs are difficult to quantify monetarily, they can often only be estimated. For the purpose of this study, they are categorised as cost of capital, risk management costs, IT costs and back-office costs. In the fol lowing, each cost category is defined briefly and its mode of measurement for the purpose of this study is determined. 3.2.2.1 Cost of capital Utilising clearing services entails the cost of capital that is lodged at the clear- ing house and tied to the clearing process. 52 The cost of capital is the expected return foregone by the clearing member by bypassing other i nvestment alter- natives, i.e. investing its capital elsew here instead of having to dedicate it to the purpose of clearing. The cost of capital is therefore an opportunity cost, and is commonly also referred to as the opportunity cost of capital. 53 Opportunity costs are transaction costs associated with missed tr ading 54 or investment opportunities. Opportunity costs thus result from not allocating capital to its most productive investment. 55 The measurement of the opportunity cost of capital is problematic in that its true measure can be calculated only if it is known how an investment would have performed had it been executed at desired times across an investment horizon. 56 Because this desired investment was not in fact executed, however, the opportunity costs are inherently unobservable and differ from member to member. Nevertheless, one can monitor the theoretical performance of (unexecuted) desired investments by tracking an investment benchmark that reflects the desired investment and thereby estimate the opportunity cost of 52 Cf. NERA Economic Consulting (ed.) (2004), p. 11. 53 Cf. Brealey/Myers (2000), p. 19. 54 Cf. Keim/Madhavan (1998), p. 54. 55 Whether or not opportunity costs should be qualified as another form of transaction cost is debated. Some authors definetheseas partof transaction costs. Cf. Neus (1998),p.84;and Collins/Fabozzi (1991), p. 28. Other authors criticise this definition, claiming that because opportunity costs can be illustrated as the difference between two alternatives for action, they should not be defined as a separate category. Further, in order to assess the opportunity costs of an alternative, it is necessary to have knowledge about ‘better’ alternatives. A rational individual would in this case choose the better alternative. 56 Refer to Bufka/Schiereck/Zinn (1999); and Bufka/Schiereck (1999); who analyse the suitability of pragmatic approaches to determine the d ivisional cost of capital for multi-industr y firms. 89 Defining the core issues – efficiency and network strategies Cost of Capital Default Fund Contribution + Value of benchmark portfolio – Value of executed portfolio (interest on margins) + Value of benchmark portfolio – Value of executed portfolio (i.e. interest payments from bonds, etc.) INDIRECT COSTS Cash (Margin) at Clearing House Collateral (Margin) at Clearing House + Value of benchmark portfolio – Value of executed portfolio (interest on default fund contribution) + Value of benchmark portfolio Liquidity to Ensure Funding of Intra-Day Margin Calls Minimum Capital Requirements + Value of benchmark portfolio – Revenues resulting from investment of customer monies Regulatory Capital Requirements Non-Segregation Costs + Value of benchmark portfolio – Value of executed portfolio (interest payments) + Value of benchmark portfolio – Value of executed portfolio (interest payments) Figure 3.6 Categorisation of clearing-related cost of capital Source: Author’s own. capital. 57 The opportunity cost of capital is neither fixed nor directly measur- able; it is generally defined as the difference between the performance of an actual investment and the performance of a desired investment, adjusted for fixed costs and execution costs. 58 Due to the complex nature of this calcula- tion, adjustments for fixed and execution costs are not made in this study. To simplify the terminolog y, the opportunity cost of capital is referred to as ‘cost of capital’. Capital is lodged at the clearing house or tied to the clearing pro- cess for different purposes. These purposes comprise possible default fund 57 Cf. Collins/Fabozzi (1991), p. 29. 58 Cf. Collins/Fabozzi (1991), pp. 27, 28. 90 Clearing Services for Global Markets contributions, margin payments in cash or collateral, liquidity tied to the clearing process or clearing-related funding efforts. For the purpose of this study, the cost of capital related to clearing is defined as the value of an invest- ment benchmark portfolio minus the value of the executed portfolio, 59 if applicable. The cost of capital a clearing member has to bear in compliance with a clearing house’s risk management requirements can be regarded as an offset for the risk assumed by the CCP for the clearing members and for the savings in risk management gained from utilising the services of a CCP. 60 In helping to manage counterparty risk and by providing netting services, CCPs can allow market participants to economise on collateral with regard to what they would otherwise need to hold to ensure equivalent protection in bilaterally cleared markets. 61 A correct calculation of the cost of capital would thus also have to take these aspects into account. Again, due to the complexity of this calculation, its various factors are not explicitly taken into account for the remainder of this analysis. As detailed in Chapter 2 , clearing houses are exposed to a common set of risks that have to be managed effectively. Clearing houses therefore employ three tiers of financial safeguards to control these risks. These safeguards usually consist of a default fund, a margining regime that collateralises the obligations of both the clearing members and their customers and the impo- sition of minimum financial and capital adequacy requirements on clearing members. These risk-management measures translate into cost of capital for clearing members. 62 Generally, cost of capital can be reduced by CCP interest payments on capital lodged at the clearing house or through interest payments from bonds, etc. If applicable, the contribution to a clearing house’s default fund is a one-off fixed payment prerequisite to becoming a clearing member. The appropri- ateness of the clearing fund contribution is re-calculated and readjusted on a regular basis by the clearing house. Different indices can be used to determine the value of the investment benchmark portfolio depending on the type of 59 The value of the executed portfolio refers to the return on investment received by the clearing member for the respective amount of capital tied to certain clearing-related purposes. 60 Further, the opportunity cost of capital clearing members have to bear can also be regarded as compen- sation for the opportunity costs they would have had to bear if they had not used a CCP. Not transacting (i.e. in case of difficult market conditions) represents an opportunity cost. Cf. Collins/Fabozzi (1991), p. 29. A CCP usually guarantees the execution of transactions even under difficult market conditions, thus eliminating these potential opportunity costs. 61 Cf. Knott/Mills (2002), p. 163. 62 Not only clearing members, but also NCMs have to bear the cost of capital related to financial safeguards, i.e. margin collected from the clearing house, and financial safeguards as required by the GCMs. [...]... hold the margin for the eligible positions in separate accounts at their respective CCPs The accounts at each partnering clearing house are treated as though the positions were internally available in terms of margin offsets granted Margin owed is thus calculated separately by each clearing house and each clearing house continues to operate its own risk management programme In the event of a default, a. .. contributions to the clearing fund according to the rules of the home clearing house Depending on the details of the functional link set-up, the away clearing house can be granted privileges that are not available to the regular clearing member firms.131 In this case, the away clearing house becomes a ‘special’ clearing member of the home clearing house, implying that the clearing house is exempt from certain routine... time The basis for the cooperation between the partners is thus not their respective rules and regulations, but a dedicated contractual framework – the clearing link agreement This defines, amongst other things, the responsibilities and obligations of each partner, as well as the risk management approach Each clearing house reflects the positions of the partner clearing house in the form of an omnibus account.136... integration of the partnering clearing houses’ entire value chains, as well as technical and legal harmonisation and integration.145 Figure 3.16 illustrates how globally as well as regionally-to-globally active clearing members benefit from the creation of a Single CCP The way and extent to which a Single CCP affects the VPN is analysed in greater detail in the remainder of the study Note that the provided... not analysed separately For further details on the functioning of mutual offset systems, refer to McPartland (2003b) 108 Clearing Services for Global Markets The different types of links can be distinguished according to the degree to which the systems of the linked CCPs are integrated and whether the obligations of the CCPs to their clearing participants are shifted In the most straightforward type... of the costs normally associated with establishing clearing relationships, links can deepen the liquidity in markets. 125 Should the link truly lead to an increase in volumes generated by members of the away clearing house, the home clearing house is initially unable to partake of these revenues Secondly, the implementation of a link enables members of the away clearing house to clear the additional... on the link structure, the network strategy can lead to an unequal distribution of benefits for the partners Whereas the away clearing house can benefit greatly from a link, as it can thereby offer broadened clearing opportunities to its clearing members, the home clearing house may find itself at a disadvantage The reasons for this are twofold: by extending trading opportunities without imposing all of. .. utilises third-party risk management software and infrastructure, the fees paid for this service are attributed to the cost category ‘service provider charges’ 94 Clearing Services for Global Markets accounts and the calling and calculation of margin requirements78 as well as the ongoing risk monitoring of its customers’ positions.79 Variable costs arise from changes or updates of the risk management system,... strategies, the nature and characteristics of each strategy as well as its impact on the structure of the VPN is explained Figure 3.10 provides a classification of the different network strategies that are analysed in this study Network strategies can be differentiated according to the related degree of value chain, technical and legal harmonisation106 as well as integration.107 Depending on the type of strategy... type of link, one CCP becomes a clearing participant of another CCP without any further integration of systems.’130 When a Clearing Membership (GCM) Model set-up is chosen, each product available for clearing through the link remains under the responsibility of the home clearing house The home clearing house is thus the counterparty in all transactions involving the particular link products The away clearing . portfolio, 59 if applicable. The cost of capital a clearing member has to bear in compliance with a clearing house’s risk management requirements can be regarded as an offset for the risk assumed by the CCP for the clearing. important financial safeguard for clearing houses. The index used to determine the value of the benchmark portfolio again depends on the nature of the margin payments. 64 Generally, the level of margin. minimum financial and capital adequacy requirements on clearing members. These risk-management measures translate into cost of capital for clearing members. 62 Generally, cost of capital can be reduced