01 October 2011

LSE to Acquire LCH.Clearnet

The London Stock Exchange has won a bidding war with Markit, a data firm, over control of LCH.Clearnet, a clearinghouse.

A clearinghouse [or "clearing house" -- both forms are in common use] is the entity within an exchange mediated transaction that ensures each party against the default of the other. Joe buys asset X through an exchange, while Jane sells an equal quantity of asset X through that exchange.  There is always a risk that the deal will not "settle," that (to put it crudely) Joe's check will bounce.

But it doesn't matter to Jane if Joe's check bounces. She'll never know, She has sold asset X through the exchange, and the exchange, through its contract with the clearinghouse, will see to it that she is paid the agreed-upon amount.

The clearing house requires that market participants make a sort of deposit, known as a performance bond or margin. A margin amount might be, say, 5 percent of a contract's underlying value. By requiring margins, or contractually requiring that the exchange require margins, the clearing house ensures that only financially solvent parties participate in the exchange activities, thus limiting its own risk.

This is a critical difference between exchanges on the one hand and over-the-counter markets on the other. OTC markets have no central clearing. If you enter such a market, you take upon yourself the "counter-party risk" that you'll make a deal that won't settle.

Anyway, there has been a good deal of debate over the years as to whether clearing operations should be internal to an exchange, or whether they should be independent entities, at arm's length from the exchange.  Over time, though, independent clearinghouses have been captured by one or the other of the great exchanges, or at least they now have the same holding corporations that one or more of the exchanges they service has.  Thus, it is a matter of some significance, it is a landmark, that a rare still-independent clearinghouse has now fallen captive.

Cheers, then, to LCH, and its now-vanishing days as an independent body.

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