The recent rise in vertical integration models, including those in which an entity operates as a clearinghouse and a futures commission market, was highlighted in a panel discussion on the changing face of clearing at FIA’s Boca conference on 11 March.
While companies in the crypto world, such as Binance and Crypto.com, run multiple services under one roof, the futures market has depended on a system where trading, settlement and clearing and intermediation have been divided among independent entities.
That began changing a few years ago when MIAX, the parent company of several options exchanges and a futures exchange, acquired Dornan Trading, a small FCM. Coinbase, one of the largest companies in the crypto markets, bought a futures exchange and received permission to set up an FCM, while the now-defunct cryptocurrency trading venue FTX applied to allow direct access to its clearing services.
These moves prompted CME Group, the largest futures exchange in the US, to seek regulatory approval to set up its own FCM. Although CME has not gone beyond acquiring the licence, the overall trend has raised concerns about the blurring of traditional dividing lines between the different functions within the industry.
At the time of CME’s application, clearing members expressed concern about the disintermediation and the heightened systemic risks created by concentrating multiple market functions under one organisation.
The move has proved to be a thorny issue because the US legal system allows exchanges to have quasi-regulatory powers as designated self-regulatory organisations, which includes overseeing FCMs. DSROs help protect customer funds and ensure clearing members comply with CFTC and exchange rules and regulations. CME is one of the industry's largest DSROs, and one of the concerns about its FCM licence is the potential for a conflict of interest.
“Conflicts of interest present themselves when you have a clearing member affiliated with a CCP when you're talking about a default management scenario, for example. I'd say the same thing applies if you're talking about an exchange having an affiliated market maker. I do have concerns about going further down the vertical integration route,” said Stephen Berger, managing director, global head of government and regulatory policy at Citadel.
Speaking on the panel, Suzanne Sprague, CME Group’s chief operating officer and global head of clearing, said the decision by CME to apply for an FCM licence was a strategic one.
“We did apply for and have been granted an FCM licence. That was really a defensive move as market structure is evolving, and over the last couple of years, more of these vertically integrated models have been coming to market. We think it is important to prepare for market structure change,” she said.
“That said, we do think FCMs play a very critical role in the ecosystem, and for us, it's about applying the same standards from a risk management approach, regardless of market structure.”
Allaying concerns from market participants about a conflict of interest, Sprague said CME has no plans to be its own DSRO.
“We are all responsible for managing conflicts of interest, and this is an example where you should not be regulated by yourself, and so for our own FCM, we do not envision being the DSRO. I agree that it would not be appropriate for a self-regulatory organisation to be the primary overseer.”
Sprague also pointed to efficiencies that can be gained from the structural shift.
“It is important to point out that there are efficiencies that can be gained through a vertical integration model in terms of having exchanges and clearinghouses evaluate what type of margin offsets, for example, can be given across correlated products. More of the discussion now is focused on the FCM space as well.”
Other panellists pointed out that any vertical integration model must be strictly controlled.
“The key thing here is that management in terms of arm’s length decision making, default triggering, margin sizing…all of these considerations will have to be strictly governed and managed,” said Mark Bortnik, managing director, global head of futures and OTC clearing at Morgan Stanley.
Also speaking on the panel, Kristin Johnson, a commissioner at the Commodity Futures Trading Commission, said the agency has been carefully thinking about vertically integrated models from a variety of perspectives.
“One is the need to manage conflicts of interest. A DSRO that performs certain examination responsibilities over an affiliated FCM clearing member does raise a number of questions for us,” Johnson said. “We want to be sure that we have crafted rules that effectively ensure that the same risk is being addressed by the same rules, or potentially modified rules, where the structure involves an affiliated entity.”
Susi de Verdelon, the newly appointed CEO of LCH Ltd, said that applying for an FCM licence is not something that the clearinghouse is considering.
“From our perspective, when we look at how we serve our clients, we think about whether something is additive to the overall mix. An FCM inside our group is not something that's met our additive test, and so it's not something that we're considering. We've seen that we can serve our clients and the open access model very well, and we can deliver efficiencies as a CCP stand-alone.”
Meanwhile, Citadel’s Berger said that he is more excited about horizontal expansion than vertical integration. “CME, for example, added interest rate swaps 15 years ago, and is now in the process of adding cash Treasury clearing capabilities. LCH is going to be clearing dollar rates futures from FMX within its clearing ecosystem. As a market participant, that's what I'm more excited about – the evolution of clearinghouse offerings, not vertical integration in this business.”
