We live in a country that prides itself on giving people a ‘fair go’, where competition is encouraged, regulated and enforced, and where the government body responsible for policing competition has as its stated purpose ‘Making markets work for consumers, now and in the future.’
Given this backdrop, the continued existence and government support of ASX as the incumbent monopolist in clearing equities baffles me.
By definition a monopoly is a situation in which a single company, or group, owns all or nearly all of the market for a specific product or service. A monopoly is characterised by an absence of competition and often results in high prices and inferior products.
The result of this monopoly? Australian investors pay significantly more for clearing services.
Larry Tabb, the New York and Boston-based founder of advisory firm TABB Group, nailed it when he recently told The Australian Financial Review that ASX does ‘a very good job of generating revenue but on the flipside, every dollar of revenue for the exchange comes out of someone's pocket, either the broker or the investor.’
That’s right – we all pay. And ASX – which according to its 2015 annual report experienced a 9.2% increase in revenue from its cash clearing services, to $47.1 million– is the beneficiary.
Why should Clearing costs come down?
There are three clear reasons why ASX can and should reduce clearing costs:
1. The default fund
Costs in clearing include providing the default fund, established in 2007, largely as a reaction to the GFC. It was largely funded by industry money, with $71 million in interest from clients’ trust fund accounts given to ASX to ‘seed’ the fund.
ASX is effectively charging brokers to use the industry’s own money in the default fund.
ASX cannot say it’s a risk premium because as brokers, we have capital risk requirements such as Rule S1, which requires us to have a certain amount of capital and liquid capital, which must be calculated/reported daily.
Add to that, Cash Market Margining (CMM) that was introduced by the ASX post GFC. All brokers have to put up a % of settlement funds upfront on T+0 in their Austraclear account; this reduces capital risk and exposure to ASX Clear.
Both CMM and Rule S1 reduces ASX’s settlement and risks, and the cost of capital is on us
2. The move to T+2
The industry is moving to T+2 in March 2016. As a result, the capital risk for ASX actually halves:
T + 3 capital risk
T + 2 capital risk
1 days’ worth trading for 3 days
1 days’ worth trading for 2 days +
1 days’ worth trading for 1 days +
= 6 units of risks
1 days’ worth trading for 2 days +
1 days’ worth trading for 1 days +
= 3 units of risks
Therefore T+2 should arguably bring down clearing costs by 75%.
As capital risk will halve with T+2, so too should the required size of the default fund halve. It should be reduced from approximately $170 million today to $85-90 million; the industry funded component (~$71 million) makes up around 80% of the default fund.
This begs the obvious question – why should the ASX charge brokers and investors such a high rate to use their own capital in the default fund?
3. Fully computerised service
Clearing is now fully computerised – this should significantly reduce the cost base.
Chi-X CEO John Fildes outlines these issues perfectly in my recent chat with him. Watch below:
An industry-wide concern
It’s not as though this issue isn’t on the radar.
Following a review in 2012, the government decided in Q1 2013 not to allow competition in clearing for a two year period, due to end Q1 2015. During this two year moratorium, ASX was required to take specific steps so the outcomes delivered by ASX Clear could be compared to those that might be achieved if competition were present.
In 2014, an independent report commissioned by a group of Australian equity clearing participants was published. The International Transaction Cost Benchmarking Review found that clearing and settlement costs in Australia are high when benchmarked across other global markets.
It found that in markets where there are dominant, vertical, for profit infrastructures, such as ASX, clearing costs tend to be at the highest level; in markets where there are competitive or utility run models, costs tend to be at their lowest.
In 2015 Assistant Treasurer Josh Frydenberg announced that the Council of Financial Regulators (CFR) would conduct a review of competition in the clearing of Australian cash equities as a follow up on the 2012 review.
Twenty submissions were received by the CFR, eight of which are publicly available [could link to the submissions]. We await the outcome.
There are viable alternatives to a vertically integrated monopoly:
1. Introduce competition
The Australian market generally isn’t considered big enough for competition in equities clearing, particularly now that the government is imposing rules that force the clearing of equities to be done in Australia, even though it has allowed the clearing of OTC derivatives to stay global. This has paved the way for London Clearing House (LCH) to provide competition to ASX in this sector.
When it comes to clearing equities, the revenues don't justify the investment for a potential provider, such as LCH, when it has to operate as a domestically incorporated entity, and therefore can't leverage its global model.
Effectively, government regulations have made competition in equities clearing unviable.
2. Clearing as a separate entity or utility structure
In the US a single, horizontal, utility model operates for clearing and settlement for equities; it is provided as a not-for-profit industry utility, which has facilitated the creation of competing venues. The effectiveness of the utility structure is evident in the very low cost.
This horizontal utility model was established prior to the demutualisation and listing of any US exchange. Is it too late to adopt this model in Australia?
3. ASX Clearing to be run as a separate entity by the ASX
In Canada, where the cost of clearing is significantly lower, the exchange owns the clearing house. However, the regulator requires separate governance, access controls and pricing controls.
Under this model, ASX Clear would be run separately from the rest of ASX, with its own governance structure and a board that includes representatives from clients and independent members. This separation would ensure fair access and predicable pricing decisions for all market participants.
4. Applying new technology
An more dramatic option to reduce costs may be to apply new technologies to the problem. This train of thought is centralised around the blockchain, a distributed ledger of information. Many Exchanges are exploring the potential of using blockchain right now, including ASX (see recent article). This approach also introduces additional future benefits including the ability to offer crytosecurities.
Whatever the solution, an unregulated monopoly is not the answer. Will a single infrastructure model, run on a for-profit basis, create the optimum risk management model and lowest costs for the whole market? The status quo says not.
It may come down to either a formal separation of ASX Clear or greater regulatory oversight of the present monopoly. The results of the current review, due to be released ‘any time now’ will provide clarity, but will it provide an equitable outcome for investors and brokers?
Is it a big deal? Every basis point saved in trading improves investment returns. Over time, the compound effect of this can be significant.