Professor Peter Swan

The prospective entry of the London-based LCH Clearnet to break ASX’s monopoly of clearing house activities is great news for Australian investors and brokers alike. It seems likely that the bid to break the ASX monopoly will be approved by the Australian Securities and Investments Commission (ASIC) and the Australian Treasurer (see Bianca Hartge-Hazelman’s AFR story). The clearing and settlement process for derivatives, cash and shares is a crucial component of trading activity. Clearing provides the critical assurance that trades will settle, removing the counterparty risk via a third-party guarantee in exchange for a fee.

Incumbency of the clearing and settlement process, like incumbency in terms of the trading mechanism, confers considerable advantage to the Australian Securities Exchange (ASX). The much heralded entry of Chi-X, providing competition in trading, has resulted in negligible loss of market share to ASX. This is testimony to ASX’s preparedness for Chi-X entry, reflected in lower fees and revamping of ASX’s trading system, as well as natural monopoly advantages.

In contrast, entry into the London market imposed serious market share losses to the London Stock Exchange (LSE) even though the incumbent’s loss of profits was far less than its market share loss with competition increasing the overall size of the market.

Clearing and settlement, as embodied in the ASX CHESS system, probably has some natural monopoly elements, although not as much as in the trading system. Hence, entry of competitive clearing house providers is unlikely to lead to any catastrophic loss of ASX market share in the short-run but will put considerable downward pressure on ASX fees in a business segment generating 15% or more of ASX revenue. Lower fees will encourage greater trading volume and liquidity.

As the ASX loses more statutory protection against entry in different areas of its business, it is going to be forced to become more innovative and competitive if it is to survive as other than a target for predators.

Its business model in recent years has been to give in to major brokers demanding less transparency and openness. Thus, in November 2005, the ASX decided to conceal broker identities in the limit order book, making it far harder for traders to find suitable counter-parties. I believe that such opacity is one of the reasons that some brokers describe the current ASX market as ‘dead’ with much less willingness for parties to trade.

Similarly, in the area of corporate governance recommendation for listed companies, the ASX has looked after the bid end of town via promotion of the rather strange idea that companies should be run with boards dominated by a majority of ‘independent’ non-executive directors (NEDs).

In practise, this means that companies are ‘monitored’ by part-timers largely ignorant of company affairs and typically recruited from outside the industry with little if any ‘skin in the game’ or alignment with shareholders. No wonder the performance of many large companies with large boards (Rio is an example) has been exceedingly poor in recent years.

Under the ASX’s non-binding governance rules, Gina Rinehart would not qualify as an ‘independent’ director if she were to join the Fairfax board as she owns more than 5% of the stock. Whatever one thinks of Gina Rinehart, rules that discourage incentivised board members are a national disgrace.

Within the top ASX 200 companies, firms with above average sized boards have on average a 50% lower market to book ratio than do firms with below average sized boards. Hence, it would seem that management is far less constrained and need not act in shareholder interests when boards are large and consist of part-timers with only weak alignment with shareholders.

The raison d’etre of the ASX board in recent years has been to try to sell itself to the highest bidder, even when that bidder, the Singapore Stock Exchange, has a dismal record in comparison with its peers, rather than trying to improve its own performance.

Clearing and settlement, and in particular, the ASX dominance of this activity, is one of those issues that led the Foreign Investment Review Board to reject the Singapore bid last year. I am sceptical that one or two entrants into clearing activity would of itself lead to a change of heart by the regulator. However, if there were to be thriving competition in clearing and settlement, together with a lot more competition in trading, and an overseas bid without close foreign government ties (unlike the Singapore bid), then the regulator is likely to be much more forthcoming.

Professor Peter Swan is the Professor of Finance at the Australian School of Business. This article first appeared in the Australian Financial Review.