NO 228 – FEBRUARY 2012
Clearing at the crossroads

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WFE Focus January 2012
Clearing at the Crossroads
Matthew Harrison
SVP/Head of Research & Corporate Development HKEx

Recent regulatory and market developments have thrust clearing houses into the limelight. In this brave new world, traditional clearing practice will need to change.

Within the exchange world, the clearing function has tended to be seen as unglamorously back office. However, that is changing. A welter of regulatory, business and market developments are pushing clearing to the fore.

The Group of Twenty nations (G20)’s call after the 2008 financial crisis for all standardised OTC derivatives to be centrally cleared gave a boost to central counterparty (CCP) clearing. The crisis also threw up incidents which tested CCPs’ strength. Higher standards proposed by the Bank for International Settlements (BIS)’s Committee on Payment and Settlement Systems and the International Organisation of Securities Commissions (CPSS/IOSCO) will require CCPs to tighten their risk management. And among exchanges themselves there has been growing realisation of the business potential of clearing.

This article discusses how these and other developments are impacting the CCP clearing function and how CCPs may need to adapt.

Clearing OTC derivatives
Perhaps the biggest development is the G20 mandate for OTC derivatives to be centrally cleared. OTC derivatives are bilateral privately-negotiated contracts the value of which is based on an underlying asset such as a commodity, security, interest rate or index. Exchange-traded derivatives are standardised in terms of contract specifications, and are cleared in a CCP; OTC derivatives are customised to the needs of the counterparty and are mostly cleared bilaterally between the players concerned.

The OTC and exchange-traded markets are interrelated. New products tend to develop first in the OTC market and move to the exchange market as they become more commoditised and liquid. OTC derivatives players often use exchange-traded derivatives to hedge their exposures. And OTC derivatives can also be centrally cleared via a CCP.

The G20 mandate
Concerned over the role of OTC derivatives in such incidents as the collapse of AIG, the G20 has called for OTC derivatives to be moved en bloc onto centralised platforms.

“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest… Non-centrally cleared contracts should be subject to higher capital requirements.”1

This is an ambitious goal. However, in fairness to the G20, a substantial proportion of the dealer-to-dealer OTC derivatives market was already being centrally cleared on a voluntary basis. By mid- 2010, 47% of interest rate swaps (IRS), 22% of multi-name credit default swaps (CDS), and over 20% of OTC commodity derivatives were being centrally cleared2, principally through LCH.Clearnet Limited and ICE Clear. Since then, further progress has been made, particularly in respect of CDS. But moving the entire standardised market to CCP clearing remains challenging.

Legislative implementation
Policy-makers are moving to implement the G20 declaration in local legislation. The US Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) of July 2010, provides among other things for the registration and regulation of swap dealers and swap execution facilities (SEFs), and for central clearing of OTC derivatives. Many swaps have to be cleared and exchange-traded, although swaps with end-users are exempt.

In September 2010, the EU Commission published the proposed European Market Infrastructure Regulation (EMIR). All financial counterparties’ eligible OTC derivatives contracts with another financial counterparty are to be centrally cleared, and all (cleared and uncleared) transactions are to be reported to a trade repository or regulator. Non-financial counterparties must clear and report transactions only if a threshold is exceeded. CCPs must have open and transparent admission criteria, and accept eligible contracts regardless of execution venue; they are subject to governance and procedural requirements, eg CCPs must be able to port positions from one participant to another. National insolvency laws are to be disapplied.

Other jurisdictions such as Japan, Australia, Hong Kong, are consulting on potential regulation. However, global progress towards mandatory central clearing has been slower than hoped. As of October 2011, the Financial Stability Board (FSB) states that, “only the United States has enacted legislation and is actively working on the detail of the implementing regulations. While the European Union… has set out the direction of its regulatory framework, it does not anticipate having legislation in place before 2013. Most other jurisdictions have not yet made basic decisions about regulatory measures, including whether any regulatory action will be taken.”3

Concerned over the role of OTC derivatives in such incidents as the collapse of AIG, the G20 has called for OTC derivatives to be moved en bloc onto centralised platforms.

Operational challenges
The transition to central clearing is challenging not only for regulators but also for CCPs. Although the final objectives of exchange-traded and OTC clearing are the same, there are many differences of process and approach. OTC transactions are by their nature more customised to the user’s needs, albeit that the International Swaps and Derivatives Association (ISDA) has introduced a degree of standardisation in OTC documentation and procedures and market practice tends to converge around key tenors and transaction sizes. While the exchange-traded market tends to be a ‘captive’ market (although Europe is seeing increasing inter-clearer competition and/or interoperability requirements, particularly in the cash market), CCPs entering the OTC clearing market face more competition. And while the exchange-traded market is usually dispersed among many broker-dealers, certain OTC derivatives asset classes are highly concentrated among a few major banks, the so-called Group of Fourteen (G14)4. Accordingly the OTC clearing house faces a near-oligopoly, and must make proactive efforts to win over its client base and tailor its pricing and services, while likely having to accept lower returns. Given, in particular, the active participation expected of members in handling a default, the clearing house may need to admit members into its risk and default committees. Nonetheless, the introduction of CCP clearing may help broaden access to and perhaps ‘democratise’ the OTC derivatives market.

Geographical challenges
While the OTC derivatives market is global, clearing houses are local, grounded in local regulation and insolvency law. If regulators feel that IRS in their respective local currency5, or CDS concerning their respective local institutions6 are systemically important they may require such contracts to be cleared at home so that collateral and default fund contributions will be protected by local insolvency law and they as regulators can oversee the default process. While this improves default management, it also raises the prospect that the global OTC market may become localised. Localised markets may be less liquid and less able to serve end users such as large multinational corporations – albeit that the equity markets while localised do manage to serve large corporations.

Interoperability among CCPs could be a way to overcome the disadvantages of mandatory local clearing. However, introducing an additional CCP into the transaction chain requires additional collateral to offset the bilateral risk between the CCPs. The CCPs may have different risk management standards and their respective jurisdictions different insolvency laws. Too zealous a pursuit of interoperability might add to systemic risk.

Clearing house OTC offerings
Notwithstanding slow development of the legal framework globally, at business level clearing houses are stepping up to offer their services. Some 23 current and prospective OTC derivatives clearing houses are listed in table “Clearing houses for OTC Derivatives.

the introduction of CCP clearing may help broaden access to and perhaps ‘democratise’ the OTC derivatives market.

Active OTC CCP highlights
Business activity tends to be concentrated in a few houses. CDS in the US are served mainly by ICE Clear Credit and CME Clearing, and in Europe by ICE Clear Europe. In IRS, LCH.Clearnet Limited and CME Clearing (US) dominate. In commodities and other asset classes, CME Clearing’s Clearport, ICE Clear and NYSE Liffe’s Bclear are ahead.

Because of their different risk profiles and participant groups, IRS and CDS tend to be ring-fenced from other asset classes. So ICE has a separate clearing house (ICE Clear Credit), for its US CDS clearing business, while in Europe CDS are cleared through ICE Clear Europe but with separate guarantee fund and participantship requirements. CME Clearing US has separate guarantee funds and separate participantship requirements for IRS and CDS respectively, although these products are cleared alongside other OTC derivatives in the same clearing house. LCH.Clearnet Limited has a single guarantee fund and single clearing house which accepts IRS alongside other products; however the participantship requirements and guarantee fund contributions for IRS are different.

CCP capital requirements for participants clearing other OTC derivatives are similar or the same as those for clearing exchange-traded derivatives, eg US$5 million adjusted net capital in the case of CME Clearing (US) and ICE Clear US. For IRS, however, CME Clearing’s requirement is US$5 billion of Tier 1 capital for a bank and US$1 billion for a non-bank. For CDS, requirements are of similar magnitude – CME Clearing (US) requires a non-bank to have US$0.5 billion of capital; LCH.Clearnet SA requires capital of EUR 3 billion (compared with EUR 25 million for a general clearing member (GCM) in exchange-traded products). In this context, it is noteworthy that the US Commodity Futures Trading Commission (CFTC) has proposed a US$50 million cap on the minimum membership capital requirements that may be imposed by CCPs – an amount two orders of magnitude smaller than CME Clearing’s requirement for IRS participantship.

Participant guarantee fund contributions for CDS and IRS also tend to be larger. CME Clearing US requires IRS and CDS participants to contribute at least US$50 million to their respective guarantee funds, while the minimum contribution to the Base Guarantee Fund (for exchange-traded and other OTC products) is just US$0.5 million. For Eurex Credit, the CDS Clearing Fund contribution is EUR 50 million, compared with EUR 5 million for GCM contribution to Eurex Clearing’s Clearing Fund for exchange-traded products. LCH has a somewhat lower Default Fund requirement for IRS (SwapClear) participants of £2 millon.

The aim of Basel III is to make banks more resilient and to mitigate systemic risk in the sector.

Banking regulation – Basel III
Although the implementation of Basel II is still in progress (to be completed by 2015), Basel III was issued finally in December 2010, with legislation to be in force by end-2012, and implementation thereafter. The aim of Basel III is to make banks more resilient and to mitigate systemic risk in the sector. The quality and quantity of bank capital are boosted, leverage is restricted, and a counter-cyclical capital buffer is introduced. To support the G20 mandate for CCP clearing of OTC derivatives, bank trading exposures to CCPs (ie margin) attract a reduced capital weighting of 2%, and bank default fund exposures a weighting calculated on a risk-based formula; bank OTC bilateral exposures attract a higher weighting.7 Where margin is posted to a bankruptcy-remote custodian, no risk capital weighting applies.

Although the 2% capital weighting for margin exposures is low, under Basel II the weighting was zero. The exemption for bankruptcy-remote margin is unlikely to be applicable for most CCPs. It will also be harder for bank participants to calculate the weighting applicable to their CCP default fund exposures.

In March 2011, CPSS/IOSCO issued its consultation report, Principles for Financial Market Infrastructures, which includes proposed enhanced principles of risk management for CCPs. The 24 principles, if approved as proposed, will substantially raise standards. One key change is the requirement for CCP resources to be sufficient to cover the simultaneous default of the one/two participants (still under debate) plus affiliates (previously, one) that would potentially cause the largest credit exposures – and the resources are to be fully funded (previously replenishment rights could be included) (Principle 4). There is also extensive guidance on stress testing, and reverse stress-testing, to gauge the sufficiency of the resources (Principle 4). Other changes include, CCPs covering their credit exposures to participants through an effective margin system for all products (some clearing houses have not previously margined their cash markets) (Principle 6); CCPs conducting money settlement in central bank money where practical and available (Principle 9); CCPs having rules to enable the segregation and portability of customer positions and collateral (Principle 14).

Submissions8 to this consultation express mixed views. A recurrent theme is that proposals that are too specific may conflict with local requirements; clearing houses should be permitted to make more use of their judgment, in concert with their respective regulator9. Concern is expressed at the cost of the proposals to market users10. There is disquiet at the report’s silence on the inclusion of assessment powers (replenishment rights) in default resources11. There are queries about the practicality of segregating client funds12, and whether the clearing house has the ability to oversee such segregation13. Respondents suggest that the proposals to broaden CCP access and facilitate inter-CCP linkages14, and to moderate collateral haircuts in difficult markets15 (in order to avoid further destabilising those markets), tend to jeopardise the safety and security of the CCP, which should be of paramount concern. Respondents also draw attention to the lack of guidance on handling the default of the clearing house itself16.

On the basis of these proposals, many clearing houses would have to change their practices substantially, and costs would rise.

Whether by accident or design, exchanges exhibit a variety of business models with respect to their clearer.

Clearing as a business
Whether by accident or design, exchanges exhibit a variety of business models with respect to their clearer. Some exchanges are vertically-integrated owning 100% of their respective clearing houses (Deutsche Börse, HKEx, SGX, etc.) or a controlling stake (Tokyo Stock Exchange). Some exchanges have a minority stake in a collective (LSE and LME have stakes in LCH), while others have no ownership interest;

yet others have relationships with more than one clearer (SIX Swiss Exchange). As exchanges become more commercial and competitive, they increasingly recognise the importance of controlling their clearing function. By the same token, exchange users and regulators are wary of the higher pricing that may come with the vertically-integrated model.

Vertical integration is under pressure in Europe. Nonetheless, exchanges at present without a CCP are showing interest in acquiring or developing one. LSE Group has declared its interest in clearing (it already operates a clearer in Italy). The London Metal Exchange has also stated its intention to set up its own clearer. And there have been a succession of bids for LCH.Clearnet Group itself.

Market incidents
Clearing houses generally came through the 2008 financial crisis well. On the collapse of Lehman Brothers (September 2008), LCH.Clearnet Limited managed the close-out and/or transfer of 66,000 Lehman IRS positions with a notional value of US$9 trillion without touching its Default Fund17; the Depository Trust and Clearing Corp (DTCC) resolved Lehman’s substantial US portfolio with similar success.

Nonetheless, the collapse of MF Global (October 2011) has underlined the need for further progress in protecting client collateral. At time of writing, it appears that up to US$1.2 billion of client collateral, supposedly secure in segregated accounts, remains unaccounted for. This perhaps validates CPSS/IOSCO’s insistence on segregation; nonetheless, as submitted by respondents to the consultation, there remain limits on the ability of the clearing house to oversee the segregation process.

If CCPs are to enjoy central bank support, logically they should be regulated by the central bank, in addition to, or instead of, the securities commission.

Systemic importance
What happens if the clearing house itself fails? In case of liquidity shortfall, one remedy would be for the clearing house to be granted access to central bank money in return for posting of collateral; this may require change to local legislation which normally reserves such access for banks. (The CPSS/IOSCO call for CCPs to conduct money settlement in central bank money, noted above, is a separate matter but may also require legislative support.) In case of CCP insolvency, it would normally be for the government to provide bail-out funds, or oversee the restructuring of a failed CCP in its jurisdiction. This is a delicate issue, as government backing for CCP operation risks creating moral hazard.

If CCPs are to enjoy central bank support, logically they should be regulated by the central bank, in addition to, or instead of, the securities commission. CCPs would then become subject to external capital and liquidity requirements, perhaps similar to those of banks or to those to which CCPs subject their own participants. In some jurisdictions, notably Australia, the UK and, post-Dodd-Frank, the US, the central bank already has supervisory authority over the CCP.

Impact on clearing houses

Where do all these changes leave CCPs? Key impacts are the following.

  • OTC derivatives clearing is a new business opportunity, but it is very competitive with different practices and risks. A new CCP or a separate risk capital pool may be needed.
  • Collateral will be increasingly scarce. OTC derivatives trades were in the main not subject to initial margin; now with CCP clearing collateral will be required. CCPs will need collateral-friendly margining policies, allowing margin offsets and accepting a wider range of instruments, not merely cash. Collateral management, either self-provided or via a custodian bank, would become important.
  • Interoperability among CCPs will be expected; the mapping from exchanges to CCPs from being one-to-one will increasingly be many-to-many.
  • Cross-margining between CCPs may be needed if fragmentation of the OTC derivatives market is to be avoided.
  • Governance. CCPs clearing OTC derivatives may need to allow more user representation in their governing committees.
  • Segregation and portability of client positions and collateral needs to be strengthened.
  • CCPs will increasingly be recognised as systemically important, and may be supervised by their respective central banks.

The reforms may impose frictions on the market process initially, but further refinement and the ingenuity of the players should help restore efficiency in the new world order.

The CCP clearing function is on the threshold of change. The financial crisis has created new opportunities, but there are also new constraints, and competition is increasing. The final shape of proposed regulatory changes is not yet clear, but CCPs are likely to have to margin all products, including cash; to find more margin offsets to relieve the collateral shortage; to accept interoperability, and possible cross-margining, with other CCPs; and to better protect client collateral. As institutions of increased, if not systemic, importance, all CCPs will be under the more watchful eye of their regulators. And a more participatory and independent CCP governance structure will add to the challenge.

Systemic risk should reduce; OTC derivatives risk, in particular, should be better managed and diversified away from the G14 banks. But all parties will have to work harder to keep down costs and optimise the use of scarce capital. The reforms may impose frictions on the market process initially, but further refinement and the ingenuity of the players should help restore efficiency in the new world order.

About Matthew Harrison

A UK-trained accountant, now essentially a policy researcher and internal consultant. Has been with Hong Kong Exchanges and Clearing (and prior to that the Stock Exchange of Hong Kong) since 1993, mostly in research, planning and development roles. Conducts studies and surveys of Hong Kong, Mainland China and global exchange and regulatory development. 

Leaders' Statement, G20, Pittsburgh Summit, section 13.2 Implementing OTC Derivatives Market Reforms, Financial Stability Board (FSB), 25 October 2010.
Implementing OTC Derivatives Market Reforms, Financial Stability Board (FSB), 25 October 2010.
OTC Derivatives Market Reforms – Progress report on Implementation, FSB, 11 October 2011, pages 1 to 2. 4 To be renamed 'G16' – G14 dealer group adds two members,, 1 December 2011.
To be renamed 'G16' – G14 dealer group adds two members,, 1 December 2011.
Australian regulators are proposing that Australian dollar interest rate contracts are cleared in Australia (Central Clearing of OTC Derivatives in Australia, Council of Financial Regulators, June 2011).
Japanese regulators are imposing local clearing on credit default contracts, OTC Derivatives in Japan – Clearing and Related Developments, Clifford Chance Client Briefing, April 2011.
Capitalisation of bank exposures to central counterparties, Consultative Document, BIS, November 2011.
Public Comments Received to Consultation on Financial Market Infrastructures Principles, Report of the Committee on Payment and Settlement Systems and the Technical Committee of IOSCO, 9 September 2011. (CPSS/IOSCO Submissions)
Eg by ISDA, page 2; CCP12, page 6 (CPSS/IOSCO Submissions, ibid)
By CCP12, page 6 (CPSS/IOSCO Submissions, ibid).
Eg by CME Group, page 8 (CPSS/IOSCO Submissions, ibid).
Eg by CCP12, page 14; CME Group, page 12-14 (CPSS/IOSCO Submissions, ibid).
Eg by Eurex Clearing, page 21(CPSS/IOSCO Submissions, ibid).
Eg by LCH.Clearnet Annex, page 5 (CPSS/IOSCO Submissions, ibid).
LCH.Clearnet, page 2 (CPSS/IOSCO Submissions, ibid).
Eg LCH.Clearnet, page 3; ISDA, page 3 (CPSS/IOSCO Submissions, ibid).
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