Central counter party clearing - The future of processing OTC transactions
The global derivatives market is a main pillar of the international financial system and economy. As an indispensable tool for risk management and investment purposes, derivatives are used by more than 94 percent of the world’s largest companies.1) They contribute to improving operational, information, price, valuation and allocation efficiency, thus substantially increasing the efficiency of financial and commodity markets.2)
Derivatives help lower the cost of capital and enable firms to effectively invest and channel their resources. These factors are an important driver of economic growth.3) Europe – as the most important region in the global derivatives market – stands to benefit immensely from the positive impact of derivatives.4)
Derivatives are traded in one of two ways: either over-the-counter or on regulated markets, i.e. on exchanges. Exchange-traded derivatives are fully standardized whereas most OTC derivatives are customized contracts between two trading parties.
The OTC segment accounts for 90 percent of the market in terms of notional amount outstanding.
Here, the market volume is split equally between bilateral trading among market participants and multilateral trading, i.e. trading across a number of different market participants on organized marketplaces) such as interdealer-brokers or electronic crossing networks.
Approximately one-third of the market’s notional is cleared via central counterparties (CCPs), which consolidate and manage risks. Exchange-traded derivatives are always cleared centrally with CCPs, thus ensuring the full collateralization of open risk positions and guaranteeing the fulfillment of contracts. For OTC derivatives that are not CCP-cleared, risks are partially mitigated through bilateral collateralization, i.e. the pledging of assets to secure fulfillment of a transaction.
Regulatory initiatives like the European Market Infrastructure Regulation (EMIR), Dodd-Frank Act, Basel III or the MIFID review will have significant impact on the future market structure for trading and clearing of derivatives. In the near future efficiency and protection will play an even more important role under these new regimes for participants of financial markets.
Eurex‘ s Wholesale Facilities for OTC Derivatives Clearing
Today, Eurex Clearing is the leading European clearinghouse processing transactions across a growing range of asset classes and products including securities, derivatives and energy. A significant business is cleared in futures and options on Euro-denominated interest rate, equity and equity index products. Products cleared are not only traded on-exchange, but also bilaterally agreed and registered for clearing via our wholesale facilities.
Eurex wholesale trade entry facilities enable participants to enter bilaterally agreed transaction into the Eurex® system for clearing and risk management. With these facilities one can benefit from the flexibility of customized trading and the advantages of standardized clearing and settlement.
The following provides a brief overview of the wholesale facilities available:
The importance of offering trade entry facilities for bilaterally agreed transactions is confirmed by its steady and increasing usage:
- In 2010, Eurex Clearing cleared a total volume of about 1.9 billion contracts - thereof 0.7 billion via our wholesale facilities.
- The Single Stock Futures wholesale segment saw the strongest volume increase where the total volume rose by 55 percent to more than 133 million traded contracts (year-to-date, May 2009 versus 2010).
- May 2010 was a record volume month with almost 130 million contracts traded using the Eurex Wholesale Trading facilities.
Development Wholesale Trading Volume (in Million Contracts)
Below, two functionalities are described allowing for more flexibility in trading at more safety thus novating exchange-look alikes and customized contracts with Eurex Clearing, Europe leading clearing house.
Block Trade Facility
The Block Trade facility supports the bilateral, off-exchange trading of standard Eurex products. Buyers and sellers can enter the trades into the Eurex System, for which they previously arranged price and quantity with each other.
The Flexible Contracts facilities support off-exchange trading of tailor-made futures and options contracts. This allows traders to customize their trades to meet their individual needs. Eurex products across various asset classes are offered via the Flexible Contracts facility. The minimum trading size for Flexible Contracts is identical to the Block Trade size of the respective product.
Market participants can design Flexible Futures by selecting:
- Flexible Maturity
Participants of a Flexible Futures trade can create their own maturity date for the transaction. Individual maturity dates can be as early as the next exchange day or as far out as the maturity date for the most distant respective standard futures listed on Eurex.
- Settlement Type
Similar to the Flexible Options facility for individual equities, Flexible Futures give Members, in most cases, the ability to negotiate the terms of settlement for Single Stock Futures (cash settlement or physical delivery).
Market participants can design Flexible Options by selecting:
- Exercise Price
The exercise price can be freely defined between the highest exercise price of the regular option series and the lowest exercise price of an option (e.g. LEPOs); maximum exercise prices are limited to 2.5 times of the highest available standard expiries in the respective product.
- Expiration Date
The expiration date can be any exchange day (with some special Eurex defined exceptions) starting from the next exchange day until the longest currently active standard expiration date of the respective product.
- Exercise Style
American-style (exercise on any exchange day during the lifetime of the option) or European-style (exercise only on the Last Trading Day of the option) can be specified.
- Settlement Type
The settlement type of Flexible Options contracts is arbitrary. For Flexible Options trades (equity and ETF options) at time of conclusion Eurex Members can choose to settle their trades either with cash or with the physical settlement type available for the product.
The block and flexible contracts facilities are available for a broad range of products. Amongst other they include:
- Fixed Income Derivatives
- Equity and Index Futures and Options
- Dividend Futures
- Exchange Traded Funds derivatives
- Commodity Derivatives
Eurex Clearing’s underlying equities currently include a wide range from the following countries: Austria, Belgium, Great Britain, Netherlands, Finland, France, Germany, Italy, Russia, Spain, Sweden and Switzerland.
In light of the financial market turmoil, politicians, regulators, market participants and many others recognize the growing importance of central counterparties (CCP) in reducing systemic risk. Central clearing services are the most effective way to mitigate existing counterparty risk in OTC derivatives and to improve market transparency. At Eurex Clearing, we believe that strengthening financial market integrity for the European market is of common interest to all stakeholders because this will also contribute to improved market stability on a global scale.
Eurex Clearing has valuable experience in supporting the idea of transparency and safety by providing a complete range of advanced risk management and clearing services to Eurex, the Frankfurt Stock Exchange (including the Xetra® cash market), Eurex Bonds, Eurex Repo, the European Energy Exchange and other securities exchanges.
The safest market is where every participant can see what is happening with their position – or what is about to happen – so they can assess their risk and organize their information. This demand has been a driving force behind Eurex Clearing’s product innovations. At the same time, customers need to see and assess the information flow within the environment as a whole so they can assess the integrity of each participant – and react quickly.
The Future of OTC Clearing
Capital efficiency is a major value Eurex Clearing can deliver, but operational efficiency is also an important consideration. With broad product coverage Eurex Clearing allows one-stop shopping for financial product focused market participants.
We are aware that the regulatory changes will also cause significant changes in the processes of our members; in order to support the transition we will connect into existing OTC infrastructures like execution venues, affirmation/confirmation platforms or trade repositories and leverage our existing Eurex Clearing infrastructure.
Besides capital and operational efficiency, client protection is an important topic for clients of clearing members. Eurex Clearing will offer a consistent set of client segregation options across all markets to address the different profiles and needs of our clients.
Eurex Clearing is absolutely committed to create market driven solution addressing the needs of the industry and the requirements of supervisory authorities and regulators.
For further information please contact Marcus Zickwolff, Eurex Group, Head of Trading and Clearing System Design at +49-69-2111-5847 E-Mail Marcus.Zickwolff@eurexclearing.com or visit www.eurexclearing.com
1) See ISDA 2009b.
2) See Tobin 1984, Bienert 1996, and Mayhew 2000.
3) See Carmichael/Pomerleano 2002, Levine 1997, Domowitz/Steil 2002.
4) Europe accounts for approximately 45 percent of the global derivatives market in terms of notional
About Marcus Zickwolff
Marcus Zickwolff is responsible for the design and implementation management of the Eurex® system for trading and clearing of derivatives as well as of the CCP system for clearing of securities and the central Risk Engine system. Having joined the IT Section of Deutsche Terminbörse (DTB) in 1992, he worked since 1997 with Deutsche Börse AG as Head of the Xetra® Market & Product Development Dept. From 2003 Marcus led the groupwide System Design Dept within the Eurex Group. He is Secretary of EACH (the European Association of Central Counterparty Clearing Houses) and Chairman of the Executive Committee of CCP12 (the Global Association of Central Counterparties).