Central counterparty clearing

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A central clearing counterparty (CCP), also referred to as a central counterparty, is a financial market infrastructure organization that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for trades in foreign exchange, securities, options, and derivative contracts. CCPs are highly regulated institutions that specialize in managing counterparty credit risk.

Contents

CCPs "mutualize" (share among their members) counterparty credit risk in the markets in which they operate. [1] A CCP reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (also called "margin deposits"), by providing independent valuation of trades and collateral, by monitoring the creditworthiness of the member firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting member's collateral on deposit. CCPs require a pre-set amount of collateral — referred to as ‘initial margin’ — to be posted to the CCP by each party in a transaction. The first line of defense is collateral provided by the defaulting member. CCPs typically adjust initial margin demands in response to changes in market conditions. For instance, a CCP may increase initial margin requirements in response to high price volatility. Variation margin is the second line of defense against fluctuation in the prices of securities pledged as collateral. If those prices fall, the member must deposit a corresponding amount of cash, and if those prices go up, the member may withdraw a corresponding amount of cash. This is done either on a daily basis or sometimes more frequently. For some financial products, members’ net payment obligations to or from the CCP are settled on a daily basis (or more frequently if there are large movements during the course of the day) to prevent the build-up of large exposures. [2] The advantages of a central counterparty clearing arrangement are greater transparency of the risks, reduced processing costs, and greater certainty in cases of default by a member. [3] Once a trade has been executed by two counterparties, it is submitted to a clearing house, which then steps between the two original traders' clearing firms and assumes the legal counterparty risk for the trade. For example, a trade between member firm A and firm B becomes two trades: A-CCP and CCP-B. This process is called novation.

As the CCP concentrates the risk of settlement failures into itself and is able to isolate the effects of a failure of a market participant, it also needs to be properly managed and well-capitalized [4] in order to ensure its survival in the event of a significant adverse event, such as a large clearing firm defaulting. Guarantee funds are capitalized with collateral from the member firms and own capital, called 'skin-in-the-game' of the CCP. [5] [6] In the event of a settlement failure, the defaulting firm may be declared to be in default and the CCP's default procedures utilized, which may include the orderly liquidation of the defaulting firm's positions and collateral. In the event of a significant clearing firm failure, the CCP may draw on its guarantee fund in order to settle trades on behalf of the failed clearing firm.

Nonetheless, it is possible that, in extreme circumstances, CCPs could be a source of systemic risk. [7] [8]

CCPs have a trade association representing them, CCP_Global.

History

Post financial crisis of 2007–08

In the wake of the financial crisis of 2007–08 the G20 leaders agreed at the 2009 Pittsburgh summit that all standardised derivatives contracts should be traded on exchanges or electronic trading platforms and cleared through central counterparties (CCPs). [7] In the United States, as part of the Obama financial regulatory reform plan of 2009, pressure has been placed on traders of derivatives such as credit default swaps (CDS) to make their trades on an open exchange with a clearinghouse. In June 2009, Federal Reserve official Alfred Kohn mentioned that the largest CDS dealers were working on an exchange, and that only regulatory approval rather than legislation would be required. [9] In March 2010, the Options Clearing Corporation (OCC) stated that it was moving forward in backing equity derivatives. [10] In Europe, the European Market Infrastructure Regulation mandated central clearing. It is estimated that almost half of all outstanding interest rate swap transactions are centrally cleared. The systemic importance of CCPs is expected to increase further as the central clearing of standardized over-the-counter (OTC) derivatives becomes mandatory in line with commitments made by G20 leaders following the crisis. The Financial Stability Board reported in April 2013 that, as at the end of February 2013, around US$158 trillion of interest rate swaps and over US$2.6 trillion of OTC credit derivatives were centrally cleared, representing 41% and 12% respectively of total outstanding notional amounts. [2]

Securities (US)

DTCC's subsidiary the National Securities Clearing Corporation (NSCC) clears broker-to-broker trades using its Continuous Net Settlement (CNS) System. This has acted as a CCP, long before the term was coined. [11] In order to deal with the default of a member broker, as happened with Drexel Burnham and Lehman Brothers, DTCC has a guarantee fund to which all broker members contribute. It also has rules to handle the gains and losses from a defaulting broker. The guarantee fund ensures that settlement can be completed. A defaulting member's contribution to the fund, along with any other assets held by the depository, are used to absorb any losses at the time of default. [12] [13]

The options market, with its Options Clearing Corporation (OCC), also acts as a central clearing counterparty. Its rules stipulate a five-step "waterfall" in dealing with a member's default: [14]

  1. The margin deposits of the suspended firm
  2. Clearing fund deposits of the suspended firm
  3. Clearing fund deposits of non-defaulting firms
  4. OCC retained earnings
  5. Clearing fund assessments

In order to assess the viability of its funds, the OCC carries out a firm-wide default test annually. In addition, the firm performs smaller, limited scope defaults throughout the year. Results are reported to its Enterprise Risk Management Committee. [14]

Europe

LCH.Clearnet, the result of a merger between the London Clearing House and Clearnet, acts as a CCP for a wide variety of financial products, from equities and commodities to credit default swaps and interest rate swaps.[ citation needed ]

Asia

Asian countries have addressed the needs of their derivative markets by forming CCPs. Shanghai Clearing House, formed in 2009, acts as a CCP for a wide range of financial products in China. [15]

See also

Related Research Articles

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<span class="mw-page-title-main">Credit default swap</span> Financial swap agreement in case of default

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.

The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives.

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The Depository Trust & Clearing Corporation (DTCC) is an American post-trade financial services company providing clearing and settlement services to the financial markets. It performs the exchange of securities on behalf of buyers and sellers and functions as a central securities depository by providing central custody of securities.

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<span class="mw-page-title-main">Options Clearing Corporation</span> Financial services business

Options Clearing Corporation (OCC) is a United States clearing house based in Chicago. It specializes in equity derivatives clearing, providing central counterparty (CCP) clearing and settlement services to 16 exchanges. Started by Wayne Luthringshausen and carried on by Michael Cahill. Its instruments include options, financial and commodity futures, security futures, and securities lending transactions.

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ICE Clear Credit LLC, a Delaware limited liability company, is a Derivatives Clearing Organisation (DCO) previously known as ICE Trust US LLC which was launched in March 2009. ICE offers trade execution and processing for the credit derivatives markets through Creditex and clearing through ICE Trust™. ICE Clear Credit LLC operates as a central counterparty (CCP) and clearinghouse for credit default swap (CDS) transactions conducted by its participants. ICE Clear Credit LLC is a subsidiary of IntercontinentalExchange (ICE). ICE Clear Credit LLC is a wholly owned subsidiary of ICE US Holding Company LP which is "organized under the law of the Cayman Islands but has consented to the jurisdiction of United States courts and government agencies with respect to matters arising out of federal banking laws."

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<span class="mw-page-title-main">Securities market participants (United States)</span>

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The Global Association of Central Counterparties or CCP Global, formerly CCP12, is the trade association of central counterparty clearinghouses (CCPs) located in Amsterdam in the Netherlands, and China. It represents 39 primary members, and 3 observer members of CCPs operating across Africa, the Americas, Asia, Australia and Europe and representing over 60 individual CCPs. CCP12 was formed in 2001 by major central counterparty organizations in Europe, Asia and the Americas to share CCP related information and to develop analyses and policy standards for common areas of concern.

References

  1. ↑ Rehlon, Amandeep; Nixon, Dan. "Central counterparties: what are they, why do they matter and how does the Bank supervise them?" (PDF). Bank of England. Retrieved 1 April 2017.
  2. 1 2 Amandeep Rehlon; Dan Nixon web (2013), "Central counterparties: what are they, why do they matter and how does the Bank supervise them?" (PDF), Bank of England, retrieved 24 April 2023
  3. ↑ Steigerwald, Robert S. (2013), "Central Counterparty Clearing" (PDF), Understanding Derivatives—Markets and Infrastructure, Federal Reserve Bank of Chicago: 12–26, retrieved 2017-03-29
  4. ↑ "Primer: Derivative Instruments". Financial Policy Forum Derivatives Study Center.
  5. ↑ Cont, Rama (2015), "The end of the waterfall: default resources of central counterparties", Journal of Risk Management in Financial Institutions, Henry Stewart Publications, 8, SSRN   2588986 , retrieved 2020-12-09
  6. ↑ Priem, Randy (2018). "CCP recovery and resolution: preventing a financial catastrophe". Journal of Financial Regulation and Compliance. 26 (3): 351–364. doi:10.1108/JFRC-03-2017-0032. S2CID   158726414.
  7. 1 2 Domanski, Dietrich; Gambacorta, Leonardo; Picillo, Cristina (2015-12-06). "Central clearing: trends and current issues". Bank for International Settlements. Retrieved 2017-10-13.
  8. ↑ Purring, Craig (May 2011). "The Economics of Central Counterparty Clearing: theory and Practice" (PDF). ISDA Discussion Papers (1): 12.
  9. ↑ Reuters. "Kohn: OTC clearinghouse could concentrate risk"
  10. ↑ Retuers. "OCC says pushing ahead on over-the-counter plan".
  11. ↑ Norman, Peter (February 2008), Plumbers and Visionaries, Chichester: John Wiley & Sons, p. 84, ISBN   978-0-470-72425-5
  12. ↑ DTCC. "CNS Overview". Depository Trust & Clearing Corporation. Retrieved 2 April 2017.
  13. ↑ National Securities Clearing Corporation, "Rule 18: Procedures for when the corporation declines or ceases to act", NSCC Rules and procedures, DTCC, retrieved 2 April 2017
  14. 1 2 OCC (September 9, 2016). "OCC Default Rules and Procedures" (PDF). Options Clearing Corporation. Retrieved 1 April 2017.
  15. ↑ "The Asian OTC Derivatives Markets". ISDA. Retrieved 2 April 2017.

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