Central Clearing 2

After completing this reading, you should be able to:

• Define a central counterparty (CCP) and describe the mechanics of central clearing.
• Explain the concept of novation under central clearing.
• Define netting, multilateral offset, and compression and provide examples of each.
• Describe the application and estimation of margin and default funds under central clearing.
• Discuss the risks faced by a CCP and the ways it manages its exposures.
• Provide examples of a loss waterfall.
• Explain the different methods of managing the default of one or more members of a CCP.
• Compare bilateral and central clearing.
• Compare initial margin and default fund requirements for clearing members in relation to loss coverage, cost of clearing, and moral hazard.
• Describe the advantages and disadvantages of central clearing.

Central Counterparty (CCP) and its Mechanics 

Overview

A Central Counterparty (CCP) is an integral financial institution that stands in the middle of transactions, acting as the buyer to every seller and the seller to every buyer in a market, with the primary aim of reducing the risk of counterparty default. It implements this by centralizing and standardizing the process of clearing and settling trades.

Cost of Clearing

Clearing trades through a CCP involves costs, which are typically covered through direct fees per trade and indirectly via income derived from holding assets, such as interest earnings. CCPs are a pivotal part of the financial market infrastructure and must be especially robust during periods of financial turbulence. The balance between a CCP functioning as a long-term stability utility versus a profit-oriented entity is crucial, as the operational model affects risk management practices, including margin calculations, potentially influencing the overall risk posed by CCPs.

Competition and Systemic Risk

The landscape of CCPs is characterized by a balance between competition, operational efficiency, and systemic risk. While competition among many CCPs can drive down costs and improve services, it could also lead to reduced safety measures. Conversely, a smaller number of CCPs might maximize multilateral offset benefits and economies of scale but increases the risk associated with a single point of failure.

Regional and Product Bifurcation

CCPs tend to bifurcate based on region — with local CCPs clearing trades in a specific currency or for local financial institutions — and product specialization, with CCPs typically focusing on clearable products like interest rate swaps or credit default swaps (CDSs). This specialization and regionalization can lead to systemic risks from mandating the clearing of only certain standardized transactions and create opportunities for regulatory arbitrage.

Ownership and Operation Models

CCP ownership and operation models are predominantly either vertical or horizontal. A vertical structure entails CCPs as a division within, and owned by an exchange, providing clearing for that specific exchange’s products. This model is common for futures exchanges. On the other hand, a horizontal structure involves separately-owned CCPs (usually by clearing members), capable of clearing trades across various markets and asset classes. This setup is well-suited for bilateral OTC derivatives that do not involve a central exchange. Regulations favor horizontal structures for their potential to increase competition.

Factors Influencing Central Clearing Eligibility

For a transaction to be eligible for central clearing, several key factors come into play, including:

• Standardization: Essential for legally and contractually binding CCPs to all cash flows of cleared products; it also enables simpler contract replacement in the event of a clearing member default.
• Complexity: Only vanilla transactions are clearable due to their easier and more robust valuation, necessary for margin calculations and default management. More complex derivatives face significant hurdles in central clearing.
• Liquidity: Central clearing requires a high level of liquidity to ensure accurate pricing for margin purposes and efficient contract replacement in default scenarios. Note that liquidity in OTC derivatives can diminish over time while CCPs guarantee positions for their entire duration.

Contract Novation in Central Clearing

Novation is a crucial legal principle fundamental to the process of central clearing where original financial contracts between two trading parties are replaced by new agreements. Here, the Central Counterparty (CCP) becomes the central figure in the new contracts, effectively taking the place of the original counterparties.

The Role of the CCP in Novation

Through novation, the CCP interjects itself into a transaction and becomes both the buyer to the original seller and the seller to the original buyer. By doing so, the CCP assumes the position of insurer against counterparty risk for both sides of the trade.

Legal Enforceability and Contractual Obligations

For novation to be effective, it must be legally enforceable with clear stipulations that once a contract is novated to the CCP, the previously existing bilateral agreement is nullified. This elimination of the initial contract ensures that the original parties are no longer legally bound to or responsible for one another.

Risk Assurance

This structural modification through novation significantly reduces the contagion of default risk. It affords a more secure trading environment, as the market participants are relieved from the obligation of assessing each other’s creditworthiness and instead depend on the robustness of the CCP’s risk management practices.

In essence, novation in the realm of central clearing represents a strategic risk management move. It enables the transfer of counterparty risk from the original participants to the CCP while providing legal certainty and strengthening market stability by consolidating credit exposures.

Netting, Multilateral Offset, and Compression 

Multilateral Offset

In the world of central clearing, multilateral offset refers to the ability of the Central Counterparty (CCP) to reduce counterparty exposure across a range of trades. Due to the centralization of trades within a CCP, trades that originated between different counterparties can be netted or compressed against one another. For example, if Party A owes Party B $100 and Party B owes Party C $100, a CCP can net these obligations so that Party A pays Party C directly, simplifying the transaction chain.

Netting 

Netting is a method whereby multiple financial claims are aggregated to calculate a singular net amount owed among the involved parties. The value of netting within a CCP structure is in consolidating several transactions into a single net position, thereby decreasing the quantity of required settlements and lowering the credit risk associated with these trades. An illustrative example would be two financial institutions that have several outstanding currency trades with each other opting to consolidate their obligations into one net payment, thereby reducing the cost and risk of executing multiple currency transactions.

Compression and its Benefits

Compression is a technique used to decrease the total notional value of a derivatives portfolio while maintaining the same net economic exposure. By eliminating redundant or offsetting contracts, the financial institution’s portfolio is made more manageable, and the demand for operational resources and capital is reduced. Consider a situation where a financial firm has a multitude of interest rate swap contracts of varying sizes and terms that offset one another. Through compression, these could be replaced with fewer contracts that hold an equivalent position but require less capital to hold.

Key Functions of CCP Risk Management

• Loss Absorbency: CCPs collect initial and variation margins from their members as a safeguard against potential default losses, as well as maintaining default fund contributions for more extreme loss scenarios. The size of these protective measures is informed by market conditions such as volatility and the overall size of the cleared portfolio.

• Default Management: A CCP manages member defaults by employing strategies such as hedging and auctioning off the defaulter’s positions. These actions serve to contain the impact of the default and prevent disruption in the broader market.

Application and Estimation of Margin and Default Funds under Central Clearing

Margin in Central Clearing

Margin functions as the main defense for a Central Counterparty (CCP) to absorb losses, differing from a bank which relies heavily on capital for this purpose. The two types of margins that CCPs collect from members are variation margin and initial margin.

• Variation Margin: Requires accurate and reliable pricing data for all cleared derivatives to adjust the value of open positions daily to the market (marked-to-market). This process ensures that profits and losses are reflected in cash flows between the CCP and its members daily. Typically, variation margins are paid in cash as they are effectively settlements of trades. Netting across different currencies for variation margin purposes generally does not occur, resulting in separate payments or receipts for each currency.

• Initial Margin: Serves to cover potential losses that would occur should a clearing member default. It exists for the life of the trade and varies in response to market conditions and remaining trade risks. Unlike variation margin, initial margin can include non-cash collateral such as treasuries and agency securities subject to certain conditions that ensure the CCP does not face significant credit, market, or liquidity risks. Initial margin is calculated based on scenarios for possible price movements over an assumed close-out period.

Default Fund Contributions

Default funds are collective pools of resources contributed by the clearing members, designed to protect the CCP in the event of a member’s default that results in losses exceeding individual initial margins. The size of these funds is influenced by factors such as market volatility and the overall cleared portfolio.

Investment and Interest on Margin

CCPs hold large margin balances, which present an opportunity for income generation. Clearing members are often paid interest on the excess cash they deposit as initial margin. The margins are invested with extreme caution in secure assets like central bank deposits, commercial banks, or very low-risk reverse repo agreements to generate income while minimizing additional risk for the CCP.

Default Management and Margin Period of Risk (MPoR)

The primary risk for CCPs is member default, which creates unmatched books and forces the CCP to manage the contingent market risk. During defaults, CCPs have enhanced control over the outcomes as compared to bilateral OTC trades, and they can undertake various actions such as:

• Macro-Hedging: Minimises the portfolio’s exposure to major risk factors, reducing the market risk faced by the CCP.
• Auctions: Portfolios are auctioned to other clearing members in sub-portfolios, often including macro-hedges, to efficiently neutralize the defaulting member’s position.
• Porting Client Trades: Client positions are transferred to solvent-clearing members when possible.

The margin period of risk for CCPs can be shorter than in bilateral markets, bolstered by daily and potentially intraday collateral calls, undisputed authority over calculations, and streamlined procedures for handling defaults.

Lehman Brothers Case Study

The Lehman Brothers bankruptcy in 2008 serves as a case study highlighting the effectiveness of CCP procedures. SwapClear reported that approximately 90% of Lehman’s risk was macro-hedged in one week, with all trades auctioned off within three weeks, requiring only a fraction of the initial margin held.

Ensuring Clearing Member Compliance

Clearing members face stringent requirements to maintain creditworthiness, liquidity, and operational capabilities, preventing undue risk to the CCP. Members must meet a minimum capital base, contribute to default funds, and participate actively in default management. Through the application of margin and default fund requirements along with prudent risk management practices, CCPs aim to contain risks and maintain financial market stability.

Risks Faced by a CCP and the Ways it Manages its Exposures

A Central Counterparty (CCP) plays a crucial role in the financial system by providing clearing and settlement services for various financial transactions. However, CCPs face a unique set of risks as they manage the middle position in trades. Here are some of the risks and the corresponding management practices:

Counterparty Credit Risk

CCPs are exposed to the risk of a clearing member defaulting on its obligations. To manage this risk, CCPs require both initial and variation margins:

• Initial Margin: The initial margin is calculated to cover potential future exposures over a given time horizon, should a member default. The determination of this margin considers various factors, including market volatility and portfolio size. Initial margin can be paid in both cash and non-cash collateral, under conditions that limit the CCP’s exposure to credit, market, or liquidity risk.
• Variation Margin: Variation margin is collected daily to reflect market-to-market movements in the value of open positions. It is typically paid in cash, ensuring that profits and losses are realized daily.

Market Liquidity Risk

This risk is associated with the CCP’s ability to liquidate or hedge positions quickly and at reasonable prices, particularly following a member default. The CCP combats this by:

• Macro-Hedging: The CCP may first attempt to neutralize the market risk of the defaulter’s portfolio by implementing macro-hedges, which are designed to be executed quickly due to the liquidity of the hedging instruments.
• Auctions: The defaulter’s positions are auctioned off to other clearing members. The effectiveness of this process may vary depending on market conditions and other factors.

Default Fund Contributions

Clearing members contribute to a pooled default fund designed to cover potential losses that exceed individual initial margins. This fund can be tapped into when a member defaults, and the margins are insufficient to cover the loss.

Default Management Group and Practices

A default management group typically comprises key personnel from the CCP and senior traders from member firms. This group is instrumental in carrying out tasks such as macro-hedging of the portfolio. Fire drills and driving tests ensure clearing members can handle the operational demands of an auction efficiently.

Porting Client Trades

When a clearing member defaults, client positions can be ported to another solvent clearing member, though this depends on the margin requirements and how client assets are segregated.

Margin Period of Risk (MPoR)

The MPoR for a CCP is characterized by shorter response and resolution times compared to bilateral markets due to daily collateral calls, undisputed authority over calculations, and streamlined default management procedures.

CCPs play an indispensable role in maintaining market stability by diligently managing the multi-faceted risk exposures inherent in their position as central counterparties. Their risk management frameworks are designed to mitigate impacts on the broader financial system, ensure the continuity of market operations, and foster confidence among market participants.

Examples of a Loss Waterfall

The concept of a loss waterfall refers to the hierarchical sequence of financial resources that a Central Counterparty (CCP) would use in the event of a member default. The loss waterfall articulates how losses are absorbed and allocated, outlining the procedures and capital used to ensure the CCP’s continual operation while minimizing systemic risk. Here is a typical sequence represented in a loss waterfall:

1. Initial Margin (Defaulter): The first line of defense is the initial margin exclusively belonging to the defaulting party.

2. Default Fund (Defaulter): In case the initial margin is insufficient, the CCP taps into the default fund contributions by the defaulter.

3. CCP Skin-in-the-Game: The CCP has a vested interest in managing risk adequately and may contribute its own funds, known as “skin in the game,” after the defaulter’s resources are depleted.

4. Default Fund (Non-Defaulting Members): If losses escalate beyond the CCP’s contributions, the collectively pooled default fund of all other (non-defaulting) clearing members is utilized.

5. Rights of Assessment and/Or Other Loss Allocation Methods: These include mechanisms where surviving members may have to pay additional funds (typically capped to prevent excessive moral hazard) if significant portions of the default fund are lost.

6. Remaining CCP Capital: The last internal financial resource is the remaining capital reserves of the CCP.

7. Liquidity Support or CCP Fails: In a worst-case scenario, if the aforementioned resources cannot cover the losses and the CCP’s continued operability is at risk, external liquidity support, such as central bank bailouts, may be sought. If all options are exhausted without success, the CCP might ultimately fail.

Other loss allocation methods include:

• Variation Margin Gains Haircutting (VMGH): Clearing members whose positions have gained value since a default may not receive full payment, while those owing funds still make full payments. This aims to balance the losses from a default, espousing the dynamics of a bilateral market.

• Tear-Up: If clearing cannot proceed as planned, the CCP might have to ‘tear up’ or terminate contracts that are counter to the defaulting party’s positions to return to a balanced, matched book.

• Forced Allocation: Similar to tear-up, it involves a mandatory allocation of specific portfolios to clearing members at prices set by the CCP.

These measures define the CCP’s systematic response to defaults, ensuring that losses are allocated in an orderly manner while preserving market stability and continuity. It’s important to note, these methods indicate that the potential default losses a member incurs are not directly related to the transactions they carried out with the defaulting member, and exposure to default losses can exist regardless of direct trading relationships. The severity of the loss allocation methods could, in extreme cases, also lead to the failure of other surviving clearing members.

Methods of Managing the Default of One or More Members of a CCP

In the realm of central clearing, handling the default of a clearing member is a critical aspect of ensuring ongoing financial market stability. Central Counterparties (CCPs) have specialized mechanisms to manage such defaults effectively.

Loss Mutualisation and Default Fund

The principle behind the default fund is the mutualization of risk. All clearing members contribute to this pool, which is designed to cover extreme losses that are not captured by individual member margins. This reduces the risk to the CCP of any single counterparty failing and potentially mitigates systemic issues.

Initial Margin vs. Default Fund Dynamics

The initial margin corresponds to an individual member’s potential losses, covering typically a 99% confidence level, while the default fund is a shared resource that absorbs losses beyond the capacity of initial margins. In this setup, initial margins are calculated with a heavy-tailed loss distribution in mind, contemplating the possibility of losses that are both improbable and large, necessitating a sum well above the margin itself.

Tear-Up and Forced Allocation

CCPs have the option to adopt loss-allocation strategies like tear-up or forced allocation in extreme cases:

• Tear-Up: In a tear-up, outstanding transactions are terminated or terminated bilaterally in response to a clearing member’s default. The CCP’s objective is to return to a matched book status (where mirrored trades cancel out), and this action is taken generally without exposing the CCP to risk premiums that might accrue in auctioning transactions. This process could be partial—only affecting some transactions—or full, resulting in the loss of uncovered positions, leaving the market risk for clearing members to manage.
• Forced Allocation: Similar to tear-up but potentially more arbitrary, forced allocation involves assigning orphaned positions from a defaulting member to remaining clearing members at set prices by the CCP. This process ensures the CCP maintains a balanced position but might impose unforeseen risks and losses upon the unwilling recipients; these cannot be passed to clients.

Moral Hazard Concerns

The balance between initial margins and default funds impacts moral hazard — a larger default fund can increase the probability of incurring default fund losses, and reliance on such a fund could incentivize riskier behavior. Conversely, high initial margin requirements may be cost-prohibitive but promote a defaulter-pays system.

Client Participation in the Loss Framework

Clients, typically non-clearing members, contribute indirectly to the financial stability of the CCP through the initial margins levied by clearing members. They don’t directly contribute to the default fund but are affected by their clearing members’ participation in it.

Portability

Portability concerns the ability to transfer clients’ positions from a defaulting clearing member to another solvent one. This is more feasible for clients directly paying their own risks through initial margins; higher default funds may complicate portability due to increased mutualized risk.

Consideration of Systemic Events

A unique challenge in calculating the appropriate default fund size comes from the unpredictable nature of extreme events with system-wide implications, such as the concurrent defaults of several clearing members coupled with adverse market movements. Complexities in financial interdependencies and wrong-way risk (WWR), where exposure to risk increases at the worst possible time, also influence the determination of fund adequacy.

Comparison between Bilateral and Central Clearing

The comparison between bilateral and central clearing seeks to understand the differences in risk management, cost implications, and market structures between the two systems. Here’s the contrast between them:

Comparison in Risk Management

• In bilateral clearing, two parties engage directly with each other in a trade, and each bears the other’s counterparty credit risk, while in central clearing, a CCP mediates the trade, standardizing margin requirements and pooling risk across multiple members.
• Margins vary and are negotiable in bilateral agreements, potentially leading to inconsistent practices, whereas the CCP’s standardized margins based on market conditions reduce variations among counterparties.
• In bilateral clearing, the default of a large counterparty can have a broad market impact due to the direct exposure of the parties, on the other hand, in central clearing, default-related losses are initially absorbed by the defaulting member’s margins, followed by a mutualized default fund that distributes the risk among all clearing members.

Discrepancies in Cost

• In bilateral clearing, costs are shaped by agreements between the two parties and may reflect the integrated potential default cost based on credit assessment, while central clearing has structured fees for trades and ongoing margin requirements, which tends to provide a more predictable cost structure due to the mutualization of default funds.
• Bilateral clearing can exhibit less standardized cost structures across the market, whereas central clearing shares costs across a larger participant pool, generally reducing individual costs but also centralizing systemic risk.

Market Structures and Practices

• Bilateral clearing transactions are less standardized, tailored to the needs of the involved parties, and capable of accommodating complex products, while central clearing adheres to stringent standardization to fit within the CCP model.
• In bilateral clearing, the degree of transparency may be variable, potentially obscuring a comprehensive view of market exposures, whereas central clearing offers a clearer view of exposures, thus aiding in the mitigation of systemic default risks.
• While bilateral clearing can lack rigorous default management procedures, central clearing enforces systematic practices such as hedging and auctioning off the portfolio of a defaulting member.

Default Fund vs. Initial Margin Dynamics

Emphasis is placed on initial margins in central clearing to cover the individual defaulter’s risk, complemented by a loss-absorbing default fund. Contrarily, bilateral clearing does not rely on such a mutualized fund and stress-testing the adequacy of the fund under extreme conditions underscores its qualitative precision, which postulates sufficient capital to weather the default of the CCP’s largest member(s), referred to as “Cover 1” or “Cover 2” standards.

Advantages and Disadvantages

Central clearing offers an array of advantages, including increased transparency and the ability to offset multilateral risks. However, there’s potential for moral hazards, as lower initial margins lead to higher contribution requirements to mutualized funds, and higher initial margins may discourage risk-taking but increase individual costs.

Both bilateral and central clearing have their own sets of strengths and weaknesses in the context of risk exposure, cost efficiency, and systemic stability. The decision between the two often hinges on the nature of the transactions involved, the appetite for risk, and the market’s regulatory environment. Central clearing demonstrates a more robust structure for managing systemic risk, emphasizing transparency, and fostering a standardized approach to market operations.