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# Central Clearing

After completing this reading, you should be able to:

• Provide examples of the mechanics of a central counterparty (CCP).
• Describe the role of CCPs and distinguish between bilateral and centralized clearing.
• Describe the advantages and disadvantages of the central clearing of OTC derivatives.
• Explain regulatory initiatives for the OTC derivatives market and their impact on central clearing.
• Compare margin requirements in centrally cleared and bilateral markets and explain how margin can mitigate risk.
• Compare and contrast bilateral markets to the use of novation and netting.
• Assess the impact of central clearing on the broader financial markets.
• Identify and explain the types of risks faced by CCPs.
• Identify and distinguish between the risks to clearing members as well as non-members.

## Mechanics of a Central Counterparty

Clearing refers to the use of a central counterparty (CCP) to mitigate risks associated with the default of a trading counterparty.

CCP clearing means that a CCP becomes the legal counterparty to each trading party, providing a guarantee that it will honor the terms and conditions of the original trade even in the event that one of the parties defaults before the discharge of its obligations under the trade.

Although a bit simplistic, the following view helps to show the role played by CCPs in trading. Each of the six entities denoted B represents a dealer bank.

CCPs are commonly used in exchange-traded markets. CCPs use various ways to protect themselves from losses that may be incurred if a member defaults. These include:

1. They adjust their initial margin requirements more often according to market price changes.
2. They collect both initial margin requirements and variation margin payments from their members during and at the end of the day. This is to avoid closing out a member’s position since a member has only two hours to meet a margin call.

Recent years have seen an increased use of CCPs in the OTC markets.

### Differences between CCPs in Exchange-Traded Markets and in OTC Markets

$$\begin{array}{l|l} \textbf{Exchange-Traded Markets} & \textbf{OTC Markets} \\ \hline \begin{array}{l} \text{Most contracts last a few} \\ \text{months with only a few that last} \\ \text{for more than a year} \end{array} & \begin{array}{l} \text{Contracts last for at least ten} \\ \text{years} \end{array} \\ \hline \text{Average trade is small} & \text{Average trade is relatively big} \\ \hline \text{Contracts trade continuously} & \begin{array}{l} \text{Contracts trade intermittently} \\ \text{making OTC markets less} \\ \text{liquid} \end{array} \\ \hline \begin{array}{l} \text{Variation margin can be} \\ \text{directly determined from} \\ \text{market prices} \end{array} & \begin{array}{l} \text{Models are needed in order to} \\ \text{determine variation margin} \end{array} \\ \end{array}$$

### Similarities between CCPs in Exchange-Traded Markets and in OTC Markets

1. They are all required to post both initial and variation margin; and
2. They are all required to make default fund contributions.

CCPs can be involved in both mergers and acquisitions.

## Operation of CCPs

Regardless of whether they are trading in the OTC markets or in exchange-traded markets, CCPs operate in a similar way.

1. The initial margin is required in both. The initial margin is set in a way that enables the CCP to close out a defaulting member’s position in 5 days.
2. Members are equally required to provide variation margin as well as default fund contributions.

If the initial margin does not sufficiently cover the losses, the variation margin will be exhausted before using default fund contributions.

The equity of a CCP will be at risk only upon exhausting the default fund contributions of all members of the CCP.

To cover their costs, CCPs charge per trade. They make profits on the excess initial margin of members. These profits may be shared out among members if the CCP is owned by members.

## CCPs May Compete with Each Other!

### Advantages of Competition between CCPs

1. Competition provides a variety for members to choose from.
2. Better services are guaranteed since CCPs will want to improve their services so as to stay ahead.

### Disadvantages of Competition between CCPs

Margin requirements and default fund contributions may be reduced so as to attract a lot of traders. This will, in the long run, increase credit risks to the CCP.

## Regulation of OTC Derivative Markets

Regulations were introduced after the 2007-2008 financial crises. The increased use of derivatives in OTC markets can be attributed to these regulations.

They were formulated mainly to hedge against systematic risk, the risk that one member defaulting could result in possible losses to the other members trading with the defaulted member.

The three major regulations affecting OTC markets as defined by the G-20 Pittsburgh meeting are:

1. All standardized OTC derivatives (plain vanilla interest swap and credit default swap) to be cleared through CCPs. This requirement helps reduce interconnectedness and systemic risk since it creates an environment where traders have less credit exposure to each other.
2. Electronic platforms to be used for trading standardized derivatives. This promotes price transparency and price availability.
3. All trade to be reported to a central trade repository. This regulation is important to regulators since it provided them with information regarding the risks being taken by the participants in the OTC market.

Conditions to be satisfied before CCPs clear transactions:

1. The product has to be a standard product.
2. The product has to be actively trading to make it easy to close out a defaulting member’s position.
3. There needs a valuation model to value the product so as to correctly determine its initial margin and default fund contributions.
4. The product should have historical data. Historical data is useful in determining the product’s initial margin requirement.
5. Products that currently meet all these requirements are interest rate swaps and credit default swaps on indices.

In CCPs, the position of the members of the CCPs is transferred to the CCP. Members of the CCP agree to post initial margin and variation margin and in addition, they also agree to make the required default fund contributions.

Novation is the term used to describe the transfer of a contract from one party to another party.

A central counterparty interjects itself between a buyer and a seller through a process called ‘Novation’ and becomes a seller to the buyer and a buyer to the seller. By novating the trade, the CCP guarantees settlement of the trade even if one of the parties were to default on their obligation, thereby eliminating counterparty risk.

Transactions not done through the CCP are known as uncleared transactions.

In the period, 2016-2020, new rules require that both the initial margin and the variation margin must be posted. This differs from the earlier pre-crisis period where OTC traders were only required to post variation margin, and also during this period, OTC markets were cleared bilaterally.

It is possible for traders to trade using different CCPs. In such a scenario, members of a CCP will trade with non-members bilaterally.  Bilateral clearing involves two parties in a transaction agreeing on how they will be cleared, what netting arrangements they would prefer, and what will be used as collateral in case of any.

• CCPs have made it easier for dealers and end-users to exit a transaction.
• By making it easier to exit a transaction, CCPs have improved liquidity in financial markets.
• By trading through a CCP, a traded reduces his/her exposure to credit risk. This is because the risk is borne by all members of a CCP and not just by the particular trader, a process called loss mutualization.
• CCPs make it smooth and easy for traders to trade since they take care of all the arrangements to hedge against risk (netting, margining, settlements, and default fund contributions).
• It is easier to perform netting arrangements while trading through a CCP.

• CCPs are prone to both moral hazards and adverse selection. Traders trading through a CCP may be least concerned with the riskiness of their counterparty since the risk will be passed on to the members of the CCP and not solely borne by the trader. This exposes CCPs to moral hazards. It is also likely that traders will prefer trading through the CCP if they consider their counterparty’s risk to be high. This exposes the CCP to adverse selection.
• CCPs are adversely affected by market changes.
• CCPs make it difficult for their members to determine the amount of risk they are getting themselves into.

## Activities of a CCP

Compared to banks, CCPs are much simpler and more transparent. The activities of a CCP are:

• Determining the initial margin requirement, variation margin requirement, and default fund contributions.
• Valuing transactions of their members.
• Managing systems for hedging against risk, for example, netting and margining.

## Types of Risks Faced by CCPs

### Default Risk

A clearing member may default on one or more transactions. Following a default event, a host of other problems may come up. These include:

• Default or increased distress of other members because of the high default correlation.
• Failed auctions, leaving the CCP with no choice but to impose losses on members.
• Resignations because initial margins and default funds have to be returned to resigning members, the loss could be felt by other members.
• A worsening reputation – a default event would also injure the reputation of other members with close ties to fallen members.

### Non-Default Events

Such events include:

• Internal/external fraud.
• Operational losses.
• Investment losses.
• Losses due to litigation.

Note that non-default and default losses may be correlated. The default of a member might cause market disturbance and increase the likelihood of operational or legal problems.

### Model Risk

OTC transactions are not standardized; they trade less frequently and their prices are not so transparent. For these reasons, valuation models are needed when determining the initial margin requirement and default fund contributions of traders. However, these valuation models may use subjective assumptions.

### Liquidity Risk

Generally, the more liquid an investment is, the lower the returns. CCPs need to consider the constraints of investments before investing so as to ensure that their investments can be easily converted to cash whenever the need arises.

### Operational and Legal Risk

Centralization of various functions fosters efficiency, but on the downside, it creates a fertile ground for operational bottlenecks. For example, the CCP may have to contend with frequent system failures due to heavy traffic. What’s more, segregation and the movement of margin and positions through a CCP is prone to legal risk, depending on the jurisdiction.

Other risks include custody risk in case of failure of a custodian, wrong-way risk, foreign exchange risk, concentration risk, and sovereign risk.

## Risks to Clearing Members and Non-Members

### Risks to Members

There are several ways through which a clearing member can experience CCP-related losses:

• Forced allocation
• CCP failure
• Auction costs
• Default fund utilization
• Rights of assessment
• Tear-up

Prior to gaining membership, there are several mechanisms through which a prospective member can assess the risks faced by a member of the CCP. Such mechanisms may involve scrutinizing:

• The membership criteria
• Investment policies
• Default management policies
• Operational capacity
• Capital requirements
• The number of alternative CCPs and their credit ratings
• Initial margin and default fund contributions

### Risks to Non-Clearing Members

Non-clearing members who clear indirectly through a CCP are usually faced with different risks, most of which may closely resemble those of clearing members. In addition, however, non-clearing members may have an additional layer of protection:

• If a clearing member defaults, clients may be safe provided their clearing member is in compliance with the CCP’s requirements and in good financial health.
• If a clearing member defaults, the CCP may safeguard the interests of non-clearing members through margin segregation and portability.
• Since non-clearing members do not contribute toward the default fund, their exposure to the CCP is indirect.

## Lessons Learned from Prior CCP Failures

In the last four decades, we’ve had several high-profile CCP failures and near-failures. Common sources of these failures include:

• Insufficient margins and default funds
• Large movements in the price of the underlying
• The failure to update initial margin requirements to reflect changing market conditions
• Operational problems associated with large price moves and system-crushing trade volumes
• Liquidity strains

Some of the lessons we can learn from these past failures include:

• Operational risk must be mitigated at all costs. Failure to act is never an option
• Variation margins should be recalculated frequently
• CCPs should have access to external sources of liquidity. They can easily default, not because they are insolvent but simply because they are illiquid in short term.
• CCPs should endeavor to monitor positions continuously and act quickly whenever there are large moves

## Question 1

Which of the following is a disadvantage of central clearing in OTC markets?

A. Procyclicality

B. Transparency

C. Loss mutualisation

D. Default Management

The following are advantages of central clearing in OTC markets:

• Transparency
• Offsetting
• Loss mutualisation
• Legal and operational efficiency
• Default Management
• Improved market liquidity

The following are disadvantages of central clearing in OTC markets:

• Moral hazard
• Bifurcations between cleared vs. non-cleared
• Procyclicality

## Question 2

Which of the following is most likely associated with non-default losses?

A. Failed auctions

B. A worsening reputation

C. Internal/external fraud

D. Resignations

A clearing member may default on one or more transactions. Following a default event, a host of other problems may come up. These include:

• Default or increased distress of other members because of the high default correlation
• Failed auctions, leaving the CCP with no choice but to impose losses on members
• Resignations because initial margins and default funds have to be returned to resigning members, the loss could be felt by other members.
• A worsening reputation – a default event would also injure the reputation of other members with close ties to fallen members.

Internal/external fraud is in the category of non-default events. However, non-default and default losses may often be correlated.

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