After completing this reading, you should be able to:
- Provide examples of the mechanics of a central counterparty (CCP).
- Describe advantages and disadvantages of central clearing of OTC derivatives.
- 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.
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. To be able to do this, the CCP collects enough money from each party which goes toward covering potential losses that may be incurred if a party fails to follow through on the initial agreement.
The following view, although a bit simplistic helps to show the role played by CCPs in trading. Each of the six entities denoted B represents a dealer bank.
From the view, we can see two advantages of having CCPs in financial markets:
- A CCP reduces the interconnectedness within financial markets. This way, even if one of the dealers defaults, the impact on other participants is minimal
- There’s increased transparency on the role and positions of each participant.
- CCPs introduce operational efficiency by reducing the number of transactions to be settled
The legal process by which a CCP interposes itself between the buyer and the seller is referred to as contract novation.The CCP becomes a buyer to every seller and a seller to every buyer. In essence, novation replaces one “direct” contract with another indirect contract, implying that the initial contract between counterparties ceases to exist, and the counterparties no longer have counterparty risk with respect to one another. It’s the CCP that bears the counterparty risk. However, the CCP bears not the net market risk, which remains with the original parties to the trade.
In order to have effective risk control over the trade, the CCP requires each party to post collateral that can be seized in the event of default. The initial margin must be posted when initiating the contract. If the equity in the initial margin account falls below the maintenance margin, the relevant party receives a margin call – a requirement to provide additional funds to restore the margin account to the initial level. The amount payable to restore the initial margin to the required amount is called the variation margin. The variation margin is settled daily, usually in cash.
Initial margin requirements may frequently change to reflect market conditions. However, it’s imperative to note that the initial margin does not depend significantly on the creditworthiness of the party posting it. A party with a good credit rating may be required to post as much initial margin as another party with a not so good credit rating.
In trades where a CCP takes the central spot, the failure of a party is less dramatic. The CCP acts as the shock absorber, ensuring that other market participants are not hit hard. Once a counterparty defaults, the CCP forecloses/terminates all financial transactions with that counterparty without suffering losses.
After that, the CCP finds new members to take up the defaulted member’s positions by way of an auction. In case a CCP’s auction does not attract bids from members, it may be forced to turn to aggressive methods of loss allocation. For this reason, members have an incentive to participate in auctions to ensure that the reallocation process proceeds smoothly without adverse consequences.
Any loss over and above the resources contributed by the fallen (defaulted) member is shared between CCP members. CCP members contribute funds that are deposited into a default fund. In the event that there’s excess loss, funds are drawn from that account to absorb the loss.
Loss mutualization encourages more members to enter the market. On the downside, however, it may lead to moral hazard and adverse selection.
Advantages and Disadvantages of Central Clearing of OTC Derivatives
- Transparency: The CCP keeps an eye on all members so that in case one has an extreme exposure, corrective measures can be taken to avert a potential crisis. Such measures may include imposing positional limits on the affected member.
- Offsetting: Central clearing makes it easier to terminate positions and open new ones
- Loss mutualization: By distributing among all members any excess loss that cannot be absorbed by the defaulted member, the impact on any one member is unlikely to be felt.
- Legal and operational efficiency: Margining and netting increase operational efficiency and may also reduce legal risks by providing a centralization of rules and mechanisms.
- Default Management: Auctions ensure that market disruptions are kept at a minimum
- Improved market liquidity: Trading is made easier for everyone.
- Moral hazard: Presence of a third party that promises to assume all the counterparty risk can easily result in reduced risk awareness among members. Participants have little incentive to monitor each other’s credit quality or actions.
- Adverse selection: A CCP is essentially an insurer of some sort. It may attract more “bad risks” than good risks, effectively raising the specter of financial strain.
- Bifurcations between cleared vs. non-cleared: This may result from the requirement to clear standard products.
- Procyclicality: A positive dependence on the state of the economy may emerge in financial markets. For example, the margin requirement may be increased during a crisis period.
Bilateral Markets vs. Netting and Novation
Suppose that parties \(X\) and \(Y\) are trading bilaterally, and there are two distinct trades between them, each with its own cash flows. Bilateral trading can lead to several problems:
- Settlement risk: Frequent exchange of gross amounts gives rise to settlement risk
- Close-out: When one party defaults on a trade, the surviving party will most likely have to terminate all other trades with the defaulted party, even if the fallen trade offsets all the others.
Bilateral markets have over the years developed netting methods. These include:
- Payment netting: where cash flows occurring on the same day are netted. This way, only the member whose account is negative makes a payment.
- Close-out netting: Allows termination of all contracts between insolvent and solvent counterparty, together with the offsetting of all transaction values.
The Impact of Central Clearing on Financial Markets
Central clearing has reduced systemic risk by providing greater transparency, offsetting positions and efficient ways to deal with large defaults, e.g., auctions. However, it has also been argued that central clearing may actually increase systemic risk. For example, by increasing margin requirements during times of turbulence, the CCP may succeed in protecting individual member counterparties but at the expense of the larger market’s stability.
Which of the following is a disadvantage of central clearing in OTC markets?
- Loss mutualization
- Default Management
The correct answer is A.
The following are advantages of central clearing in OTC markets:
- Loss mutualization
- Legal and operational efficiency
- Default Management
- Improved market liquidity
The following are disadvantages of central clearing in OTC markets:
- Moral hazard
- Adverse selection
- Bifurcations between cleared vs. non-cleared