Evolution – Exchange Trading

• Exchanges are central hubs that facilitate the trade of standard contracts. They enhance market efficiency and liquidity by consolidating trading in one location. For a financial contract to become exchange-traded, it must develop critical trading volume, standardization, and liquidity.
• Futures exchanges originated as a means for parties to agree on buying or selling a specified asset at a future date at a predetermined price. This allowed merchants to hedge against price fluctuations. Initially, exchanges were mere trading forums without settlement or counterparty risk management, however, defaulting members were fined and/or expelled. Transactions were bilateral, with the exchange serving as a certification for the counterparty’s membership. Exchanges serve multiple functions:
  • Product Standardization – They create standardized contracts with uniform terms (e.g., maturity dates, price increments, underlying grade, delivery mechanism) for efficient trading.
  • Trading Venue – Exchanges, whether physical or electronic, offer a centralized platform for approved firms and individuals to trade and hedge. This centralization supports price discovery.
  • Reporting Services – Exchanges provide transaction price reports to enhance price transparency for trading participants, data vendors, and subscribers.

Evolution – Complete Clearing

• As derivative exchanges developed, it led to certain mechanisms of risk reduction such as –
  • Direct clearing – This involves offsetting positions with the exchange, allowing netting instead of physical exchange. For example, the figure shows if A buys 100 contracts at $105 and later reverses at $102, a net settlement of $300 occurs. Differential payment became standard in futures markets for creditworthiness ease, highlighting the importance rather than delivery of standardized terms for fungibility.
  • Clearing rings – It allowed three or more counterparties to offset positions. Participants had to accept substitutes for original counterparties. In today’s OTC derivatives market, portfolio compression serves a similar role.
    
  • Complete clearing – It introduced a CCP positioned between all counterparties. As shown in the figure, CCP assumes all contractual rights and responsibilities, preventing huge losses during member defaults, even in an anonymous trading process.
    

Evolution – CCP

• A Central Counterparty (CCP) is a financial market infrastructure designed to manage and reduce counterparty risk in bilateral markets. As shown in Figure 1, it alters financial market dynamics by inserting itself between buyers and sellers. The figure also highlights two key benefits of such markets –
  • Reduced interconnectedness in financial markets mitigates the impact of participant default.
  • Enhanced transparency due to centralized trade positions within the CCP.
    
• The CCP, as depicted in Figure 2, is an intricate hub-and-spoke system. It involves:
  • Client Clearing – Non-members (C) are cleared through clearing members (D) (shown with grey lines) and members clear directly with the CCP (shown with black lines). This adds to the complexity of margin transfer and defaults.
  • Bilateral Trades – Many OTC derivatives are still bilateral transactions (shown with dotted lines).
    
    
• Globally, various CCPs may be interconnected, sharing members and implicit connections. Central clearing, however, has certain drawbacks. The CCP becomes a single point of failure, eliminating the diversification of errors. A mistake or failure at the CCP, instead of its members, has the potential to be catastrophic.

Central Clearing Mechanics – Landscape

• CCPs also incur costs that are covered by trade fees and indirect sources like interest from held assets. Resilience during financial disruptions is crucial, suggesting a utility CCP driven by long-term stability may be ideal. Yet, there’s a need for top-notch personnel and systems for advanced risk management, potentially favouring profit-driven models. Competition among CCPs benefits users but introduces the risk of a race to the bottom in certain practices. Balancing the number of CCPs is complex; many enhance competition but may lead to cost-focused practices, while a few offer offset benefits and economies of scale but increase systemic risk. Though a single global CCP is optimal, a relatively large number seems likely. The proliferation of CCPs is influenced by bifurcation on two levels:
  • Regional – Major regions emphasize having local CCPs for currency-denominated trades or clearing for regional financial institutions. Some regulators mandate the use of regional CCPs for specific products.
  • Product – CCPs specializing in certain product types, like interest rate swaps or CDSs, create vertical structures. This specialization results in no single CCP offering coverage for all clearable products, as regulations do not favour such comprehensive solutions.

• Mandatory clearing can heighten systemic risk as large banks are restricted to clearing only standardized transactions, leading to net exposure issues with bifurcation between standard and non-standard contracts. Exemptions for end users and foreign exchange transactions may result in suboptimal outcomes and regulatory arbitrage possibilities. The extent of bifurcation depends on practical clearing capabilities; ISDA estimates around 80% for OTC derivatives.
• CCP ownership models are typically vertical, tied to an exchange, or horizontal, independently owned. Vertical setups, common in futures exchanges, have the CCP as an exchange division, clearing only its products. Horizontal setups, more common in bilateral OTC derivatives, involve separately-owned CCPs with financial autonomy, clearing across various markets. Regulation favours horizontal models, promoting competition by requiring CCPs to be ‘open.’ For instance, MiFID II proposes giving CCPs access to trading venues, enhancing competition, reducing costs, and improving clearing services.
• A large portion of the OTC derivatives market is moving towards central clearing, with notable progress, especially in widely traded products like interest rate swaps. Clearing expansion to new products is slow, as it requires specific features for a product to be deemed clearable.
• For a transaction to be centrally cleared, key conditions include:
  • Standardization – Legal and economic terms must be standardized for the CCP to assume contractual responsibility. This facilitates offsetting, compression, and ease of replacement in default scenarios.
  • Complexity – Centrally cleared transactions are typically non-exotic, as complex derivatives pose challenges in valuation, margin calculations, and default management.
  • Liquidity – Centrally cleared products require liquidity for accurate pricing, historical data for initial margins, and efficient replacement in default scenarios.
  • Wrong-way Risk – Ideally, centrally cleared products avoid wrong-way risk, where counterparty default is adversely linked to the underlying contract value, complicating default management.
  • Market Volume – The market size for a product should be sufficiently large for a CCP to recoup the costs of developing processes, models, and systems for clearing.
• LCH Ltd is a major OTC derivative clearing player, particularly through SwapClear, dominant in interbank interest rate swaps. Other notable OTC clearing CCPs include ICE (Intercontinental Exchange) for certain CDSs via ICE Clear Credit, Chicago Mercantile Exchange (CME), and Eurex.

Central Clearing Mechanics – Novation

• Central clearing involves the crucial concept of contract novation, where the CCP replaces the original contract between buyers and sellers with new ones, acting as an insurer for counterparty risk. Novation hinges on the legal enforceability of the new contracts, ensuring the original parties are no longer legally obligated to each other. Once novation is complete, counterparty risk between the original parties ceases to exist.
• The CCP guarantees transactions from the matching point, becoming the buyer to the seller and seller to the buyer, allowing clearing members to avoid counterparty risk assessment. With a matched book, the CCP holds no net market risk but assumes centralized counterparty risk. In the event of a member default, the CCP faces conditional market risk and employs methods like auctions to return to a matched book. To mitigate counterparty risk, CCPs require financial resources from members to cover potential losses in case of defaults.

Central Clearing Mechanics – Multilateral Offset And Compression

• Bilateral derivatives trading leads to redundant contracts, increasing counterparty risk and financial system interconnectedness due to diverse market participants with varying objectives. Central clearing offers a crucial advantage with multilateral offset, where cash flows or margin requirements can be offset.
• As shown in the figure, in bilateral trading, participants have total liabilities of 180, with A exposed to C by 90, creating a potential domino effect in case of C’s failure. Central clearing eliminates this risk through novation and netting with the CCP. C’s liability is offset to 60, and C’s insolvency no longer poses a knock-on effect to A due to the CCP’s intermediation.
• Portfolio compression, creating multilateral offset effects like netting, is a method used, but it requires eliminating actual transactions. In contrast, CCPs achieve more general multilateral effects, reducing net market risk even when transactions aren’t precisely offset. While bilateral compression can only compress objective quantities like cash flows, CCPs can compress risk, resulting in lower initial margin requirements.
  
  

• However, this representation overlooks key factors: the impact of multiple CCPs, non-cleared trades, and effects on non-derivative positions, which will be discussed later. Centrally cleared trades can still benefit from portfolio compression, enhancing efficiency by reducing the number of trades and total notional cleared. This reduction affects various aspects, including initial margin requirements, regulatory capital, operationality, computational burden, and simplification of the auction process.
• Compression services complement central clearing. In the case of interest rate swaps cleared by SwapClear, the figure illustrates the impact of compression on total notional outstanding and the compressed notional, showcasing a steady increase in cleared notional with almost constant outstanding notional. Compression, demonstrated in the figure, is extending to cover more products and counterparties. Advanced approaches, like blended-rate compression, are emerging, enabling compression of multiple positions with varying fixed rates but the same remaining cash flow dates.
  

Central Clearing Mechanics – Margin And Default Funds

• With complete clearing, CCPs rely on both variation and initial margins to guard against clearing member insolvency. Historically, centrally-cleared markets enforced standard and stricter margin requirements compared to bilateral markets, although BCBS-IOSCO bilateral margin requirements have narrowed this gap. CCPs typically mandate daily (or intra-daily) cash transfers for variation margin. Initial margin requirements, often adjusted with market conditions, demand cash or liquid assets and are calculated to high confidence levels (at least 99%). These margins cover the anticipated timeframe to close out a defaulted clearing member’s portfolio.
• In central clearing, the ‘defaulter-pays’ approach dictates that a clearing member contributes funds for their potential future default. Covering all scenarios is impractical due to high costs, so contributions aim to assure confidence in covering losses in a default scenario. There’s a small chance of losses not following the defaulter-pays approach, potentially borne by other clearing members.
• In central clearing, the principle of loss mutualization entails sharing losses above the defaulter’s resources among CCP members. This is typically achieved through a CCP default fund, contributed to by all members and utilized after the defaulter’s resources to cover losses. The intent is to make losses wiping out a substantial part of the CCP’s default fund unlikely.
• In a CCP, a member’s default losses are not directly tied to transactions with the defaulting member. A member can incur default losses even without trading with the defaulted counterparty, having no net position, or holding a net position in the same direction as the defaulter.

Central Clearing Mechanics – Clearing Relationships

• Clearing members, who can transact directly with a CCP, must meet the following criteria –
  • Admission criteria – It includes credit rating strength and a sufficiently large capital base.
  • Financial commitments – Contribution to the CCP’s default fund.
  • Operational requirements – It involves frequent margin postings and participation in simulations and auctions in case of a member default.
• These criteria limit direct clearing membership to large global banks and some very large financial institutions, while smaller banks, buy-side firms, non-financial end users, and other financial entities are unlikely to be direct clearing members. Large regional banks may opt for membership in a local CCP to support domestic clearing services for their clients.
• Non-clearing members (clients) can clear through a clearing member, maintaining a direct bilateral relationship with the clearing member rather than the CCP. Though this relationship is bilateral, clearing members often align their requirements with those of the CCP, such as margin-posting, in their dealings with clients.
• The figure in the next page, illustrates the client clearing setup, where clients can have clearing relationships with many clearing members, allowing them the option to port the portfolio to a different clearing member if needed.
• In a default scenario, achieving client portfolio portability aims to ensure continuity for clients. However, successful portability hinges on the specific setup for client clearing, particularly how the client’s posted margin is passed through to the clearing member and/or the CCP and the manner of segregation. The segregation approach determines whether the client bears risk to the CCP, their clearing member, or their clearing member along with other clients. Two broad account structures used for client clearing are-
  • Omnibus segregation – It involves separating the clearing member’s account from those of their clients (omnibus account). The margin in the house account can cover client losses, but not vice versa, avoiding client exposure to their clearing member’s portfolio losses. However, all assets in the omnibus account can be used for defaulted client obligations, introducing fellow customer risk among clients.
  • Individual segregation – It isolates client accounts, preventing them from covering other clients’ losses, providing greater safety against clearing member and fellow customer risks but at a higher cost.
    
• Other crucial considerations include the segregation method for margin, the nature of segregation, and whether the omnibus margin is posted on a net or gross basis. Additionally, variations exist in handling any excess margin.

CCP Risk Management – Overview And Membership

• In a centrally-cleared market, a CCP assumes the role of guaranteeing trade performance and centralizing counterparty risk. Original counterparties are relieved from monitoring each other’s credit quality, relying instead on the overall credit quality of all CCP members. This underscores the importance of the CCP’s operational efficiency and resilience. A CCP mitigates counterparty risk through –
  • Multilateral offset – CCPs provide netting and compression benefits for trades originating from different counterparties.
  • Loss absorption – CCPs collect variation and initial margins, along with default fund contributions from members. Factors influencing these margins include volatility, correlation, and the cleared portfolio size.
  • Default management – CCPs manage defaults through hedging and auctioning positions, allocating losses beyond margins, and porting client trades to solvent clearing members.
• To manage risk, CCPs enforce mechanisms ensuring continuity and resilience against counterparty and liquidity risks. Membership requirements are designed to prevent clearing members from introducing undue risk while avoiding anti-competitive practices. These requirements typically focus on –
  • Creditworthiness – Assessed by external or internal methods
  • Liquidity – Ability to meet margin calls promptly
  • Operationality – Ability to adhere to CCP rules, including those for auctions
• Additional requirements for CCP members cover minimum capital base, default fund contributions, and participation in default management.

CCP Risk Management – Margin

• A central counterparty’s primary defence relies on margin. The two types of margin are –
  • Variation Margin – It requires timely and reliable price data for cleared derivatives. Market-standard valuation methods may evolve with market practices, such as the transition from Libor to OIS discounting for interest rate swaps. Typically, only cash is accepted as a variation margin, often netted for a single currency across clearing members’ activities.
  • Initial Margin – It is intended to cover potential close-out losses in case of a clearing member’s default. Calculated based on various price movement scenarios over an assumed close-out period (e.g. 5 days), the initial margin can be adjusted based on market conditions and remaining risk. It need not be in cash and can include assets like government treasury securities, subject to haircuts to minimize credit, market, and liquidity risks.
• CCPs pay interest to clearing members on excess cash deposited as initial margin, often tied to short-term deposit rates like Fed Funds minus 10 bps. To generate returns, CCPs invest margin cautiously, depositing with central banks, commercial banks, or engaging in reverse repos to mitigate additional risks.

CCP Risk Management – Default Scenarios And Margin Period Of Risk

• A primary risk for a CCP is a clearing member default, resulting in an unmatched book. The CCP faces contingent market risk, as it must pay a variation margin to non-defaulters with valuation gains, not offset by a variation margin from the defaulting counterparty. CCPs hold significant authority in managing default risk, with rights to declare a clearing member in default, suspend trading, close positions, transfer client positions, and liquidate margin securities. During default, CCPs employ various measures to reduce exposure, such as –
  • Macro-hedging – It minimizes portfolio exposure to major risk factors through liquid transactions, reducing market risk. The default management group can strategically apply market risk macro-hedges.
  • Auctions – After macro-hedging, the CCP auctions the portfolio by sub-portfolios (e.g., currency). The default management group splits the portfolio into sub-portfolios, ensuring balanced directional risks through macro-hedging. Surviving CCP members submit two-way prices, and the best bidding member wins a sub-portfolio. Incentives for participation include achieving a favourable resolution collectively and potential loss allocation to losing bidders before winners. The macro-hedges ensure reasonable bids in volatile markets.
• A CCP also benefits from a default management group made up of key personnel from the CCP together with senior traders from member firms who may be seconded on a revolving basis. Such traders can help with tasks such as the macro-hedging of the portfolio.
• CCPs leverage a default management group, comprising CCP personnel and rotating senior traders from member firms, aiding in tasks like portfolio macro-hedging. Efficiency in the auction process is enhanced through regular fire drills, occurring, for example, bi-annually, where clearing members submit prices. New CCP members must pass a driving test to demonstrate operational competence in processing, pricing, and bidding on substantial trade portfolios within a short timeframe (a few hours).
• Efficient porting of client positions to surviving clearing members is a priority, often facilitated by prearranged backup member agreements. However, successful porting hinges on the receiving clearing member’s acceptance of the portfolio and associated margin, contingent upon margin charging and segregation practices. If porting is unfeasible, defaulted member trades and client positions are managed jointly.
• Following Lehman Brothers’ bankruptcy in 2008, SwapClear neutralized 90% of Lehman’s risk within a week, auctioning all 66,000 trades in three weeks, utilizing only a third of the initial margin. Conversely, a recent Nasdaq instance required a significant portion of the default fund, indicating varied outcomes in default scenarios.
• CCPs significantly decrease the Margin Period of Risk (MPoR) by issuing daily, possibly intraday, cash collateral calls without settlement delays. It is depicted in the figure given alongside. They maintain full control over calculations, disallow disputes, and ensure members can meet operational requirements for margin posting, even guaranteeing posting on behalf of clients if required.
• CCPs can swiftly declare a member in default without external hindrances, expediting the default management process due to their advantageous position in bankruptcy law. As shown in the figure above, the MPoR for a CCP comprises three periods –
  • No action – The pre-default period is shorter compared to bilateral markets, given the CCP’s ease of declaring members in default.
  • Macro-hedging – The CCP quickly neutralizes portfolio sensitivities through liquid macro-hedges, significantly reducing overall risk.
  • Auctions – The CCP conducts auctions to trade out of the portfolio, gradually diminishing risk to zero, though incurring potential auction costs.
    

• In the Lehman Brothers default, SwapClear’s response was swift –
  • The default management group, comprising rotating member firms and experienced traders, was established immediately after Lehman’s default on September 15, 2008.
  • Applying strict confidentiality, the group implemented macro-hedges promptly to neutralize market risk in Lehman’s portfolio.
  • Daily reviews of risk positions were conducted, adjusting hedges as needed based on changing market conditions
  • From September 24 to October 3, competitive auctions for the five currency-specific sub-portfolios were successfully conducted
• The process spanned three weeks, but the risk was largely hedged earlier. The Margin Period of Risk (MPoR) in CCP default management, analogous to a metaphorical parameter, gradually reduces risk. CCPs typically employ a five-business-day MPoR for OTC derivatives, shorter than the minimum 10 days in bilateral markets.

CCP Risk Management – The Loss Waterfall

• During a clearing member default, the CCP uses the member’s initial margin and default fund contributions for macro-hedging and auctions. If these are insufficient or the auction fails, the CCP relies on other financial resources and mechanisms, outlined in a loss waterfall. This guides the sequence of resource utilization as shown in the figure.
• The initial components of the loss waterfall include the defaulter’s initial margin and default fund contribution(s). Following this, the CCP typically provides a skin-in-the-game equity contribution to incentivize loss mitigation.
• If the above resources are exhausted, the remaining default fund of the CCP is utilized, following a survivors-pay approach. This collective contribution from all clearing members may involve a pro rata allocation of losses or other rules incentivizing proactive participation in the auction. While the prospect of losses depleting a substantial portion of the default fund is deemed highly improbable, alternative methods for absorbing such losses exist depending on the specific CCP.
  
  

• Some alternative methods for absorbing losses are given below –
  • Rights of assessment are unfunded obligations allowing a CCP to seek additional contributions to a depleted default fund. Typically triggered after a substantial fraction, like 25%, of the fund is utilized, this recapitalization measure is capped to avoid moral hazard, unlimited exposure for clearing members, and potential market destabilization. Imposing limits ensures responsible use, preventing clearing members from contributing to default funds at worst possible time.
  • Variation Margin Gains Haircutting (VMGH) is a common loss-allocation concept, aiming to offset losses from a defaulting clearing member by ‘haircutting’ the corresponding gains of other members. This mimics bilateral market economics, ensuring members pay for their losses. VMGH may not lead to an overall profit for a clearing member, considering potential losses elsewhere. Successful VMGH relies on auctioning a defaulter’s portfolio at mid-market prices; failure may occur if the CCP closes out at a substantial premium to mid-market prices.
  • A CCP may opt for a tear-up where unmatched contracts with surviving clearing members are terminated. The goal is to restore a matched book by ending opposite trades to those of the defaulter. Unlike VMGH, tear-up avoids exposing the CCP to risk premiums in auctioning transactions. Tear-up can be partial or full, with the latter ensuring the CCP’s continuity but leaving clearing members with losses and market risk exposures.
  • Similar to tear-up, forced allocation compels clearing members to accept specific portfolios at CCP-determined prices, achieving a similar outcome by imposing reverse trades. However, forced allocation may be more random, as any member can receive allocated positions, unlike tear-up, which requires specific trades in a member’s portfolio. Also, this allocation prevents clearing members from passing on the impact to their clients.
• A CCP can impose losses on its members through the default fund without nearing its own failure. Notably, a member’s default losses are not directly tied to transactions with the defaulted counterparty. Loss-allocation methods like tear-up or forced allocation, theoretically infinite, imply the CCP’s continuance by imposing any level of losses on clearing members, potentially causing surviving members to fail.
• In case loss allocation exhausts the CCP’s remaining capital, external liquidity support, such as a central bank bailout, becomes necessary to prevent CCP failure. Some CCPs may include additional components like lines of credit and financial guarantees. While these options are costly, they act as safeguards against significant market movements or the default of a clearing member. It’s crucial to note that none of these methods involve using the initial margin of non-defaulting members.
• Although initial margin haircutting has been proposed, it has not been implemented, and regulators may prohibit its use. Consequently, initial margin contributions remain theoretically risk-free. However, given the potential for infinite loss allocation methods, this offers limited comfort to surviving clearing members.

CCP Risk Management – Bilateral Vs Central Clearing

• The table given below shows a comparison of bilaterally- and centrally-cleared markets.
  

  Feature	Bilateral Market	Centrally-Cleared Market
  Counterparty	Original	CCP
  Products	All	Must be standard, vanilla, liquid, etc.
  Participants	All	Clearing members are usually large dealers
  Netting	Bilateral netting arrangements and portfolio compression	Multilateral netting (including compression)
  Margining	Bilateral, bespoke arrangements dependent on credit quality Regulatory rules being introduced	Full collateralization, including initial margin enforced by CCP
  Close-out	Bilateral	Co-ordinated default management process (macro-hedges and auctions)
  Loss absorbency cost	Mainly capital	Mainly initial margin (and default fund)

Initial Margin And Default Funds – Coverage

• Initial margin aims to provide high confidence coverage (e.g., 99%) in case of a clearing member default, but breaches can occur. Inadequate initial margin may lead to substantial losses, as evidenced by Bates and Craine’s (1999) estimation of increased losses post the 1987 crash when margin calls were breached.
• As shown in the figure, the default fund’s purpose is to absorb severe losses beyond margin coverage, mitigating heavy-tailed distribution risks. In sharing the default fund, CCP members collectively address improbable but potentially significant losses from a single counterparty’s failure. This mutualisation helps alleviate systemic issues but introduces new risks. The default fund’s size is determined through stress scenarios involving member defaults and market conditions.
  

Initial Margin Vs Default Funds

• The default fund, crucial in clearing, offers extensive loss coverage beyond the initial margin, thanks to mutualisation. Contributions to the default fund may appear modest compared to the initial margin, but they significantly enhance loss absorbency through shared responsibility.
• Examining the allocation of resources in the figure, three scenarios display the split between initial margins (IM) and default funds (DF). Each of the five CCP members contributes one unit. Smaller initial margins and larger default funds are cost-effective but elevate moral hazard, increasing the likelihood of default fund losses and reducing adherence to the defaulter-pays principle.
  
  
• Non-clearing members do not contribute to CCP default funds, meaning clients only impact their portfolio risk via the CCP-imposed initial margin. Default funds mutualize clearing and client defaults. Large default funds and smaller initial margins may discourage clearing members from facilitating portability. The choice between more initial margin for better behaviour and more default funds for cost efficiency and loss absorbency is given below.

Feature	Higher Initial Margin and Lower Default Fund	Lower Initial Margin and Lower Default Fund
Cost	Higher	Lower
Client Clearing	Clients pay for their own risk via initial margin, promotes portability	Clients do not pay for their own risk directly, portability difficult
Moral Hazard	Lower	Higher

Default Fund Coverage

• Losses affecting CCP default funds are rare, aligning with high-confidence initial margin calculations. For instance, LCH has encountered seven defaults, all absorbed within the defaulter’s initial margin without impacting others. However, when default fund losses occur, they can be substantial, as seen in historical cases like the 1987 Hong Kong Futures Exchange losses and Nasdaq’s default fund losses. The likelihood of such losses may rise with larger CCPs dealing with increasingly complex and risky financial products.
• The default fund ensures cost-effective clearing by mutualizing losses beyond initial margins, covering potential tail risks. Determining the optimal size is challenging due to uncertainties stemming from extreme events, fail tail behaviour, complex interdependencies, and what-went-wrong scenarios. The probability of a CCP depleting its default fund is unquantifiable, tied to events involving one or more clearing members, extreme market shifts, and illiquidity.
• CCPs, owing to the inherent uncertainties, qualitatively calibrate the default fund size using pre-defined stress tests. The allocation to clearing members can be relatively simple, such as pro rata with initial margins or based on total position size. The total default fund size is often expressed in terms of the number of defaults a CCP can withstand (typically one or two), and contributions are less frequently updated compared to initial margins.
• The CPSS-IOSCO (2012) principles mandate a CCP to fulfil 2 requirements –
  • Cover 1 Requirement – A CCP should maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the participant and its affiliates that would potentially cause the largest aggregate credit exposure to the CCP in extreme but plausible market conditions.
  • Cover 2 Requirement – A CCP that is involved in activities with a more complex risk profile or that is systemically important in multiple jurisdictions should maintain additional financial resources sufficient to cover a wide range of potential stress scenarios that should include, but not be limited to, the default of the two participants and their affiliates that would potentially cause the largest aggregate credit exposure to the CCP in extreme but plausible market conditions.
• As an example, SwapClear sizes its default fund to cover the default of the largest two Clearing Members, aligning with CPSS-IOSCO principles. The fund employs extreme yet plausible stress test scenarios tailored for the interest rates market.
• For OTC CCPs, ensuring resilience is crucial due to potential crises involving SIFIs. Default funds are designed to withstand the failure of the two most significant clearing members, providing confidence and stability during turbulent market conditions. The larger default funds are seen as necessary to prevent systemic disturbances, considering that failed counterparties are likely members of multiple CCPs. This approach safeguards financial integrity, mitigates risks, and averts major crises during serious market disruptions.

Central Clearing – Advantages

• Advantages of a CCP include –
  • CCPs enhance market transparency by monitoring and acting on concentration risks among clearing members, reducing the potential for panic arising from undisclosed exposures.
  • CCPs enable multilateral offsetting of risks between different counterparties, providing flexibility in transactions and cost reduction.
  • In the event of a default, losses exceeding the defaulter’s commitments are spread across CCP members, mitigating the impact on individual members and reducing systemic risks.
  • CCPs streamline margining, netting, and settlement functions, enhancing operational efficiency and reducing legal risks through centralized rules and mechanisms.
  • Market liquidity is improved by facilitating easy trading and multilateral netting, potentially reducing barriers to market entry.
  • CCPs, through well-managed central auctions, minimize price disruptions associated with the replacement of positions during a clearing member’s default crisis.
• Historically, clearing focused on listed derivatives, while bilateral over-the-counter (OTC) markets, with more illiquid, long-dated, and complex derivatives, experienced substantial growth surpassing exchange-traded products over the last two decades.

Central Clearing – Disadvantages

• The following are the disadvantages of a CCP –
  • CCPs face moral hazard as members may neglect counterparty risk management, relying on the CCP to absorb most risks, leading to inadequate monitoring and risk mitigation.
  • CCPs are susceptible to adverse selection, where OTC derivatives traders exploit superior knowledge to pass riskier products to underpriced CCPs, causing potential imbalances.
  • The mandatory clearing of standard products may create bifurcations between cleared and non-cleared trades, limiting the benefits of multilateral offset and increasing overall costs.
  • CCPs may introduce procyclicality by raising margin requirements during volatile or crisis periods, potentially exacerbating economic downturns compared to the more flexible practices in bilateral OTC markets.
• CCPs execute various functions like netting, margining, transparency, loss mutualisation, and default management. However, alternative mechanisms such as trade compression, bilateral margining, and trade repositories can also achieve similar objectives, emphasizing the adaptability of these functions across different platforms.

Central Clearing – Effects on Credit Value Adjustment

• CCPs, by mitigating counterparty risk, raise questions about the relevance of credit value adjustment (CVA), funding value adjustment (FVA), and capital value adjustment (KVA). The impact on these components, originating largely from non-margined OTC derivatives with exempt end users, is expected to diminish. As these end users, exempt from the clearing mandate, may not voluntarily move to central clearing due to challenges in posting margin, the significance of CVA, FVA, and KVA is likely to decrease.
• In examining a bank’s CVA breakdown, approximately 15% of CVA arises from exposures to banks and other financial institutions, which could see a significant reduction through clearing and bilateral initial margin posting. However, the remaining 85% of CVA, stemming from exposures to exempt counterparties like corporates and governments, is likely to persist in uncollateralized bilateral transactions. While central clearing and collateral rules may alter components like CVA, they can increase other factors such as margin value adjustment, necessitating a holistic consideration of xVAs to comprehend the overall impact. Assessing CVA impact on central counterparties is also becoming increasingly crucial.