Introduction

• Central counterparties (CCPs) have been used for trading derivatives in exchange-traded markets for many years. A derivatives exchange is organized so that its CCP is the counterparty to all its member traders (whether they are buyers or sellers).
• The rules developed by CCPs for members posting margin allow the exchanges to handle credit risks efficiently. As a result, failures of CCPs handling exchange-traded products have been rare. One example of such a failure is that of French clearing house Caisse de Liquidation in 1974. Following a steep decline in sugar futures prices, the exchange was required to make large variation margin payments to its members with short positions. However, some members with long positions failed to make their variation margin payments. As a result, their initial margin balances were insufficient to make the variation margin payments even when combined with other funds the CCP could access. A similar failure is that of the Kuala Lumpur Commodity Clearing House. The Malaysian exchange was forced to close in 1983 after a steep decline in palm oil futures prices left the CCP unable to pay margin owed to members with short positions. As with Caisse, this inability to pay was the result of members with long futures positions failing to post variation margin when required.
• Failures such as these are rare and futures markets have almost always been able to survive periods of market volatility. For example, futures markets in the United States were tested on October 19, 1987, when the S&P 500 index declined by over 20% in one day. This created a stressful situation for exchanges trading S&P 500 futures, such as the Chicago Mercantile Exchange (CME). Despite the dramatic fall in prices, however, the CME was able to pay in full all members with short futures positions.
• Exchanges have learned from the failures and near-failures of CCPs in the past and are now considered to be extremely safe. For example, initial margin requirements are now adjusted more frequently to reflect changing market conditions. Furthermore, initial and variation margin payments may be required from members during the day (as well as at the end of a day) when asset prices are especially volatile. If a margin call is not met, the member's position is closed out. The positions of members are monitored carefully by the CCP and members may be required to reduce their exposures by the CCP in some circumstances.
• CCPs in OTC markets operate similarly to the CCPs used by exchanges. As with exchange CCPs, members of OTC CCPs are required to post initial and variation margin as well as make contributions to the default fund. However, products being cleared in the OTC market differ from those being cleared by exchanges. For example, most exchange-traded contracts last only a few months, and very few last more than three years. In contrast, OTC contracts often last ten years or longer. The average futures trade on an exchange is also much smaller than the average trade in the OTC market.
• Another key difference is that while exchange-traded futures contracts trade continuously, OTC contracts trade only intermittently. As a result, OTC contracts are less liquid than exchange-traded contracts. The differences in trading frequencies between the two types of markets also affect variation margin calculations. While exchange traded variation margin requirements can be determined directly from market prices, it is often necessary to use a model when determining margin requirements in the OTC markets.
• Three large CCPs for clearing OTC transactions are:
  • SwapClear (part of LCH Clearnet in London),
  • ClearPort (part of the CME Group in Chicago), and
  • ICE Clear Credit (part of the Intercontinental Exchange).
• These large CCPs are critical for the smooth functioning of the global financial system and are regarded as “too big to fail” by financial regulators. This means that in the event of financial difficulties, they would almost certainly receive some type of bailout. It is therefore important to examine their risks.
• There are also several other smaller, more localized OTC CCPs that might need to be bailed out in the event of financial difficulties. This is because some authorities regard it as important to have local OTC CCPs to service financial institutions in their region and clear transactions denominated in local currency.
• While cooperation between CCPs is limited, there are significant economies of scale involved with running a CCP. Thus, mergers between CCPs as well as takeovers of smaller CCPs by larger ones can be expected.

The Operation of CCPs

• CCPs clearing trades in the OTC markets operate in much the same way as CCPs clearing trades on exchanges.
  • Members are required to post initial margin and variation margin as well as make contributions to the default fund.
  • The variation margin is paid or received daily (or even more frequently) by members and reflects the change in the value of each member's portfolio of transactions with the CCP.
  • In absence of a member default, the variation margin received by the CCP should always equal the variation margin paid by the CCP. This is because the CCP has a matched book and therefore it takes no market risk.
  • When there is a default, there is market risk as the CCP closes out the positions of the defaulting member.
• The initial margin required from each member is calculated using historical data based on the amount that could be lost if the member defaults and reduction in value of the member's position during closing out because of market price movements.
• Typically, the CCP sets the initial margin so that if it takes five days to close out the member's position, the CCP is 99% certain that the initial margin will cover the losses. If the defaulting member's initial margin proves insufficient to cover losses, however, the default fund contributions from the defaulting member are used. If this is still not enough, the contributions from other members are used. Only when this amount is insufficient does the CCP's equity become at risk.
• When a member defaults, the exchange typically holds an auction inviting other members to bid for transactions that offset the defaulting member's transactions.
  • The incentive of the members is that if a CCP can quickly close out a defaulting member's positions, the remaining members' default fund contributions will be safe, and they can continue to clear transactions through the CCP.
  • If the auction fails, however, the CCP may have the right to allocate losses to members who have made recent gains.
  • Additionally, the CCP may choose to tear up transactions. This procedure involves closing out transactions between members and the defaulting party at prices that leave the non-defaulting members with some loss.
• CCPs cover their costs by charging fees per trade. They may also earn interest on initial margin in excess of that paid to members. For CCPs owned by their members (or a subset of their members), excess profits are distributed to member–owners.
• CCPs that are owned by outside investors and are under pressure to generate profits. Competition between CCPs can benefit users by providing choices and encouraging CCPs to improve their systems. However, there is a danger that CCPs will try to compete with each other by reducing initial margin requirements and default fund contributions, increasing the risk.
• OTC CCPs are subject to a great deal of regulation. For example, the Financial Services Authority in the United Kingdom monitors risks taken by LCH Clearnet.
• It is important that OTC CCPs not be allowed to take risks unrelated to their main activity of clearing OTC transactions. For example, it would be inappropriate for them to engage in speculative trading activities. In this respect, an OTC CCP should behave like a public utility.

Regulation of OTC Derivatives Market

• Since it is widely believed that complex OTC-traded derivatives played a significant role in causing the crisis, regulations introduced since the 2007–2008 global financial crisis have led to an increase in the use of CCPs in the OTC derivatives market.
• While discussing introduction of regulations during the Pittsburg Summit, systemic risk was a very important concern. This is the risk that a default by one derivatives dealer could lead to losses being incurred by other derivatives dealers on their transactions with the defaulting dealer. In the worst-case scenario, this interconnectedness of derivatives dealers would lead to a collapse of the global financial system. The statement issued by the G-20 leaders after the Pittsburgh summit included the following paragraph:
  • All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Noncentrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.
• The G-20 Pittsburgh meeting resulted in three major regulations affecting OTC derivatives.
  1. A requirement that all standardized OTC derivatives be cleared through CCPs. The purpose of this requirement is to create an environment where dealers have less credit exposure to each other, reducing interconnectedness and systemic risk.
  2. A requirement that standardized OTC derivatives be traded on electronic platforms to improve price transparency. If there is an electronic platform for matching buyers and sellers, the prices at which products trade should be readily available to all market participants. These platforms are called swap execution facilities (SEFs) in the United States and organized trading facilities (OTFs) in Europe. In practice, standardized products are passed automatically to a CCP once they have been traded on these platforms.
  3. A requirement that all trades in the OTC market be reported to a central trade repository. This requirement provides regulators with important information on the risks being taken by participants in the OTC market.

Standard Versus Non-Standard Transactions

• The meaning of the term standard transaction is obviously important to the application of the rules just mentioned. Standard transactions are transactions that CCPs are prepared to clear. For a CCP to clear a product, several conditions must be satisfied.
  • The legal and economic terms of the product must be standard within the market.
  • There must be generally accepted models for valuing the product (because the CCP needs to determine variation margin at least once a day).
  • The product must trade actively. If this is not the case, it may be difficult to unwind a member's position if the member fails to produce margin when required. It may also be difficult to obtain up-to-date valuations for non-actively traded products. A related point is that CCPs will not consider it worthwhile to develop the systems to support the clearing of a product if their members do not trade it frequently.
  • Extensive historical data on the price of the product should be made available to enable initial margin requirements to be determined.
• The main product categories currently classified as standard are interest rate swaps and credit default swaps on indices. Other products, such as options on interest rate swaps and single-name credit default swaps, may be added at some stage. However, it seems likely that most exotic derivative products will be classified as non-standard for the foreseeable future.
• Transactions that are cleared bilaterally (rather than through a CCP) are known as uncleared.
• Regulators recognized that derivatives dealers could avoid the intent of the regulations described above by adding features to standard transactions that would make them slightly non-standard. A 2011 G-20 meeting resulted in uncleared derivatives joining their CCP-cleared counterparts in being subject to initial and variation margin requirements.
• Variation margin on uncleared trades is usually transmitted from one counterparty to the other directly. However, initial margin cannot be handled in this way. The regulations require initial margin on uncleared transactions to be transmitted to a third party to be held in trust.
• The initial margin that A has to post should cover the greatest decrease in the value of the contracts to itself (and therefore the greatest increase in their value to B) estimated to occur over a ten-day period with 99% confidence in stressed market conditions.
  • This requirement recognizes that if A defaults, it could take B up to ten days to close out (or replace) its positions with A. This means that the close out could be quite expensive if the value of these positions to B increase during that time.

The Move to Central Clearing

• This first figure shows a simplified situation where there are six participants in an OTC derivatives market trading with each other. It assumes that all contracts are cleared bilaterally and there are master agreements between every pair of participants covering all contracts between them. The agreements outline netting arrangements, collateral arrangements, and what happens in the event of a default by one side. Standard documentation for master agreements has been provided by the International Swaps and Derivatives Association.

• The second figure shows the situation when all transactions between the six market participants are centrally cleared through the same CCP. In this case, we assume that the six market participants are members of the CCP. The positions of market participants are transferred to the CCP, and each market participant agrees to adhere to the terms set by the CCP. Specifically, each participant agrees to post initial margin and variation margin. The participants also agree to make contributions to the default fund as required.

• In practice, the current environment for trading derivatives is a mixture of what is shown in the previous two figures. Some transactions (i.e., non-standard transactions between financial institutions and a subset of transactions with non-financial end users) are cleared bilaterally. Standard transactions between financial institutions (and some standard transactions with non-financial end users) are cleared though CCPs. A further complication is that there is more than one CCP. This means that even if all trades by the six market participants are cleared centrally, they might be cleared though different CCPs.
• Members of a CCP clear the trades of non-members bilaterally. These non-members are small financial institutions and non-financial companies. (Retail investors do not generally trade in the OTC market.) The non-members must post initial and variation margin with the member who is clearing their trades. This is similar to nonmembers' trades being cleared by exchange CCPs.
• OTC transactions are different from futures in that they are not settled daily. Cash flows settling the contracts occur periodically and sometimes (e.g., in the case of European options) all cash flows are settled at the end of the contract's life. However, CCPs value OTC contracts at least once a day and transfers the required variation margin reflecting the change in net value of outstanding contracts. This means, for example, that the variation margin transferred from Party A to Party B belongs to Party A until the contractual cash flows occur. As a result, Party B must pay interest on the variation margin it receives from A. If clearing is through a CCP, the interest is paid by Party B to the CCP and by the CCP to Party A. Interest on initial margin balances is paid by the CCP (as is the case with exchange-traded contracts).
• Even though interest is paid on margin transfers as appropriate, financial institutions still regard them as a cost. Typically, institutions compare the interest rate paid on their margin with their average cost of borrowed funds and calculate a cost relating to the difference.

CCPs may give rise to an increase in netting. For example, consider the situation in this figure where three market participants trade bilaterally. The arrows in this figure indicate that Party A has transactions with Party C that are worth +USD 8 million to Party A and -USD 8 million to Party C. Party A also has transactions with Party B that are worth +USD 5 million to Party B and -USD 5 million to Party A. Finally, Party B has transactions with Party C that are worth +USD 2 million to Party C and -USD 2 million to Party B. Positive values lead to potential credit exposures, while negative values do not. In the absence of any credit mitigation procedures:

• Party A has a credit exposure of USD 8 million to Party C and none to Party B,
• Party B has a credit exposure of USD 5 million to Party A and none to Party C, and
• Party C has a credit exposure of USD 2 million to Party B and none to Party A.

The total credit exposure of all three parties is USD 15 million (=8 million + 5 million + 2 million).

Next, suppose that all transactions are cleared through a single CCP. This figure indicates how this would work. In this example, a transaction between A and B would be converted into a transaction between A and the CCP as well a transaction between the CCP and B.

The CCP would then net the transactions in the manner shown in this figure. This demonstrates that the CCP has increased netting.

• Party A is able to net its transactions with Party B against its transactions with Party C.
• Party B is able to net its transactions with Party A against its transactions with Party C.
• Party C is able to net its transactions with Party A against its transactions with Party B.

However, the overall credit exposure in the system is lower. Parties A and B each have a credit exposure to the CCP of 3 million USD and Party C has no credit exposure at all. If the credit exposures were handled with variation margin and initial margin, there would be a saving of initial margin.

• Clearing through CCPs usually increases netting, but this is not always the case. For example, the transactions with one CCP cannot usually be netted against transactions with another CCP.
• Furthermore, some transactions (e.g., non-standard transactions) cannot be cleared through CCPs. And while standard transactions and non-standard transactions between two parties can be netted when cleared bilaterally, this is not the case if the standard transactions go through a CCP (while the non-standard transactions continue to be cleared bilaterally). This means that the loss of netting could outweigh the extra netting provided by diverting transactions through CCPs even when the same CCP is used for all transactions.

Advantages and Disadvantages of CCPs

• A key advantage of the central clearing model is that it is much easier for market participants to exit a CCP transaction than a bilaterally cleared transaction.
  • When transactions are cleared bilaterally, a market participant can only exit a trade by approaching the original counterparty and trying to negotiate a close-out (which usually would involve a payment from one side to the other).
  • If the original counterparty does not offer reasonable close-out terms, the market participant would need to enter into an offsetting transaction with another counterparty.
  • This arrangement creates credit risk because either the original counterparty or the new counterparty may default.
• However, the credit risk is eliminated if both the original trade and the offsetting trade are cleared with the same CCP.
• If the original transaction and the new transaction are cleared with different CCPs, the market participant will have to post initial margin with each one. In the future, it may be possible to arrange for trades with different CCPs to be netted so that the initial margin is avoided. This arrangement is known as interoperability and is not (as of yet) common practice.
• If trades are cleared through a CCP, the risks are shared by all members of the CCP. This sharing of credit risk is referred to as loss mutualization and is attractive to regulators because it has the effect of reducing systemic risk. It does this by dispersing the impact of a default by a market participant throughout the market.
• Another advantage of CCPs is that they manage the margining, netting, settlement, and default resolutions. A CCP can handle these functions better than any single market participant in the bilaterally cleared market.
  • However, any operational problems experienced by the CCP could have widespread consequences because it is responsible for a far larger number of transactions than any single market participant.
• CCPs may also improve liquidity in the OTC market by making it much easier for market participants to net and exit from transactions.
• Another positive aspect of central clearing is that it encourages the development of standard documentation for OTC derivative transactions.
• A disadvantage for CCPs is that they entail both moral hazard and adverse selection risks.
  • Moral hazard exists because market participants have less incentive to concern themselves with the riskiness of the companies they trade with when much of the risk will be passed on to the CCP.
  • Adverse selection exists when a dealer has a choice between clearing a transaction through a CCP or clearing it bilaterally (e.g., when it is trading a standard derivative with a non-financial end user). If the dealer considers the credit risk of the counterparty to be high, it might persuade the counterparty to clear through a CCP. If the counterparty is financially strong, however, the dealer may be comfortable clearing the transaction bilaterally.
• Another disadvantage of CCPs is that they tend to increase the severity of adverse economic events (i.e., they are pro-cyclical). When markets are highly volatile or there is a financial crisis, for example, many financial institutions are likely to have liquidity shortages. At the same time, CCPs are likely to increase initial margin requirements and default fund contributions. These actions would thereby exacerbate the liquidity shortages faced by financial institutions.
• It is also difficult for CCP members to evaluate the credit risk they are taking. Note that a CCP member's default fund contributions (and even some of its variation margin gains) may be at risk if another member defaults. However, a CCP member may have very little information about trades done by other members. This can be contrasted with bilateral clearing, where exposures are more concentrated but better understood.
• Conversely, a CCP has a great deal of information about the portfolios of its members and can act to address excessive risk taking. If a member has a particularly large exposure, for example, the CCP may limit trading or increase the required initial margin. In the bilaterally cleared market, however, participants typically see a much smaller percentage of their trading partners' portfolios.

CCP Risks

• The new derivatives regulations replace too big- to-fail banks with too-big-to-fail CCPs. It certainly would be a disaster for the financial system if a major CCP were to fail. But CCPs are much simpler organizations than banks and are therefore much easier to regulate.
• The key activities of CCPs are
  • Admitting members,
  • Valuing transactions,
  • Determining initial margin and default fund contributions, and
  • Managing systems for netting, transferring variation margin, and so on.
• OTC CCPs have (up to now) functioned well. When Lehman Brothers declared bankruptcy in September 2008, for example, it was the largest bankruptcy in US history. However, CCPs (both those clearing exchange-traded products and those clearing OTC transactions) managed to close out Lehman's positions within a matter of days. By contrast, disputes concerning Lehman Brothers' bilaterally cleared OTC transactions dragged on for many years at great cost to everyone involved. But still, OTC CCPs pose some risks.
• One significant problem with CCPs is that there is a positive correlation among member defaults. If one member defaults because of difficult economic conditions, others are likely to do so as well. Recognizing this, regulators ask CCPs to consider scenarios where multiple members default at the same time. Regulators also require CCPs to conduct stress tests involving imaginary adverse events to determine whether they would survive and conduct close-outs efficiently.
• CCPs treat all members in the same manner when calculating initial margin and default fund contributions. A consequence of this is that CCPs do not take the credit quality of its counterparties into account in the same way that a dealer does in the bilaterally cleared market. Once a dealer has been admitted as member, it is treated in the same way as all other members.
• A risk for CCPs is that the auction processes for closing out defaulting members could fail in the turbulent markets. It may then be compelled to force other members to share in the losses and thereby cause more defaults. It might also lead to resignations among members unwilling to stay in the central clearing model. This in turn could lead to a loss of reputation for the CCP and further resignations.

• Other risks faced by a CCP are:
  • Fraud,
  • Computer systems failure/hacking,
  • Litigation costs, and
  • Losses on investments of the initial margin and variation margin.

There may be correlations between losses arising from defaults and these types of losses. In the stressed market conditions that can lead to defaults, investments may perform poorly and litigation costs may increase.

• Model Risk
  • OTC transactions last longer, are less standard, have less price transparency, and trade less frequently. As a result, OTC CCPs are more reliant on valuation models in determining transaction values and clearing variation margin transfers. If these models function poorly, the operation of the CCP may be compromised and member disputes may follow.
  • OTC CCPs also rely on models to determine initial margin requirements. An OTC CCP must run models to determine how much initial margin is appropriate for each member's position. A lesson from the failures of exchange CCPs is that initial margin requirements should be updated regularly as volatilities change. Members should be required to post initial and variation margin almost immediately upon request.

• Liquidity Risk
  • A large CCP holding tens of billions of dollars of initial margin is faced with a trade-off between the return it gets by investing this cash and the liquidity constraints of its investments. Liquid investments (e.g., Treasury bills) tend to provide lower returns than less liquid investments (e.g., corporate bonds). At the same time, CCPs need some of their investments to be readily convertible into cash in the event one or more members default.
  • It is important that the liquidity of an investment be assessed assuming stressed market conditions because member defaults are likely to be accompanied by turbulent market conditions (which typically reduce investment liquidity).