Central counterparty clearing

Central counterparty clearing, also referred to as central counterparty (CCP), is a financial institution that provides clearing and settlement services for trades in foreign exchange, securities, options and derivative contracts. A clearing house stands between two clearing firms (also known as member firms or participants). Its purpose is to reduce the risk a member firm failing to honor its trade settlement obligations. A CCP reduces the settlement risks by netting offsetting transactions between multiple counterparties, by requiring collateral deposits (also called "margin deposits"), by providing independent valuation of trades and collateral, by monitoring the credit worthiness of the member firms, and in many cases, by providing a guarantee fund that can be used to cover losses that exceed a defaulting member's collateral on deposit. The advantages of a central counterparty clearing arrangement are greater transparency of the risks, reduced processing costs, and greater certainty in cases of default by a member.[1] Once a trade has been executed by two counterparties, it is submitted to a clearing house, which then steps between the two original traders' clearing firms and assumes the legal counterparty risk for the trade. For example, a trade between member firm A and firm B becomes two trades: A-CCP and CCP-B. This process is called novation.

As the CCP concentrates the risk of settlement failures into itself and is able to isolate the effects of a failure of a market participant, it also needs to be properly managed and well-capitalized[2] in order to ensure its survival in the event of a significant adverse event, such as a large clearing firm defaulting. Guarantee funds are capitalized with collateral from the member firms. In the event of a settlement failure, the defaulting firm may be declared to be in default and the CCP's default procedures utilized, which may include the orderly liquidation of the defaulting firm's positions and collateral. In the event of a significant clearing firm failure, the CCP may draw on its guarantee fund in order to settle trades on behalf of the failed clearing firm.

History

The origins of clearing houses dates back to the late 19th century, when they were primarily used to net payments in commodities futures markets. CCPs are financial market infrastructures that can reduce and "mutualize" (share among their members) counterparty credit risk in the markets in which they operate.[3] The use of clearing houses by financial exchanges is somewhat more novel. Financial exchanges only first began to use clearing houses in the latter part of the 19th century. As late as 1899, the London Stock Exchange was still the only stock exchange in Europe using a clearing house.[4] The first stock exchange in the United States, the Philadelphia Stock Exchange (founded 1790), was also the trend setter that was the first U.S. stock exchange to use a clearing system. It began using a clearing system in 1870,[5] but the much larger New York Stock Exchange (NYSE) still had no clearing system some two decades later in 1891. The Consolidated Stock Exchange of New York (Consolidated) used clearing houses from its inception in 1885. This exchange existed in competition with the NYSE from 1885-1926 and averaged 23% of NYSE volume. Its competitor Consolidated's use of clearing houses, finally forced the NYSE to follow suit (from 1892) to gain the same market advantages of at least prevention of frauds and reneging on bargains.[6] Some major U.S. commodities exchanges, like the New York Coffee Exchange (today the Coffee, Sugar and Cocoa Exchange) and the Chicago Mercantile Exchange did not begin using clearing houses to settle their transactions until the second decade of the 20th century. The New York Coffee Exchange began using clearing houses in 1914.[7] The Chicago Mercantile Exchange began using them even later in 1919.[8]

Post 2008 crash developments

In the wake of the financial crisis of 2007–08 and as part of the Obama financial regulatory reform plan of 2009, pressure has been placed on traders of derivatives such as credit default swaps to make their trades on an open exchange with a clearinghouse. In June 2009, Federal Reserve official Alfred Kohn mentioned that the largest credit default swap dealers were working on an exchange, and that only regulatory approval rather than legislation would be required.[9] In March 2010, the Options Clearing Corporation stated that it was moving forward in backing equity derivatives.[10]

Foreign exchange

CLS Group acts as the global CCP for banks trading foreign exchange contracts with each other.

Securities (US)

DTCC's subsidiary the National Securities Clearing Corporation clears broker-to-broker trades using its Continuous Net Settlement (CNS) System. This has acted as a CCP, long before the term was coined.[11] In order to deal with the default of a member broker, as happened with Drexel Burnham and Lehman Brothers, DTCC has a guarantee fund to which all broker members contribute. It also has rules to handle the gains and losses from a defaulting broker. The guarantee fund ensures that settlement can be completed. A defaulting member's contribution to the fund, along with any other assets held by the depository, are used to absorb any losses at the time of default.[12][13]

The options market, with its Options Clearing Corporation (OCC), also acts as a central clearing counterparty. Its rules stipulate a five step "waterfall" in dealing with the default of a member:[14]

  1. The margin deposits of the suspended firm
  2. Clearing fund deposits of the suspended firm
  3. Clearing fund deposits of non-defaulting firms
  4. OCC retained earnings
  5. Clearing fund assessments

In order to access the viability of its funds, the OCC carries out a firm wide default test annually. In addition, the firm performs smaller, limited scope defaults throughout the year. Results are reported to its Enterprise Risk Management Committee.[14]

Europe

LCH.Clearnet, the result of a merger between the London Clearing House and Clearnet, acts as a CCP for a wide variety of financial products, from equities and commodities to Credit Default Swaps and Interest Rate Swaps.

Asia

Asian countries have addressed the needs of their derivative markets by forming CCPs[15]

References

  1. ↑ Steigerwald, Robert S. (2013), "Central Counterparty Clearing" (PDF), Understanding Derivatives—Markets and Infrastructure, Federal Reserve Bank of Chicago: 12–26, retrieved 2017-03-29
  2. ↑ Primer: Derivative Instruments. Financial Policy Forum Derivatives Study Center.
  3. ↑ Rehlon, Amandeep; Nixon, Dan. "Central counterparties: what are they, why do they matter and how does the Bank supervise them?" (PDF). Bank of England. Retrieved 1 April 2017.
  4. ↑ Lloyd, H.D. (1899), "Clearing, and clearing houses", Cyclopædia of Political Science, Political Economy, and the Political History of the United States, 1, New York: Maynard, Merrill, and Co, p. 223)
  5. ↑ Guarino, A.S. Philadelphia Stock Exchange, Encyclopedia of Greater Philadelphia
  6. ↑ Sobel, R. (2000) The Big Board. Washington, D.C.: Beard Books, p. 131 (Original work published 1965 New York, New York: Free Press)
  7. ↑ Staff, Simmon’s Spice Mill, Vol. 37, No. 10, October, 1914, p. 1036
  8. ↑ Labuszewski, J.W., Nyhoff, J.E., Co R., and Peterson, P.E. The CME Group Risk Management Handbook (2010) Hoboken, New Jersey: John Wiley & Sons, p. 80
  9. ↑ Reuters. Kohn: OTC clearinghouse could concentrate risk.
  10. ↑ Retuers. OCC says pushing ahead on over-the-counter plan.
  11. ↑ Norman, Peter (February 2008), Plumbers and Visionaries, Chichester: John Wiley & Sons, p. 84, ISBN 978-0-470-72425-5
  12. ↑ DTCC. "CNS Overview". Depository Trust & Clearing Corporation. Retrieved 2 April 2017.
  13. ↑ National Securities Clearing Corporation, "Rule 18: Procedures for when the corporation declines or ceases to act", NSCC Rules and procedures, DTCC, retrieved 2 April 2017
  14. 1 2 OCC (September 9, 2016). "OCC Default Rules and Procedures" (PDF). Options Clearing Corporation. Retrieved 1 April 2017.
  15. ↑ "The Asian OTC Derivatives Markets". ISDA. Retrieved 2 April 2017.

See also

Further Overview:

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