Mandatory central clearing of OTC derivatives, as promoted by the G20 Leaders at the 2009 Pittsburgh Summit, addresses some of the financial stability risks that materialised during the Great Financial Crisis. The concept of a Central Clearing Counterparty (CCP) plays a pivotal role in ensuring the stability and integrity of financial markets.As a critical component of the modern financial infrastructure, CCPs are instrumental in reducing counterparty risk, enhancing market transparency, and fostering confidence among market participants. In recent years, we have seen an enormous increase in clearing volumes and products in the financial industry. But are CCPs as safe as they are claiming to be? And will the pros outweigh the cons? We take a look at these questions and also look into what Basel has to say about CCPs. Are they the master machines they claim to be?
A Central Clearing Counterpart is an intermediary organization that acts as a guarantor in financial transactions, particularly in the derivatives and securities markets. Its primary role is to step between the buyer and seller of a financial instrument, becoming the counterparty to both sides of the trade and thereby eliminating the need for direct counterparty risk between the original parties. This mechanism is known as novation.
CCP’s enforce standardized protocols for trade clearing, settlement, and reporting. They enhance market transparency by providing a centralized platform where trades are processed, reducing complexity and operational costs for market participants.
Market participants often use clearing brokers to get access to a CCP. The market participant has a client relationship with the clearing member or broker and the collateral for variation margin is passed through to the CCP (individual segregation). Although clearing via a broker seems favorable for the client, complexity with legal documents, set up costs and infrastructure maintenance can be challenging.
The main disadvantage is that the clearing broker mostly defines the collateral (and volume) that is accepted for initial margin requirements. There can be a mismatch and especially in a financial crisis, a clearing broker can unilaterally demand more collateral of the highest grade.
Although CCPs have a lot of positives, there are some concerns and challenges regarding CCPs:
Since the global financial crisis in 2008 and the mandatory clearing by CCPs of certain products, we haven’t had a comparable crisis. However, like any financial institution, CCPs are not immune to the possibility of default or financial stress. To manage such situations, CCPs employ a mechanism known as the "Waterfall Structure." This structure outlines a systematic approach to handling losses and defaults, prioritizing the protection of the financial system.
Although CCP is a general term and suggests most CCPs have common features, there are some small differences that can result in additional costs, namely:
Basis risk is volatile as you can see in the graph below, the difference in spread between Eurex and LCH for different maturities:
The Waterfall Structure is a risk management framework employed by CCPs to manage potential losses and defaults. It is designed to ensure that losses are absorbed in a structured and orderly manner, with the primary goal of protecting the financial system and market participants. The Waterfall Structure consists of several layers or tiers, each with its own source of funds and priority of claim in the event of a default.
For example, on Eurex, the waterfall structure will result in the following amounts to cover losses:
With the default of a clearing member, the trading positions will be hedged and closed. The Initial margin would be used to cover the losses. If this is not sufficient, the default fund of the client approx. 315 Mio would be used and thereafter the 143 Mio of EUREX (skin in the game).
For example, during the Lehman default and the resulting 2008 financial crisis, CCPs had no trouble managing the crisis and no non-defaulted member had to contribute.
Exposures from cleared transactions attract capital charges under the CCR. Importantly, a CCP has to be a Qualified CCP to obtain the preferential risk weight treatment.
The capital charge is (simplified) calculated as the product of the exposure value and the corresponding RWA (risk weight). The correct calculation depends on fulfilment of the following requirements:
Where a bank acts as a clearing member (CM) of a CCP, any exposure to the CCP from its own/client transactions, or where the bank is obligated to reimburse the client for any losses suffered if the CCP defaults, would attract a risk weight of 2%.
The exposure amount will be calculated using the IMM approach for the banks that have an Internal Model approval for measuring counterparty credit exposure. Banks without that approval will calculate the exposure amount using SA-CCR (instead of CEM as under the interim capital rules), or the Comprehensive
A risk weight of 4% would be applicable if the client is not protected against the joint default of CM and any other clients of CM.
The calculation of the capital requirement of the default fund is done in two steps, namely, calculating the hypothetical capital requirement of the CCP and then of the clearing member. The calculation takes into consideration the size and quality of the CCP and the counterparty credit risk exposures of such a CCP. The safer the CCP is, the lower the capital requirement for clearing members. This creates an incentive to avoid a race to the bottom on IM and default fund contributions.
In conclusion, Central Clearing Counterparties are the unsung heroes of the financial world, working behind the scenes to ensure the stability and integrity of global financial markets. Their role in mitigating counterparty risk, enhancing transparency, and promoting capital efficiency is indispensable. However, they are not immune to challenges, including the concentration of risk, cybersecurity threats, and evolving regulatory landscapes. As financial markets continue to evolve, CCPs must remain vigilant and adaptive, as their effectiveness is crucial to safeguarding financial stability in an ever-changing landscape.
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