This blog makes an attempt to cover the role of central counterparties and processing of OTC derivatives in five parts as under

Part I – All about Central Counterparties

Part II – Best practices framework for CCPs

Part III – Some loud thinking on their future roles

Part IV – Can they add comfort to clearing OTC derivatives

Part I – All about Central Counterparties

What is counterparty risk?

Counterparty risk is the risk that a counterparty in a transaction will default prior to the expiration of the contract and will be unable to make agreed contractual payments. In this event, the risk can be quantified as the replacement cost – the cost in replacing the defaulted transaction at current market rates to meet the obligations. Sometimes, the counterparty can default on the expiry day, after the other party has met the obligation under the transaction in which case, the loss would be the entire value of the transaction. Sometimes, counterparty risk is mistaken as the lending risk. The feature that differentiates and distinguishes counterparty risk is the inability to ascertain the exact exposure at any given future date.[1]

In the case of a derivative transaction with a named counterparty, the market value is known only if the market rate is available. For any date in future, since the market rate is not known, the market value is unknown. At best one can work out its value with assumed rates. Therefore, if a counterparty to a derivative transaction defaults prior to the expiration of the contract, the said transaction will need to be replaced. And therefore, the maximum loss will be the replacement cost of the transaction

What is a central counterparty?

A CCP – central counterparty - is “an entity that interposes itself between counterparties to contracts in one or more financial markets, becoming the seller to the buyer and the buyer to the seller” (CPSS / IOSCO, Recommendations for Central Counterparties, November 2004). CCP is defined by legal / contractual obligations for transactions it clears, not by function. Central Novation or Open Offer are main legal mechanisms. A CCP ultimately takes Counterparty Risk on itself, as opposed to mutualising the risk exposure amongst its members. CCP concentrates risks and manages them. It does not eliminate counterparty risk exposures.[2] Some of the leading central counterparties are: ICE, CME, NYSE-Liffe-LCH.Clearnet, Eurex, ICE Trust Europe, LCH.Clearnet SA

What does a central counterparty do?

CCPs help facilitate the clearing and settlement process in financial markets. CCPs enter the stage after a trade is concluded and act as intermediary between the trading partners. A CCP interposes itself between counterparties to financial transactions, becoming the buyer to the seller and the seller to the buyer. A well designed CCP with appropriate risk management arrangements reduces the risks faced by SSS participants and contributes to the goal of financial stability. Although a CCP has the potential to reduce risks to market participants significantly, it also concentrates risks and responsibilities for risk management. Intraday margin is a generally accepted risk management tool of central counterparties to cover increased risk exposure during the day. Central counterparties may call for intraday margin on a routine basis, but also in case of extreme price volatility or large changes in positions of clearing members.

Part II – Best practices framework for CCPs

Best practices

Going by the market experience and practice, we have identified certain critical best practices in our suggested framework for Central Counter Parties.

- Legal framework

- Membership criteria

- Exposure management

- Default procedures

- Financial wherewithal

- Margin requirements

- Risk management

- Efficiency and transparency

- Regulatory oversight

Recommendations for CCP

Therefore, the effectiveness of a CCP's risk control and the adequacy of its financial resources are critical aspects of the infrastructure of the markets it serves. Committee on Payment and Settlement Systems of the Bank for International Settlements and Technical Committee of the International Organization of Securities Commissions have come out with a set of recommendations for central counterparties in November 2004.

CCP Risk models and alternatives

Ideally a central counterparty is expected to have well defined risk models to manage its operations efficiently and cost effectively. Along with the risk models, it would be better if they also put in place appropriate default protections in place.

The following table brings out one such risk model and default protection followed by LCH Clearnet.

Risk Models

- Strict membership criteria ensures high quality counterparties

- Real-time novation / open offer of cash market trades

- Clearing members become the 'Principal' to trades

- Multilateral netting to reduce value at risk

- Initial and variation margins

- Intraday margin calls

- Clearing fund to cover risk in abnormal market positions

- Buy in / Sell out capabilities

- Secure payments systems

Default Protection

- Membership criteria

- Initial margin

- Variation margin

- Intra-day margin

- Defaulter's own default fund contribution

- Ltd's own capital (capped)

- Remaining default fund

- Insurance

- Reminder of Ltd's capital

Modelling risk in a central counterparty

Central counterparties form a core part of the financial market infrastructure. CCPs were established originally to protect market participants from counterparty risk in exchange-traded derivatives markets, but they now also have an important presence in cash and over-the-counter derivatives markets. By interposing themselves in transactions, CCPs help to manage counterparty risk for market participants and facilitate the netting of positions. In performing this role, however, CCPs are themselves exposed to various risks. To protect themselves, they have developed various models and procedures, amongst which the margining of members’ positions plays a central role. CCPs need to assess the losses they could face on occasions when margin proves insufficient, and ensure that they can meet these losses from extreme events by other means. Sometimes margins alone, calculated to cover losses from typical price movements over one or more days may not be sufficient to protect CCPs from rare but plausible events.

Part III – Some loud thinking on their future roles

Performance targets for central clearing

Senior Managements of leading dealers and buy-side institutions have conveyed to the Federal Reserve Bank of New York[3] that they are actively engaging with CCPs to broaden the range of cleared products and market participants. They have also confirmed that they fully understand and support that CCPs will be regulated with particular emphasis on financial strength to absorb market shocks including bankruptcy of a major market participant. As CCPs expand their offerings, they will work with supervisors to deliver a set of performance targets for CCP usage by August 31, 2009.

Competitive clearing

There is a felt need in the market place to derive highest value at low cost and this is only possible by encouraging competitive clearing. The objectives of a competitive clearing are

ü To provide counterparties with more flexibility and freedom of choice to select their central counterparty including to keep their current clearing arrangements if they so desire

ü To ensure that the central counterparty services are of the highest quality

ü To deliver at the lowest price through open competition between central counterparties

ü To enable central counterparties to operate on equal terms, i.e. neither CCP will operate as a sub CCP of the other

ü To provide solutions based on existing and or proposed infrastructure to reduce the impact for all stakeholders wherever possible

ü To make no difference to one party whether their trading counterparty is using the same CCP or different one.

Is a global CCP desirable?

In the private sector, greater financial discipline at individual institutions must be reinforced by a renewed commitment to collective discipline in the spirit of elevated financial statesmanship that recognizes that there are circumstances in which individual institutions must be prepared to put aside specific interests in the name of common interest. Such a commitment may require market participants to (a) to make costly investments in infrastructure (human capital and technology and (b) change business processes, and accept changes to market practices, that in the past have generated sizeable revenues but at the cost of weakening the underlying foundation of the markets. Costly as these reforms will be those costs will be minuscule compared to the hundreds of billions of dollars of write downs experienced by financial institutions in recent months to say nothing of the economic dislocations and distortions triggered by the crisis.[4]

At first sight, a global CCP is most desirable as it will be characterized by economies of scale and scope. In normal times, the concerns could be – static vs. dynamic efficiency, regulatory and supervisory differences and reliance on third country authorities. However in a crisis situation, limits to central bank emergency liquidity provision beyond currency area, single point of failure and legal risks in case of default (access to assets) can be overcome through this global CCP.[5]

Part IV – Can they add comfort to clearing OTC derivatives

Recommendations on clearing OTC derivatives

The use of a clearing through clearing house has the potential to mitigate each of the types of counterparty risk associated with OTC derivatives. With respect to credit risk, clearing would achieve through multilateral netting. Margining arrangements typically would then eliminate or collateralize the net exposure on a daily basis. A clearing house has the potential to reduce liquidity risks by broadening the scope of payment netting. Legal risk would be reduced by clearing house’s default procedures often supported by specific provisions of national law. A clearing house could reduce operational risks by imposing high standards of operational reliability and by promoting further development of automated systems for confirming transactions. Thus, the value proposition of central counterparty clearing services is to ensure market integrity.

Central counterparty clearing houses are a key element, together with other market infrastructures and service providers, of an integrated and efficient post-trade process, which serves to increase market efficiency by improved market operations with standardized, electronic processing of transactions.

European CCPs coped successfully with the recent default of Lehman Brothers International (Europe), and the Icelandic banks, by closing-out or transferring the positions of the defaulter, without impacting other participants, and within the collateral amounts and other financial resources available to them.

The European Association of Central Counterparty Clearing Houses, in February 2009 has come out with a set of recommendations on clearing OTC derivatives. Some key recommendations are:

ü Transparency and effective risk management are key elements to reduce systemic risk in financial markets

ü Effective risk management is the most important benefit to deliver in clearing derivatives markets as they significantly exceed the amount of counterparty risk to be managed in cash markets

ü The value proposition of clearing houses includes the automation of transaction processing, which increases the efficiency of market operations and reduces the likelihood of manual errors

ü It can serve as part of the blueprint to effectively mitigate counterparty risk and improve operational efficiency in OTC derivatives markets across asset classes and products

ü Sound market regulation includes as a guiding principle that the same rules are applied for the same activities in order to avoid regulatory arbitrage. Derivatives markets are global by their nature and product distribution

Does a CCP add anything to OTC derivative markets?

A central counterparty can add benefits to the OTC derivative markets.

Concentrative Approach

- Systemic market risk can be reduced by multilateral netting and the application of margin to collateralise losses and protect against future price changes

- Multilateral netting can improve capital efficiency

- Multilateral netting can lead to significant reduction in ‘open’ contracts to be tracked and managed

Extensive Approach

- Active counterparty credit risk management through close-out netting and collateralization

- Extension of credit to customers is an important competitive tool for financial institutions

- Supports competition and continued derivative product innovation

- Risk diversified away from a single piece of infrastructure

Conclusion

In an ideal world, the need for central counterparty may not arise only when the systems are upgraded to provide for real time gross settlement – payment / receipt of funds and receipt / delivery of the underlying securities. This could be possible only when all the systems – settlement and payment systems – are linked across borders. This has been recognized as a minimum requirement of a truly globalised and matured international market. For this one may need synchronization of the best practices in all parts of the financial markets – commodities, equities, foreign exchange, fixed income and derivatives (commodities, equities, foreign exchange, fixed income, interest rate and credit derivatives to begin with) and prescription of common rules and regulations. Let us hope the arrival of such an integrated market may not be very far off given the need of the market place and also the growing awareness and advances being made in the technology space.

[1] Whitepaper on “Counterparty Risk Management” by Dr Guru Raghavan in June 2009

[2] Does a Central Clearing Counterparty Reduce Counterparty Risk? A research paper by Darrel Duffie and Haoxiang Zhu of Stanford University, 1^st July 2009

[3] Their letter dated 2^nd June 2009

[4] Gerald Corrigan, Counterparty Risk Management Group (2008)

[5] Mario Nava, LSE Financial Markets Group, 17^th March 2009