Regional CCPs: How compelling a business case?
Note: Originally published in 2011 – we reloaded the images and this happened to republish itself. The piece is still relevant, even if events have moved on with regional clearing in Hong Kong, China, India, Chile, Australia and Poland.
Corinna Athanasopoulos with input from myself and David Gardiner, debates the arguments for and against the creation of national clearing houses for OTC (and other) products, in relation to the G20 commitments.
The central clearing landscape in the aftermath of the Lehman default in 2008 looked very different to the one we see today. Pre-Lehman, LCH.Clearnet was the only Central Counter Party (CCP) clearing OTC IRS for the dealer community, but now CME, IDCG, SGX and OMX all offer to clear IRS. The financial crisis was a turning point in the history of OTC clearing, resulting as it did in the G20 commitments, which many nations translated into national legislation, for example the EU and US interpretations, EMIR & Dodd-Frank. The CCP landscape started to evolve after the Lehman crisis as the benefits of central clearing became more and more evident. Shortly after, LCH.Clearnet expanded their OTC IRS offering to cater for clients (not just dealers) and in March 2009, ICE Clear launched the first OTC CDS service. CCPs began to launch across the asset-classes and across the world. However, the dominance of certain CCPs (SwapClear for IRS and ICE Clear for CDS) has recently begun to be challenged by the emergence of various regional CCPs. Today, we see various countries such as Canada, Australia & South Africa embroiled in lengthy discussions over whether they should create a regional CCP, or whether they should simply leverage the existing clearing infrastructure using asset class champions such as LCH.Clearnet Some nations have taken the plunge and are in the process of launching an OTC clearing service (HKEX) or have already launched a service (JSCC for CDS and SGX for IRS). When one takes stock of the CCP landscape and sees the proliferating number of CCPs seeking to provide competing services the natural question that follows is, why? Why is the clearing infrastructure becoming more fragmented and what potential complications can the existence of such regional CCPs create? Do the benefits outweigh the complications?
Figure 1 CCP activity landscape
G20 commitments to central clearing
One strand of the G20 commitments concerns clearing, and mandates that all eligible transactions are cleared by the end of 2012. These commitments make clearing mandatory, however do not mandate where the trades should be cleared. For example, a Canadian institution clearing IRS at SwapClear would be deemed to meet the clearing requirement. Yet, in spite of this the Canadian financial authorities spent quite some time grappling with the question of whether Canadian IRS dealers should rely on LCH.Clearnet / CME to clear their trades or whether they should build their own, national CCP. One of the key drivers behind these discussions was the concern around relinquishing regulatory control to a foreign (British/American) regulatory jurisdiction, and there was strong consensus that having a CCP governed by Canadian regulators would be more desirable. This leads to point number one on our business case for creating a regional CCP; the desire to have full regulatory control over the clearing institution.
There are unresolved debates about cross-product and cross-CCP margining offsets. In a perfect world a trading institution could offset the market risk of one instrument hedged with an instrument from another asset class and expect the CCP to calculate their Initial Margin on their net position across both markets. For example, a trader who has an IRS (five year fixed versus 3 month LIBOR) position (cleared at CCP 1) hedged with a set of 3 month LIBOR futures (cleared at CCP 2), will not receive any netting benefits and will hence generate a larger margin requirement. The margin requirement is larger because the trader will have to pledge Initial Margin based on the worst case loss of the swap with CCP 1 who will see the swap as un-hedged market risk exposure and similarly have to post margin on his futures position at CCP 2.
Figure 2: No risk offset, as portfolio split across two CCPs
Figure 3 Theoretical netting benefits illustration of a portfolio at one CCP
Again, if he delta-hedges his non-clearable Swaption with a cleared swap, he will again have to post IM on his swap as if it were an un-hedged yield-curve exposure, a much larger risk than the risk he is taking as a pure volatility trader. This bifurcation results from the clearing regulations and actually increases counterparty risk because it sucks collateral out of the system according to various passes at modelling the effects of mandatory clearing (ISDA studies among others).
Single currency regional clearing
Various proponents of regional CCPs (notably the Bank of Canada) have suggested that having all “currency X” (such as CAD) IRS trades cleared at the same CCP would allow more efficient netting of exposures and therefore create considerable collateral savings. This would also allow the central bank and regulatory bodies responsible for activities in “currency X” a much better view of their market, better opportunity to identify major problems earlier and therefore exercise more control over a default situation. This approach makes sense for a domestic, single-currency market participant but, let us consider the medium and large derivative trader’s typical portfolio. CHF and EUR curves show a close, historic-correlation of interest rate patterns. LCH recognises this in SwapClear (as the Initial Margin model is multi-currency, and nets across currencies) and allows a considerable reduction in IM to the swaps trader who is long CHF and short EUR. If the dealer had to put those CHF swaps with two different CCPs, one a Swiss CHF CCP and the other an EUR CCP he would need to post more IM, posting to both CCPs without the cross currency benefits. Should he default while carrying these positions with the different CCPs, the two CCPs would have no mechanism, nor legal background, for netting out the defaulter’s exposures and each of the CCPs would need to utilise most of the IM they held.
Interoperability – it solves everything?
Various regional rates CCP project sponsors and regulators have declared that CCP interoperability provides the solution to these problems. The market is a long way yet from agreeing a risk or default processing methodology to take care of the exposures that may arise in a matrix of inter-operating CCPs to all stakeholders’ satisfaction. Consider the legal and operational implications of this:
Figure 4 US OTC clearing model
- Both CCPs would need to pass through their margin calculations – and would need to use the same Risk models
- Both CCPs would cross-settle with each other, daily and intraday – and need to use the same operational design to avoid exposures to each other
- Both CCPs would need to integrate their legal frameworks to ensure a common approach to the declaration and processing of a default
- Both CCPs would need similar / coordinated capital, legal and regulatory treatment for the default management process in their respective jurisdictions
- Both CCPs would need to agree to jointly declare default should one of the parties reach that state
This design is something the market might conceivably achieve in the medium to long term, but presents a considerable cross-border challenge to succeed.
Perception is reality
Point number two that appears on the business case is perception. Hong Kong Exchange (HKEX) performed a cost-benefit analysis and determined that a local CCP for IRS and FX should be built and is due to launch by the end of 2012. As Hong Kong works towards meeting G20 commitments, it openly states that one of its driving forces is the desire, as ‘an international financial centre… to ensure that its financial markets’ regulation is on a par with international standards’. SGX has also launched an IRS and FX clearing service, which it brands “AsiaClear” and JSCC in Tokyo is already clearing CDS and expects to offer IRS clearing by end 2012.
The issue of volume
The business case for one super-regional CCP per geographical region/time-zone could appear more viable (one in Asia, one in North America, one in Europe), but it is harder to justify when one considers that:
- the currently dominant CCPs are extending their operating hours to cover all geographical regions – e.g. SwapClear has made significant progress by extending its working day to cover the US east coast, to facilitate client clearing. Also,
- the amount of work involved in having one CCP per country and building out an OTC clearing division for each is substantial.
For instance, SGX already had experience in the (non OTC) clearing space.However, clearing OTC trades (that are longer-dated and with very different risk profiles and hence margin regimes) makes not only the process, but also risk management more complicated. There is substantial cost involved in mobilizing staff to design the new processes for all aspects of the clearing project, significant interaction with the industry to gather and execute requirements, skilled project management to ensure that deadlines are met along with substantial periods of testing and documenting of procedures. Building all the necessary IT infrastructure is also an equally time and budget-consuming activity. Once launched, there is substantial cost involved in running the service. However, providing that the CCP has a healthy number of members and good trade flow, the cost involved in launching and running the CCP should be recoverable. However, when we read the press-statements issued by some regional CCPs, many of them openly acknowledging that their domestic OTC derivative markets are not large, we start to wonder whether how profitable the service will be.
Does the business case for regional clearing make sense?
Given that there are already dominant CCPs across the asset classes which the dealer (and to a certain extent, the client) community have already spent significant time and budget implementing and supporting, it’s hard to understand why members would duplicate the cost and effort to go-live with all the various, regional CCPs that are appearing. If the global dealers aren’t going to be using the local CCP, then that confines cleared business to the local market participants. And if the local market is, as the financial authorities of many of the regional CCPs are themselves openly admitting, of a relatively small size that raises concern over what volumes of the IRS and FX market they will capture and whether it will be big enough to:
- break even on the launch of the CCP and
- to fund the daily running of the CCP with a healthy profit margin.
To guarantee that a regional CCP receives support from local participants, legislation would need to be brought in, mandating that domestic institutions clear their trades at the local clearing house. For example, two Singaporean financial institutions would have to clear all eligible SGD IRS at SGX. But returning to the original point, what comfort and risk reduction does this provide if the local market is small to begin with? To take the point one step further, even if regional CCPs did mandate the clearing of OTC products locally, how damaging would this actually be to the currently dominant CCPs (such as LCH.Clearnet)? For instance, if SGX mandate that all SGD-denominated IRS must be cleared at SGX, this legislation would only apply to Singaporean institutions. If a Singaporean entity interacted with a UK entity, there would be a conflict of clearing requirements. However, if the UK authorities recognized SGX as an approved CCP and the two parties were both members of SGX, then the trade could theoretically be cleared there. (currently SGX will only accept membership from Singapore entities of financial institutions). However, if the majority of the SGD market is between non-Singaporean entities, they could currently clear the trades at SwapClear which offers a clearing service for SGD IRS. How much of the IRS market will regional CCPs actually capture, even with domestic legislation in place? Moreover, major international banks often have the ability to book trades through alternative centres if they feel unhappy with constraints in a given jurisdiction , giving them avoidance strategies around national legislation Much of the OTC derivatives market remains global in nature and will continue to behave that way in spite of efforts to constrain it on a regional basis.
Taking the above scenario one step further, if we had a US bank transacting a SGD IRS with a Singapore-based institution, then what margin inefficiencies might be created if they had transacted a portion of their SGD trades with a UK institution and cleared those trades at SwapClear, and not in Singapore. To achieve margin efficiency (not having margin posted at two separate institutions and maximising off-set benefits) the firm would have to migrate all of those trades over to SGX and the ability to do that would depend on whether their UK counterpart to the trade was also a member of SGX. Unnecessary complication, excessive tying up of collateral and more cost would seem to be the inevitable consequence of the proliferation of regional CCPs.
Figure 5 Netting Benefits of Clearing at one CCP
On the flip-side, if this article seems to have been biased against regional CCPs, then it would serve us well at this point to remember that the more concentrated clearing activity becomes, the more that CCP starts to become a ‘too big to fail institution’ and the more of a back-stop liability is created. If the G20 channel their OTC IRS volumes through LCH.Clearnet domiciled in the UK and regulated by the FSA, for example, how massive will be the liability in a nightmare CCP default scenario? How heavy will lay the head that bears the Clearing crown?
Potential benefits of regional CCPs
In addition to the points mentioned earlier in this article about regional CCPs reducing concentration risk and providing local regulators with control, there are some other benefits of regional clearing that should be considered. Though a regional CCP may be clearing for a small market they will understand and hence cater for local market conditions and characteristics. For example, in Hong Kong it has been argued that, since the local participants in the OTC market are not big, it is difficult to qualify for direct membership at global CCPs. A local CCP could help solve this issue and create a pool of national firms transacting OTC products. The unique nature of the transactions has also been cited as a reason to support a local CCP. For example, funds such as the Mandatory Provident fund scheme in Hong Kong (that generates large trades) require specialist treatment. A local CCP might cater for this better than a global one, by virtue of being interested in specialist needs to the national market, even if low volume. By developing local CCPs the respective nations also show that they are taking the G20 clearing commitment seriously and looking to emulate the behaviours and initiatives of the major OTC markets players, even if they are not driving them or are not bound to comply with them. For HKEx, for example, there is a clear desire to live up to expectations as a major financial centre; ‘As an international financial centre, Hong Kong endeavours to ensure that its financial markets’ regulation are on a par with international standards.’ This would enhance a regional CCP’s profile as a serious OTC market participant. It has also been pointed out that regional CCPs, such as HKEX, view their regional clearing service as a commercial opportunity. There has been some commentary in the media about how HKEx might be taking a long-term approach to capitalise on future opportunities that might be offered by the RMB market. Moreover, by creating their own OTC clearing services, the levels of market knowledge and risk knowledge will improve in the region as a result.
It seems the industry is already aware that there are advantages (from a collateral and liquidity perspective) to clearing the portfolio of an international OTC market participant at, if not one CCP, as few as possible. However, before the industry starts to move in this direction the question of ‘back-stopping CCPs’ should receive more attention. By back-stopping, we mean that national governments would act as the lender of last resort to a national CCP such as LCH.Clearnet, should the CCP ever exhaust it’s lines of defence, as shown below.
Figure 6 LCH.Clearnet SwapClear lines of defence
The concentration risk arising from there being global CCPs is a frightening prospect for national regulators & politicians as is the prospect of CCP interoperability for long-dated and complex OTC instruments. Could even the best-intentioned college of regulators from the G20 take the rapid and coordinated decisions necessary to forestall (or rescue) the default of a global CCP at a time of unprecedented market stress? Other than a CCPs national regulator, other regulators have no direct powers to support a ‘foreign’ CCP, but could voluntarily work to contain any contagion should a CCP be threatened. What is clear, at the time of writing is that we will have to live for some time with the contradictions inherent both in centralised global clearing platforms and in an array of local CCPs serving OTC markets with both global and local characteristics. The reliance seems to be on risk specialists to formulate margining solutions to contend with the challenges that the developing clearing infrastructure looks likely to present to the OTC markets.