Review of Participation Requirements in Central Counterparties – March 2009 1. Background
1.1 Central counterparty clearing and risk controls
Most financial exchanges, and some over-the-counter (OTC) markets, are supported by central counterparty arrangements. Under such arrangements, the central counterparty interposes itself as the legal counterparty to all purchases and sales via a process known as novation. This process involves the replacement of the original contract by separate contracts between the buyer and the central counterparty and between the seller and the central counterparty.
Central counterparties facilitate anonymous trading, since participants need only monitor and assess the central counterparty, rather than each individual trading counterparty. They also offer important benefits in terms of standardised and robust risk management, and greater opportunities for netting of obligations. At the same time, they result in a significant concentration of risk in the central counterparty. In the event that a clearing participant defaults, the central counterparty may face a loss in closing out the defaulter's positions. The central counterparty must therefore have appropriate risk controls and other measures in place to provide confidence that, in all but the most extreme circumstances, a default can be accommodated without threatening the central counterparty's solvency or significantly disrupting financial markets or the financial system more generally.
Central counterparties have a variety of risk controls, which combined seek to address this risk. These can be broken down into three categories: ex-ante controls on exposures; margin policy; and arrangements to fund a shortfall.
- Ex-ante controls on exposures: These controls attempt to limit the central counterparty's exposures by restricting the trades that it accepts. Setting threshold requirements, either via the imposition of a minimum capital requirement or a minimum credit-rating, is the most direct way of doing this. Another possibility is the imposition of position or exposure limits, perhaps based on credit quality, although such limits are typically monitored only ex post. It is important to note that while capital requirements seek to ensure the financial standing of participants, central counterparties would typically rank equally with other creditors in the event of liquidation of a participant.[1] This leads to a second set of risk controls – margins.
- Margin policy: Margin requirements seek to manage the risk associated with exposures once they have been novated to the central counterparty. Three types of margin requirements are typically imposed in practice: (i) mark-to-market (variation) margin is generally called daily to cover any losses on a participant's open positions; (ii) a fixed level of initial margin is called in respect of each new position novated to the central counterparty to cover prospective future price moves before a defaulter's positions can be closed out; and (iii) some central counterparties, including the Australian central counterparties, also call for additional margin contributions from participants with particularly large or concentrated positions.
- Arrangements to fund a shortfall: This is the last line of defence for a central counterparty. If a participant were to default and margin posted by the defaulter was not sufficient to fully cover any losses arising in the close-out of positions, the central counterparty needs to have in place arrangements for dealing with the shortfall. Such arrangements typically comprise a guarantee fund, made up of contributions by clearing participants and/or the central counterparty's own capital, supplemented with promissory resources in the form of default insurance or emergency assessments on participants.[2] In the event of a default, any contribution to the fund by the defaulting party would typically be utilised first.
1.2 Public policy objectives
In the first instance, the particular combination of risk controls implemented by a central counterparty is the responsibility of its board. These decisions must, however, be made in the context of any public policy requirements imposed on the central counterparty.
In Australia, a licensed central counterparty must meet two main public policy requirements. First, it is required to meet the Financial Stability Standard for Central Counterparties determined by the Reserve Bank.[3] Guidance to measure 2 of the Standard casts the specific financial stability objective of participation requirements as being ‘to promote the safety and integrity of the central counterparty and in doing so limit the potential for financial system instability.’ The guidance also acknowledges that ‘participation requirements should include various financial requirements, such as a minimum credit rating or level of net tangible assets, so as to reduce the exposure of the central counterparty to credit and other risks,’ while at the same time ensuring that ‘access to the central counterparty is not restrictive beyond the need for ensuring financial system stability.’ These requirements are consistent with international best practice, as set out in Recommendations for Central Counterparties drafted by the Bank for International Settlements Committee on Payment and Settlement Systems and the International Organisation of Securities Commissions.[4]
Second, a licensed central counterparty is required, under the Corporation Act 2001, to provide its services in a fair and effective way (to the extent that it is reasonably practicable to do so). A key consideration here is the basis for any differentiation between participants, and in particular assurance that no end users of the central counterparty are improperly disadvantaged by the way in which the central counterparty interacts with its clearing participants. Differentiation by reference to legitimate differences in risk or services provided is likely to be appropriate. In the context of a change in participation requirements, a central counterparty would, consistent with its obligation to provide services in a fair and effective way, need to consider the impact on existing participants. In this regard, it would be encouraged to consider any allowances that might reasonably be made for certain types of existing participants, particularly those with low risk profiles.
1.3 ACH's risk framework
Like all central counterparties, the risk framework at ACH utilises a combination of controls. These have evolved somewhat in recent years, with the key elements of both ACH's and SFE Clearing Corporation's (SFECC) current risk framework summarised in Table 1. Notwithstanding that ASX has recently taken a number of steps to apply a consistent risk-management approach across the two central counterparties, it is clear that there remain considerable differences, including in respect of participation requirements.
ACH's risk framework involves a combination of minimum and risk-based capital requirements, some margining, and a pool of risk resources. Following the change which took effect on 31 December 2008, participants clearing cash equities or options are required to hold at least $2 million in ‘core liquid capital’.[5] In addition, they are subject to a risk-based requirement under which they must hold sufficient ‘liquid capital’ (which overlaps in part with ‘core liquid capital’), to cover counterparty risk, large exposure risk, position risk and operational risk (the so-called ‘total risk requirement’).[6] The risk-based requirement also applies to ASX market participants, for whom the minimum ‘core liquid capital’ requirement remains at $100,000. With effect from 1 January 2010, ACH has announced a further increase in the minimum ‘core liquid capital’ requirement to $10 million.[7] This compares with SFECC's minimum capital requirement of $5 million currently. SFECC has also announced that it intends to increase its minimum capital requirement for participation to $10 million, with a higher minimum of $20 million for third-party clearers.[8]
As noted above, while these capital requirements give ACH some confidence in the financial standing of its participants, they do not provide the central counterparty with direct resources to draw upon in the event of default. If a default actually occurs ACH is, however, able to call on any margins held, and if these are not enough, its pooled risk resources.
Currently, ACH levies initial and mark-to-market margins for derivatives, but not cash equities.[9] For derivatives, ACH imposes initial and mark-to-market margins – consistent with the practice at SFECC. These are calculated overnight and collected from participants the next morning. In addition, ACH conducts ‘stress tests’ to simulate the impact on the clearing house of the failure of a clearing participant at the same time as a substantial movement in the market. Where such losses exceed a particular threshold, participants are obliged to lodge collateral with ACH. SFECC has similar arrangements for calling additional collateral from participants where stress tests indicate significant potential exposures.
Finally, ACH can access a pool of risk resources to meet any obligation arising in the event of a participant default that is not covered by margin or other collateral; currently this amounts to $550 million (Graph 1). ACH's own capital, including subordinated debt issued to ASX as parent, would be the first to be drawn upon in the event of a default. SFECC also holds resources to meet such a shortfall, but the structure is somewhat different to that for ACH in that it also includes up-front contributions from participants.
Footnotes
Higher capital might in practice increase the likelihood that a central counterparty was able to recover some funds in the event of a participant default. However, a central counterparty has no higher priority than other creditors in liquidation and, since legal proceedings would likely be triggered to effect a claim, the central counterparty's access to such funds would be neither certain nor timely. [1]
Where a central counterparty's risk framework includes promissory contributions from participants, higher minimum requirements for participants might, by increasing average financial standing, increase the likelihood that such contributions could be made. [2]
The Financial Stability Standard requires the following: ‘A CS facility must conduct its affairs in a prudent manner, in accordance with the standards of a reasonable CS facility licensee in contributing to the overall stability of the Australian financial system, to the extent that it is reasonably practicable to do so.’ The Standard is supported by a set of measures that the Reserve Bank considers relevant in assessing compliance. A licensed central counterparty is required to comply with the Standard on a continuous basis, with a formal assessment conducted once a year. [3]
See <http://www.bis.org/publ/cpss64.htm> [4]
‘Core liquid capital’ is defined by ASX to be the sum of: all paid-up ordinary share capital; all non-cumulative preference shares; all reserves, excluding revaluation reserves; and opening retained profits/losses, adjusted for current year movements. [5]
‘Liquid capital’, the relevant measure for comparison with the ‘total risk requirement’, is defined by ASX to comprise total tangible shareholders’ funds held in liquid assets, net of any guarantees and indemnities. Participants clearing futures only may elect to be covered by an alternative capital regime, based either on a net tangible asset requirement (under which participants must hold a minimum of $5 million in net tangible assets) or compliance with the regime of another prudential supervisor. As at the end of December 2008, 57 ACH participants were subject to the risk–based regime, with a further 2 participants subject to the net tangible asset requirement. [6]
ACH has announced that it proposes to broaden the definition of ‘core liquid capital’, so as to allow participants additional flexibility in meeting the new requirement. This flexibility is considered further in Section 4.1.1. [7]
SFECC is yet to implement rule changes to give effect to this increase. [8]
In an international context, ACH is unusual in that it does not impose initial and mark-to-market margins for cash equities. Some information on international central counterparties’ risk frameworks is presented in Section 3.4. [9]