Central Clearing of OTC Derivatives in Australia – June 2011 2. Central Clearing of OTC Derivatives

2.1. Introduction

Developments over recent years have seen the attention of many regulators focused on the potential risks arising from OTC derivatives: counterparty credit risk, operational risks, and the systemic consequences that a serious disruption might have, given the interconnectedness of many large financial institutions.

As noted in Section 1.2, APRA, ASIC and the Reserve Bank undertook a joint survey of risk management practices in the Australian OTC derivatives market in 2009. The survey found that the use of risk management tools within the Australian industry was broadly in line with international practice. However, as a result of the survey, the regulators made a number of recommendations, encouraging market participants to:

  • promote market transparency;
  • ensure continued progress in the timely negotiation of industry-standard legal documentation;
  • expand the use of collateral to manage counterparty credit risks;
  • expand the use of automated facilities for confirmations processing; and
  • expand the use of multilateral portfolio compression and reconciliation tools.

The regulators also recommended that market participants should promote Australian access to central counterparties for OTC derivative products.

In dialogue with the Australian Financial Markets Association (AFMA), the regulators have continued to advocate improvements, and have been monitoring the domestic industry's progress with respect to these recommendations. The regulators have been encouraged by the steps that have been taken to date to improve bilateral risk management, and the regulators will continue to examine developments in this area. However, in many ways a move to central clearing could result in a significant advance in risk management as well as provide other benefits to markets. In particular, central clearing provides a focal point for market oversight and participant default management, which can enhance the resilience of financial markets. For these reasons, the Council agencies support a move to central clearing. It is acknowledged, though, that central clearing can bring a new set of risks, and that this trade-off needs to be carefully thought through.[15]

Determining suitable clearing arrangements for Australian OTC derivatives markets is further complicated by the rapidly evolving global landscape for CCPs. In some ways, a theoretical optimum might be a single global CCP clearing all product classes, since this would maximise multilateral netting opportunities and reduce counterparties' associated collateral requirements. However, this solution would lead to concerns around the concentration of risk in a single global CCP and its participants. In any event, the reality is that this option shows no signs of eventuating, and therefore a significant degree of clearing fragmentation appears likely to be a feature of markets for some time to come. One consequence of this fragmentation is that market participants may need to join, or clear different types of OTC transactions through clearing participants of, more than one CCP. This, together with changes to banks' capital charges for OTC derivatives exposures and other regulatory developments, makes it difficult to assess the overall impact on the Australian market of various potential clearing arrangements.

2.2. Bilateral Risk Management in OTC Derivatives Markets

Two areas in which the risks of OTC derivative markets differ substantially from traditional exchange-traded markets are in relation to counterparty risk and operational risk. The regulators' 2009 survey report discusses these risks in more detail, including measures available to market participants to mitigate them.

2.2.1. Counterparty risk

Counterparty risk is the risk that contracted financial obligations are not fulfilled as required. This risk may have a credit risk or liquidity risk dimension. Since large market participants often have numerous counterparties with which they have undertaken offsetting positions, the default or non-performance of one participant can potentially reduce the ability of the non-defaulting counterparty to meet its obligations in turn. Depending on the magnitude and incidence of any defaults, counterparty risk may have systemic implications.

The counterparty risk of an OTC derivatives transaction can be very long-lived, with some contracts lasting several years, or even decades. The complexity of counterparty risk management by active market participants is compounded by a build-up of positions across multiple counterparties over time.

To manage some of this risk, the chief tools that are generally used in bilateral arrangements include:

  • due diligence and counterparty approvals;
  • the agreement of robust legal documentation; and
  • the collateralisation of exposures.

Naturally, a first protection against counterparty risk is to understand the nature of the counterparty, as with other credit relationships. This can be straightforward – for instance, where counterparties have an established banking or dealing relationship – or some preliminary steps may be needed before trading is undertaken. As part of a trading relationship, it is common for the rights and obligations between two counterparties to be governed by a master agreement that applies to all transactions, rather than a detailed (long form) contract needing to be negotiated for each transaction. A master agreement typically allows one counterparty to calculate a net exposure across all its positions with respect to another counterparty, and sets out the circumstances under which positions can be closed out. An international industry body, the International Swaps and Derivatives Association (ISDA), has developed a master agreement that is in wide use among active market participants.

This agreement is often supplemented by a Credit Support Annex (CSA) to cover collateralisation arrangements. The CSA sets out arrangements for how and when a counterparty must provide collateral (such as pay margin) to offset adverse price movements, with this often calculated as a net requirement across all positions between two counterparties. In the event of a counterparty's default, the only liability that exists between two counterparties is a single marked-to-market position netted across all eligible transactions.[16] Where marked-to-market positions have been well collateralised, the potential loss faced by the non-defaulting counterparty may be significantly reduced. For prudentially regulated market participants, legally enforceable netting can also reduce the amount of capital that must be held against counterparty exposures.

The bilateral nature of these legal arrangements provides flexibility in tailoring agreed terms to individual circumstances, which is clearly a benefit for many counterparties. However, a consequence of this flexibility is that parties' relative negotiating power can be a factor in determining the strength of risk management arrangements. For instance, high volume clients, or counterparties with higher credit standings, may be able to negotiate more favourable terms.[17] Over the lifetime of a contract, commercial considerations can also be a factor in determining how rigorously provisions are enforced. The potential for an uneven application of risk management standards is therefore a key disadvantage of bilateral arrangements.

Data from ISDA indicate that in 2010 around 70 per cent of global OTC derivatives trades were subject to collateral arrangements (Table 1). Within this, there is considerable variation depending on dealer size and product type; more than 90 per cent of credit derivatives trades across all dealers are covered by collateral agreements (reflecting the incremental reform process discussed in Section 1.2), while only around 40 per cent of commodity derivatives transactions have collateral agreements in place. The extent of collateralisation actually employed under these arrangements also varies considerably, depending on the size of the dealer and the nature of the counterparty. Non-financial counterparties, such as corporate treasuries and governments, generally exhibit lower levels of collateralisation, whereas fund managers and banks have higher levels; collateralisation levels are generally higher for transactions undertaken by larger dealers (Graph 1). The Australian regulators' 2009 survey found a similar pattern of collateralisation across counterparty types in the Australian market.

Table 1: OTC Derivatives Covered by Collateral Agreements
Per cent of derivatives trades(a)
Product type Large dealers Medium/small
All dealers
Interest rate 88 75 79
Credit 96 92 93
FX 65 53 58
Equity 73 72 72
Commodity 63 57 60
All products 80 66 70

(a) Unweighted average across dealers

Source: ISDA Margin Survey 2011

Graph 1
Graph 1: Share of Total Payments

2.2.2. Operational risks

As well as counterparty risks, the long maturity and bespoke nature of many OTC derivatives contracts can give rise to numerous life cycle events that can bring a variety of operational risks (Figure 1). For active market participants with many simultaneously open contracts, the risk management task can be extremely complex. In many instances, these risks can be efficiently mitigated through automated and electronic processes, though the efficacy of these is often dependent on how widely they are used by other counterparties. Individual counterparties' operational capacities can also be a factor in determining the effectiveness of some of these arrangements. For instance, for a margin call to proceed smoothly, both counterparties need to agree on valuations, both counterparties need to agree on how and when any necessary collateral will be exchanged, and both counterparties need to be able to execute this transfer in a timely manner.

Figure 1
Figure 1: Life Cycle of an OTC Derivatives Contract

Active market participants must therefore be able to handle a host of cash flows, securities transfers and valuations across the multitude of positions they have with their counterparties, which can require significant investment in internal operational systems. In order to reduce some of these problems, proprietary and third-party vendor systems have been developed to streamline the management of some transaction life cycle events such as trade confirmations, mark-to-market valuations, collateral management, portfolio reconciliation and settlement of cash flows.

2.3. Central Counterparties and OTC Derivatives

There is a limit, however, to the improvements to system-wide risk management that can be accomplished by unilateral and bilateral tools. In part, this is because a move from one set of arrangements to another can be difficult to co-ordinate across all market participants. In order to better manage the proliferation of bilateral counterparty exposures, to ensure uniformly high standards of counterparty risk management, and to accommodate the growing operational complexity of OTC derivatives markets, regulators and market participants have been examining the potential for central clearing in these markets. Moreover, recognising that individual market participants may not fully internalise the costs of higher systemic risk arising from bilateral arrangements, and so not have an incentive to move to a CCP, numerous jurisdictions have been mandating central clearing for some markets.[18]

2.3.1. The design and benefits of central clearing

The key to central clearing is that, through a legal process known as novation, a trade that is dealt between two counterparties can be given up to a CCP. As a result of this, the CCP assumes responsibility for the obligations associated with the trade by becoming the buyer to every seller, and the seller to every buyer. This mechanism allows the numerous bilateral exposures of a market participant to be substituted for a single net exposure to a financially and operationally robust CCP (a stylised representation of this is shown in Figure 2). The resulting multilateral netting has the potential to substantially reduce the size of individual counterparties' outstanding obligations relative to bilateral arrangements, reduce market-wide liquidity and collateral needs, and reduce prudentially regulated firms' capital requirements. The capital efficiency attractions of central clearing will be further increased by the revisions to the Basel Accord noted in Section 1.3.2, that will give centrally cleared exposures a substantially lower risk weighting than bilateral exposures (subject to certain conditions being met).

Figure 2
Figure 2: OTC Derivatives Counterparty Relationships

Use of a CCP does not necessarily reduce the amount of risk in a market, but rather concentrates it. This obviously creates a risk management need for the CCP, for which it will typically use risk mitigation tools similar to those used in bilateral arrangements:

  • CCP participants can be required to meet minimum credit standards and undergo initial and ongoing due diligence examinations. Such participants are known as clearing, or direct, participants of the CCP.
  • The netted down exposures between a clearing member and the CCP are typically subject to standardised risk management tools, including initial and variation (or mark-to-market) margins.

The setting and enforcement of these risk management tools are likely to be free from some of the commercial considerations that may, as discussed above, play a role in bilateral arrangements.

The central role of the CCP, and its oversight of the entire market that it clears, can enable a counterparty default to be handled in a more orderly manner relative to a situation of bilateral exposures. Although a CCP will calculate margin requirements daily based on market movements, so as to ensure that it is well secured in the event of a participant's default, it also typically maintains additional financial resources to deal with extreme events. These resources may include clearing participants' contributions to a pooled guarantee fund and/or capital contributed by the CCP itself.[19] Where a CCP needs to cover a defaulting participant's positions, it will often have rules that require non-defaulting participants to co-operate in a collective and equitable resolution mechanism. For instance, where the collateral of the defaulting participant (in the form of margin and other contributions) is insufficient to cover any resulting losses, the CCP's rules will set out the order in which its additional financial resources will be utilised, as well as the method in which any losses may be allocated among participants (see, for example, Figure 3). If all ‘paid-up’ financial resources have been exhausted, the CCP may have the right to call for additional contributions from surviving members. For some products, a CCP may also call on members to take on a defaulting participant's positions. In effect, the loss absorption mechanism provided through the CCP plays a role similar to a sinking fund or insurance for the market that it is clearing. The mutualisation of risk and the constraints imposed on participants' behaviour can also help prevent ‘fire sales’ or other destabilising actions, thereby contributing to the resilience of the markets served by the CCP. Therefore, although on the one hand a CCP is designed to reduce some of the interdependencies between members, the ongoing success of a CCP will depend on the continuing alignment of members' interests and their preparedness to underwrite it as necessary.

Figure 3
Figure 3: CCP's Financial Resource Depletion in Response to a Clearing Member Default

By acting as a central hub for other market participants, CCPs can co-ordinate operational improvements and efficiencies. For instance, CCPs can bring standardisation of legal frameworks, streamlined day-to-day payment flows and calculations, and reduced collateral management complexities. They also provide a focal point for regulation and oversight of market-wide risk management, as well as reduce information asymmetries in the market more generally.

To ensure the soundness and effectiveness of a CCP's risk management arrangements, the legal basis of a CCP is clearly very important. To become a clearing member of a CCP, a participant must agree to be contractually bound by its operating rules, part of which sets out the legal jurisdiction in which the membership terms are governed and to which the member submits. The CCP will typically hold members' default fund contributions and initial margin monies under legal structures governed by the CCP's home jurisdiction, while the default resolution arrangements of the CCP will rely on its home jurisdiction's bankruptcy and netting regimes.[20]

2.3.2. Direct and indirect clearing in centrally cleared markets

For dealers in some financial markets, the ability to participate in a CCP as a direct clearing member can be a competitive advantage for a number of reasons. First, being able to clear directly may provide a cost advantage to a dealer, either through greater netting opportunities (reducing capital and liquidity needs) or through avoiding an additional layer of fees for clearing through another participant. Second, direct clearing may provide a capital advantage in circumstances where indirect clearing through a CCP does not qualify for a lower risk weighting under the revised BCBS standards. Third, direct participation can also allow dealers to offer clients a more comprehensive service by combining both trading and clearing. Finally, membership of a CCP might act as a signal of a dealer's creditworthiness or market standing.

For other market participants – such as smaller banks with a more limited intermediary role in the market served by the CCP, or for buy-side end-users – the desire to be a clearing member might be less pressing, particularly given the significant financial and operational commitment taken on by clearing members. Instead, a CCP will often support arrangements for these participants to access many of the benefits of central clearing by being able to clear transactions via an existing clearing member as an indirect or client member. However, indirect members may face some bilateral risks should their clearing member default; the extent of this risk will depend on the specific legal and operational arrangements of the CCP.

A particular issue is how clients' initial margin monies are handled by clearing members and the CCP. For example, a client's initial margin might be held in an individual account with the CCP, or it might be co-mingled with the funds of a clearing member's other clients in an omnibus account. The repercussions of a clearing member's default on its clients will therefore depend on the nature of the segregation and portability arrangements in place.[21] Under revisions to the BCBS standards, the protection afforded by a CCP's arrangements in these respects will determine if a prudentially regulated indirect participant can receive a lower capital weighting for positions that are centrally cleared.[22] Even if a transaction has been cleared, if a CCP's counterparty risk mitigation offers a lower standard of protection for an indirect member than it does for a direct clearing member, the exposure may need to be treated as a bilateral one, rather than as a centrally cleared position – with a consequently higher risk weighting. For some market participants, this might be a deciding factor as to whether they seek to become direct members of a CCP or not.

2.3.3. Specific issues in the central clearing of OTC derivatives

In order for a CCP to clear a certain class of products reliably, there must be:

  • a well established market and robust valuation methodology for this product, so that the CCP can confidently determine margin and default fund requirements, and appropriately manage a default scenario; and
  • some standardisation of contracts, to facilitate the CCP's trade processing arrangements.

For exchange-traded instruments, these prerequisites are typically quite straightforward. In contrast, these tests may be more difficult for some OTC derivatives products, particularly where they have highly bespoke contract terms or difficult-to-model price movements. In these situations, it is arguably not appropriate for these products to be centrally cleared. Nonetheless, there are numerous classes of OTC derivatives that are actively traded in quite standardised forms, suggesting that these prerequisites can be met without too much difficulty. Indeed, as discussed in Section 2.5 below, a number of CCPs in offshore markets are either currently or prospectively clearing various classes of OTC derivatives.

Although some classes of OTC derivatives have a sufficient degree of product and pricing standardisation to permit central clearing, individual contracts within these classes may still contain highly tailored terms such as the contract maturity or periodic payment amounts and timing. In many cases, there may be no other contract that has exactly the same terms, and therefore it may not be possible to net off many individual contracts across counterparties. This is in contrast to, say, a clearinghouse for a traditional exchange, where typically many participants have traded numerous identical or fully fungible contracts that can be closed out on a regular basis. Centrally cleared positions might, though, be able to be simplified through the use of portfolio compression tools, such as might be used for bilateral positions.

A CCP taking on heterogeneous and potentially long-lived OTC derivatives exposures is assuming similar risks to those currently faced in an OTC market by a financial intermediary such as a bank. However, market risk to the CCP will be fully hedged for all positions unless there is a CCP participant default. Since the contracts being submitted to the CCP by participants are likely to be individually tailored, this means that many individual contracts will likely continue to stay on participants' books, though with the CCP novated as the new counterparty. The effect of this is that the CCP is providing multilateral netting of exposures across a market, rather than of individual contracts. In the event of a clearing member's default, this means that potentially the CCP could be left with multiple individual positions against non-defaulting counterparties for which counterparties with precisely offsetting contracts cannot be found. The risk management of this could be a greater challenge than for CCPs serving highly liquid and fungible products. Rather than replace each defaulted transaction, the CCP may instead need to hedge these with a combination of new contracts that are economically equivalent to those of the defaulting member.[23]

2.4 Other Policy Considerations Regarding Central Clearing

CCPs can bring numerous benefits to markets. However, regulators must consider several interrelated matters regarding the consequences of central clearing for financial system efficiency and stability.

2.4.1. Default and crisis management

The fact that a CCP stands in the middle of other market participants, and therefore has comprehensive information on all participants' exposures, means that it is well placed to monitor the evolution of risks in the market that it is clearing – particularly where it is the sole CCP serving the market. Because of this, CCPs can centralise and co-ordinate default management within a market if necessary. This is a significant advantage of centrally cleared markets, in contrast to bilaterally organised markets where crisis management might be much more ad hoc.[24] This was demonstrated in the case of the default of Lehman Brothers in September 2008, where the various clearing houses of which it was a member were able to manage this large and complex event in a fairly orderly fashion.

Of course, a CCP standing between all other counterparties results in a very high concentration of counterparty and operational risk. Within systemically important markets, should the CCP itself fail – say, due to operational difficulties, inadequate risk management, or as a result of multiple participant failures – this has the potential to cause severe disturbances within the broader financial system. In part because of the stringent risk management arrangements of CCPs, there have been only a few recorded failures over recent decades.[25]The systemic importance of these entities also means that they are intensively regulated in many jurisdictions.

A key focus of regulatory oversight is the adequacy of a CCP's financial resources, since it acts as a loss absorber for the market it serves. In this regard, a CCP potentially faces liquidity and solvency risks similar to other financial institutions. To manage the risk that an obligation to make a payment cannot be met in a timely fashion (say, where a participant has failed to pay a margin call), CCPs generally hold their funds in highly rated and liquid financial assets, perhaps supplemented with back-up lines of credit from banks. As discussed in Section 2.3.1, a CCP will also have various layers of financial protection to cope with the possibility that the loss arising from a participant's default exceeds its paid-up margin.

In general, a CCP will calculate its financial resourcing requirements as appropriate to withstand extreme but plausible events, generally based on stress testing that incorporates a long run of historical experience. While this is designed to make a CCP highly resilient, there always remains the possibility that circumstances exceed a CCP's resources. For instance, a CCP may face a situation where market turmoil means that financial assets cannot be liquidated as needed. Alternatively, the default of one or more large participants may result in a substantial depletion of financial resources that endangers the CCP's status as a going concern. A CCP might then have a capacity to call on surviving clearing members to make additional contributions, but the success of this could be uncertain, particularly if clearing members themselves were under pressure. In these crisis situations, some involvement of public authorities may be necessary, given the importance of the CCP to broader financial markets, and the consequent disruption to markets if the CCP itself were to fail.

As well as financial considerations, a serious operational disruption to a CCP also has the potential to become a systemic event. Although CCPs generally have robust back-up systems and disaster recovery arrangements, it is unreasonable to expect that these could withstand all possible contingencies. A brief service disruption in benign market conditions is unlikely to be too troublesome for market participants. But if a significant or long-running disruption were to occur at a time of unsettled market conditions, the halt in transaction processing or payment flows, and/or uncertainty regarding the status of cleared transactions, may have a compounding effect on market uncertainty and liquidity pressures. Again, some public sector actions to mitigate the effects of this disruption, or to co-ordinate an industry-wide response, may be warranted.

Of course, since any prospect of public sector involvement gives rise to some potential moral hazard in a CCP's approach to mitigating these risks, this must be carefully managed by regulators. A key role of regulators in this respect is to ensure a CCP has put in place an appropriately high level of self-insurance, such as calibrating its financial resources to withstand the stressed default of one or more large participants.

2.4.2. Competition for clearing

The strong network effects at work with a CCP also mean that, historically at least, each particular market or set of products within a jurisdiction has been served by a single CCP. In part, this is because once a given central clearing arrangement is adopted, it can be difficult for participants to then co-ordinate a move to a different arrangement if ever this was desired. More recently, though, examples have emerged of multiple CCPs serving a single market. This development has likely been driven in part by changes in the regulatory landscape, technological advances and increasing globalisation of financial markets.[26] But the longer-run implications for market functioning, and whether any optimal design for the market for clearing services exists, are very much open questions.

Where a single CCP clears all products and participants in a market, it may have a greater capacity to monitor and mutualise risk across this market. A single CCP may also face less commercial pressure with regards to its choice of risk controls.[27] A CCP's operation is also likely to exhibit increasing returns to scale, reducing its unit costs, which potentially suggests a monopoly structure is the most efficient organisational arrangement. A single CCP might also provide greater netting opportunities for participants the more extensive is its product range and the number of participants it has. In contrast, CCPs that clear fewer products or have fewer participants might have higher costs, reducing their attractiveness to the market. Given a choice between clearing through a smaller CCP and not participating in the market, some dealers may exit, with a detrimental effect on the efficiency and liquidity of the market.

However, an increase in the scope of products and participants also increases a CCP's systemic importance. The incumbency of a CCP may also facilitate some monopolistic behaviour, such as charging excess clearing fees or only slowly enhancing its service offering. A consideration for regulators, therefore, is the potential for a mandatory clearing policy to contribute to the development of monopolistic power by CCPs. Careful consideration might need to be given to whether particular access requirements are imposed on such CCPs; this also raises the question of whether a user-owned CCP, a public utility or a commercial for-profit CCP should be preferred by policy makers.

2.4.3. Dealers, participation criteria and tiering

Where the scale and complexity of the CCP increase its risk management task, these may also have a bearing on the criteria it sets for accepting market participants as clearing members, potentially reducing the range of participants able (or willing) to join the CCP directly. As discussed in Section 2.3.2, direct participation can be an important distinction between dealers in a market, and a CCP's participation requirements can influence the degree of tiering within a market. This will not only affect the status of dealers, but will also drive the extent of concentration risk within a market. For instance, if a smaller dealer were forced to clear as a client, and had only a restricted set of direct clearing participants to choose from, it may have less capacity to control counterparty exposures than under bilateral arrangements. If smaller dealers were unable to clear directly and they decided to exit markets where they had previously been active, this would see activity in these markets further concentrated in the hands of larger dealers.

Calibrating optimal participation criteria is a difficult challenge for CCPs, market participants and regulators, since these will in part be a function of the degree of heterogeneity of market participants, the scope and capacities of the CCP, and the characteristics of the products being cleared. Participation criteria that are set too stringently will result in an overly tiered market, while criteria that are too relaxed may increase the risks faced by a CCP and its members.[28]

2.4.4. Netting, liquidity and capital efficiency for participants

A move to central clearing of OTC derivatives will likely bring some costs to the market. First, the requirement to post initial margin will likely increase many market participants' collateral needs above levels that characterised bilateral arrangements, particularly where these do not currently require exposures to be collateralised. Second, a more widespread use of variation margin could see a net increase in the quantity of collateral held across the market.[29] Third, market participants who join CCPs as direct members will typically be obliged to make a contribution to pooled risk resources, as well as hold capital against their trades and any contingent obligations to the CCP. On top of all of this, ongoing fees that might be paid to CCPs will introduce further costs.

Central clearing of only part of a market participant's portfolio can potentially lead to increases in some counterparty exposures, particularly where previously offsetting bilateral exposures are ‘un-netted’ (that is, some positions are now cleared while others remain uncleared). This could be exacerbated if the various cleared components of a participant's portfolio are cleared through different CCPs . For some market participants, then, a single global cross-product CCP might be an optimal solution based on netting and collateral considerations alone.[30] However, the extent of un-netting compared to a bilateral position will depend on the composition of a participant's portfolio, and on the degree of netting that could be achieved through bilateral agreements as opposed to multilateral netting. For instance, a large globally active fund manager using derivatives to manage risks across multiple currencies and assets may see a substantial increase in collateral if these positions are cleared across numerous CCPs. In contrast, a small financial institution that occasionally hedges a particular exposure (say, credit or interest rate risk) through a small number of counterparties may be relatively indifferent to the configuration of CCPs.

One way to maintain or improve multilateral netting opportunities within a centrally cleared environment is to increase the range of products that are cleared through a single CCP.[31] While participants would in some respects welcome the netting and operational efficiencies (and associated capital benefits) that might accrue from a CCP increasing the range of its products, this further increases the concentration risk and systemic importance of this entity – a significant concern for many market participants and regulators.

As noted in Section 2.3.3, some OTC derivatives may not be amenable for central clearing in the near future, and so some fragmentation of bilateral and centrally cleared positions will likely persist. Fragmentation is already a feature of OTC derivatives markets that are currently centrally cleared, as discussed below in Section 2.5, and this is likely to be a part of the global landscape for some time. A market participant's exchange-traded positions may also contribute to the degree of fragmentation, given the sometimes close relationship between these transactions and similar OTC derivatives. Further complicating a comparison of capital requirements across different arrangements is the fact that, irrespective of any move to central clearing in Australia, under revised BCBS standards a higher capital charge for uncleared bilateral exposures will be imposed globally on many banks. In some jurisdictions, minimum margin requirements are being imposed on uncleared transactions even for non-prudentially supervised institutions.

Market participants in turn can be expected to adjust aspects of their operations – such as their organisational structures, market presences and trading strategies – in response to these economic and regulatory forces. This will also influence developments in the market for clearing services. The endogenous nature of these various factors makes it very difficult to determine ex ante what the overall effect of a move to central clearing might be on participants' capital and liquidity requirements, and the consequences of this for the cost and availability of services to end-users.

2.4.5. Links between central counterparties

As an alternative to an increased range of products within a given CCP, the capacity for participants to maintain or increase netting opportunities (for cleared products at least) can be facilitated by establishing links between CCPs.[32]

There are various forms of co-operation among CCPs. Two commonly discussed methods are cross-margining and interoperability. Under a cross-margining arrangement, two CCPs grant margin discounts to a common member who holds positions that are negatively correlated across the CCPs (such that the combined risk posed to both CCPs is less than the sum of the risk posed to each one separately). Although a market participant must still be a member of both CCPs, the arrangement restores some netting opportunities that would otherwise not be available.[33]

An interoperability arrangement, on the other hand, allows trades to be cleared without counterparties (or their clearing agents) needing to be members of both CCPs. Instead, depending on the details of the arrangement, the CCPs essentially become members of each other, allowing them to novate opposite sides of the same trade.[34] Two common models of interoperability are a ‘peer-to-peer’ arrangement, in which each CCP recognises the other as an ‘equal’, or a ‘sub-CCP’ model, in which one CCP acts as a clearing member of another. Such links create exposures between the CCPs that must be appropriately managed and collateralised. The management of such exposures has been a key focus of European regulators over recent years.[35]

A further example of co-operation between CCPs is a mutual offset arrangement. This allows traders on two exchanges to open a futures position on one exchange and liquidate it on another (for given fungible contracts with harmonised specifications and settlement prices). In this way the participant can choose the clearinghouse at which the contract is held, regardless of where this was executed. The clearing member at the CCP serving the first market gives up the contract to the trader's clearing member at the CCP serving the second market. This provides some efficiency by enabling a trader to consolidate positions at a single CCP.[36]

Co-operation between CCPs has the potential to restore efficiencies lost through un-netting that might result from the presence of multiple CCPs in a single market or serving different product classes. However, such arrangements also create exposures and interdependencies between CCPs, giving rise to regulatory concerns. Therefore, while the benefits to participants of such arrangements may be significant, they also clearly require careful consideration and regulatory oversight to minimise or mitigate any associated systemic risks.

2.5. The Global Landscape for OTC Derivatives Central Counterparties

While CCPs have been a component of traditional exchange-based markets for many decades, the emergence of CCPs dedicated to clearing OTC markets has only been a relatively recent development.[37] In the late 1990s, SwapClear – a service operated by LCH.Clearnet Ltd for clearing interest rate swaps – was developed in London, with this service now widely used by participants in the major European and US markets. Following the bankruptcy of Enron in 2001, clearing for OTC energy derivatives emerged in the United States. Recently, though, the development of OTC derivatives CCPs has been more driven by the accelerating regulatory agenda. For instance, the push for improvements to credit derivatives markets has seen several CCPs for this market emerge in Europe and the United States.[38] At the same time, new clearing services for interest rate derivatives have emerged. The regulatory imposition of central clearing requirements represents a fundamental change in the market for clearing services. Whereas CCPs had previously developed organically in response to the underlying economics of the markets they served, a growing number of CCPs have been entering the market as the push for central clearing of OTC derivatives has become more global and mandatory. The expanded commercial opportunities for central clearing that this regulatory effort is creating have also been an important factor in a number of recent merger or takeover proposals among global exchange and CCP operators.

The fluidity of the global market for clearing services has resulted in a good deal of uncertainty for Australian market participants in considering any move to a centrally cleared environment. Present indications are that more than 25 central clearing services are active or proposed, ranging across many OTC derivatives classes (Table 2). Both the European Union and the United States have multiple CCPs, while a number of smaller countries have also had CCPs established or proposed. In many cases, there is direct competition for clearing similar product classes.

Table 2: Existing and Proposed OTC Derivatives Central Counterparties
As at May 2011
Domicile Clearing service Derivatives classes Status
Brazil BM&F Bovespa FX, equity Active
Canada CDCC Equity Active
China Shanghai Clearing House Not yet specified Proposed
France LCH.Clearnet SA Credit Active
Germany Eurex Clearing Credit Active
Equity Proposed
Interest rate Proposed
Hong Kong HKEx Interest rate Proposed
India Clearing Corporation of India FX Active
Japan JSCC Interest rate, credit Proposed
Poland KDPW_CCP Interest rate Proposed
Singapore AsiaClear Interest rate, commodity Active
Sweden Nasdaq OMX AB Commodity Active
Interest rate Proposed
CME Clearing Europe Commodity, energy Active
ICE Clear Europe Credit, energy Active
LCH.Clearnet Ltd Interest rate, equity, commodity Active
FX Proposed
NYSE Liffe Equity, commodity Active
CME Group Interest rate, credit, commodity, energy Active
FX Proposed
ICE Trust Credit Active
IDCG Interest rate Active
NYPC Interest rate Proposed
Options Clearing Corporation Equity Proposed

Sources: FSB; RBA; Risk Magazine


For a more detailed comparison of some of the costs and benefits of bilateral and centrally cleared arrangements, see European Commission (2009). [15]

In many jurisdictions, the legal robustness of these netting and close-out arrangements is underpinned by legislation. In Australia, the relevant legislation is the Payments Systems and Netting Act 1998. [16]

As an example, counterparties with traditionally high credit ratings, such as sovereigns, have typically had ‘one-way’ agreements in place, whereby they can demand collateral should valuations move in their favour, but not be obliged to make payments should valuations move against them. [17]

For further discussion on some of the issues discussed here, see Duffie, Li and Lubke (2010), and Pirrong (2011). For a discussion of central clearing considerations for some specific OTC derivatives classes, see RBA (2009) for credit derivatives, and Manning, Heath and Whitelaw (2010) for foreign exchange markets. The latter uses a stylised example to illustrate the reduction in exposures that can result from a centrally cleared arrangement. [18]

The BCBS is currently considering an appropriate methodology for calculating risk weightings for participant contributions to CCPs' default funds; for more discussion, see BCBS (2010b). [19]

For CCPs with foreign participants, the legal robustness of its arrangements may depend upon both jurisdictions' laws. [20]

For more discussion of the issues surrounding the segregation and portability of client positions, see CPSS-IOSCO (2011, pp 66–70). [21]

See BCBS (2010b). [22]

For more discussion of the distinctive features that should be considered in the central clearing of OTC derivatives, see CPSS-IOSCO (2010). [23]

Partly because of this aspect of a CCP's role, a senior official at the Bank of England has recently called on CCPs to think of themselves as ‘system risk managers’, putting this public role ahead of other more commercial considerations; for more discussion see Tucker (2011). [24]

Researchers at the Bank of England have identified three instances of failure over the past 40 years: Caisse de Liquidation (Paris) in 1974; the Kuala Lumpur Commodity Clearing House in 1983; and the Hong Kong Futures Guarantee Corporation in 1987. For more discussion, see Hills, Rule and Parkinson (1999). For a discussion of the history of CCPs within the United States, and the challenges posed by various crises, see Bernanke (2011). [25]

For a discussion of these developments, see CPSS (2010). [26]

As an example, the choice of initial margin rates set by a CCP can involve a trade-off between the short-run profitability of participants (who need to fund these margin payments) and the longer-run resilience of the CCP. Given a choice, myopic clearing participants may prefer a CCP with lower margin requirements (and potentially lower resilience) than one requiring higher margin payments. [27]

See ASIC and Reserve Bank (2009) for a discussion of these considerations in the context of a review of participation requirements for the ASX's clearinghouse for cash equities. [28]

For discussions of these and related issues, see, for instance, Singh and Aitken (2009). [29]

See, for example, Duffie and Zhu (2011). [30]

For a discussion of where an increase in the range of products cleared through a single CCP might have some benefits, see Jackson and Manning (2007). [31]

For more discussion of CCP linkage arrangements, see Chapter 7 in European Central Bank and Federal Reserve Bank of Chicago (2007). [32]

For example, CME has cross-margining arrangements with FICC, ICE and OCC. A similar arrangement operated between LCH.Clearnet Ltd and CME from May 2000, although this was recently terminated. [33]

One example of such an arrangement is a link between LCH.Clearnet Ltd and SIX x-clear, enabling their members to clear equities trades made on either the LSE or SIX Swiss Exchange. [34]

For a discussion of recent practical policy considerations of these issues, see Joint Regulatory Authorities of LCH.Clearnet Group (2008). [35]

Such an arrangement exists between CME and SGX for a limited range of derivatives contracts. [36]

For a discussion of the longer run history of CCPs, and the recent development of clearing for OTC products, see Norman (2011). [37]

For a discussion of some of the forces behind the establishment of CCPs clearing credit default swaps in the United States and Europe, see Chander and Costa (2010). [38]