„Cross-jurisdictional netting
and global solutions‟
LSE conference, 12 May 2011
„The economics of CCP operations and netting‟ by
Prof. Robert Kosowski
(Assistant Professor and Director of Risk
Management Lab and Centre for Hedge Fund
Research at Imperial College London)
2
Presentation Outline
1. CCP and netting: basic structural elements
2. Economic role of CCPs in the global financial system and regulatory context
3. Economic Costs and benefits of CCP/netting:
– Risk-adjusted return on capital and capital charges, informational asymmetries, counter-party risk, risk-return trade-off, systemic risk/moral hazard, economies of scale, network effects,
4. Economics of CCP operations/netting, corporate governance
– Perspective of the operator
– Perspective of Members and their clients
– Perspective of governments
5. Conclusions
Appendix: References, Definitions
3
1. CCP operations and Netting: Basic Elements
• Clearing/CCP structural elements
– GCM, clients of clearing members (NCM/TM)
– Ownership and corporate governance issues (EMIR, CPSS)
– The „default waterfall‟
– Business models (vertical silo, ...), Pre-trade/post-trade links
– US paper crisis and DTCC
• Netting (settlement/payment, novation, open-offer,
close-out netting, multilateral netting, gross/net)
– Eligible parties (banks, funds, non-financials, CBs..)
• Dealer-Dealer (IRS, CDS) vs Dealer-Client clearing
– Eligible contracts (primary/cash securities, derivatives (ETD,
OTCD), securities lending, CFDs..)
– Interaction with country‟s legal regimes
• Collateral versus contracts; collateral segregation/portability
4
2. Economic Role of CCPs in the Global
Financial and Regulatory Context
Custody (CSD,..)
Collateral
Management
Settlement
Post Trade
Regulation
• EMIR
(asset
segregation,
ESMA)
• BIS(capital
charges) ,
CRD4
• MIFID
(MTF)
•CPSS/
IOSCO, D-F
•T2S,
CCBM2,
SEPA
Exchange 1OTC
CCP 1
(netting/
clearing)
MTF
Client 2
Central Bank 1
Bank 2
A L . Loans Dep.
Sec. Equity TM/NCM
(e.g. Bank
3)
Client 1
Fund 1
Country/ Government 1
GCM (e.g.
Bank 1)
Central Bank 2
Fund 2
Bank 4 Bank 5
Client 3
Country/ Government 2
Swap
NCM GCM
Exchange 2
Custody (CSD,..)
Collateral Man‟t
SettlementS
ilo M
od
el
CCP 2
Different Legal & Regulatory
Environments (insolvency laws,
ownership transfer, supervisors,
CB collateral)
5
3. CCP and netting: Potential Economic Costs
and BenefitsBenefits
– Fungibility of contracts, capital efficiency and
reduced margins (in theory relative to
properly collateralised bilateral system!!!)
– Reduced information asymmetry (about CPs)• Through standardisation and trade repositories
– Choice for clients; lower dealers‟ barriers to
entry & information advantage
– Reduction of settlement risk, fewer contracts
and lower back office costs
– Reduction of liquidity risk (anonymous trading
increases liquidity)
– Reduction of systemic risk (risk
mutualisation)
• Reduction of information asymmetry compared
to bi-lateral clearing (CCP reduces information
problem; CCP is neutral)
– Reduction of operational risk by end-to-end
STP?
– Lower credit risk
Costs
• moral hazard for users;
(reduced incentives of
market participants to
monitor each other,
Pirrong (2009));
competition on margin
• Clearing fees
• Systemic risk from one or
few Super-SIFIs
• Collateral: – Extra $2tr collateral (TABB
(2011)
– Pro-cyclicality of collateral
– Concentration risk for
collateral (letters of credit)
– Fewer options regarding
acceptable collateral
6
Issues to Address when Moving OTC derivatives
from SIFIs to CCPs (Singh (2011, IMF))
1) Interoperability of CCPs which would allow multilateral netting of
positions across SIFIs residual positions;
– e.g. U.K.‟s LCH.Clearnet/Swapclear issues in US
2) Sizable additional collateral needs
– Tabb (2010), Singh and Aitken (2009), Singh (2010);
Zawadowski (2011, „Entangled Financial Systems‟)
3) Unbundling netted positions;
4) Duplicating risk management;
5) Likely regulatory arbitrage
– Senator Lincoln‟s “push out” clause under Dodd-Frank Act
6) Concentration of systemic risk;
7) Decrease in rehypothecation of collateral
8) Backstopping by central banks; (BoE position and (1))
9) more SIFIs to supervise (old SIFIs to retain exposures + new CCPs)
7
TABB estimates OTC Derivatives collateral may
need to be raised by up to $2tr
• TABB group uses margins on ETDs
in 2009 as benchmark for OTCD
collateral requirements
• Applying the $3.8tr benchmark to
existing collateral implies that
additional collateral requirement
could be as high as $1.9-2.2tr
(assuming total estimated OTCD
collateral for 2009 was $ 1.6tr)
• Factors that reduce collateral: 1) Not
all OTCD exposures will move to
CCPs, 2) high likelihood of end-user
exemption, 3) extremely short term
exposures, like a majority of FX, will
require little or no collateral, and 4)
innovations in cross-margining.
• Factors that increase collateral: (1)
increasing volatility, (2) decreasing
liquidity, (3) increasing duration, (4)
increasing complexity, (5) and lack of
netting efficiencies
8
4. Economics of CCP operations/Netting:
different perspectivesA. Operator/ CCP
– Competition on price, risk management (moral hazard), quality, coverage
– Inter-operability, corporate governance, Ownership: profit centre vs utility;
B. GCMs/NCM
– choice of CCP issue, Gross/Net netting
C. Clients of GCMs/NCMs
– Under certain conditions, incentives for moving certain positions to
CCP (but not necessarily tail risk), see Singh (2011, IMF)
– regulatory and business model uncertainty, sunk costs of choosing
one CCP as well as cost of breaking portfolio
– BRC, BIS 190 capital charges and membership
D. Government
– Backstop and moral hazard
– Competition vs natural monopoly
– National champion vs footing the bill in crisis
9
Price Compression and Cost Savings Example from Cash
Securities: Competition on (Explicit) Price
Source: http://www.euroccp.co.uk/docs/leadership/FYI_Changing_Landscapes_in_Equities_Clearing.pdf
• This slide shows
data from Euroccp
• Results dependent
on assumptions
• Careful to
distinguish explicit
(clearing fees,..) and
implicit costs (risk
management)
10
How many CCPs will there be/should there be
in the future?
“...consolidation into fewer, better capitalised CCPs. A globally
competitive system with less systemic risk” ? • DTCC response to paper crisis
source: http://www.euroccp.co.uk/docs/leadership/FYI_Changing_Landscapes_in_Equities_Clearing.pdf
Distinguish investor vs issuer (that
influences where liquidity is)
Via MiFID I &II
Competitive trading
Via EMIR: Access &
Interoperability for equities
Via: TARGET2 Securities
12
Potential Inconsistencies in Regulation:
• BIS CPSS‟ demand for „Enforceability of netting arrangements‟ may clash with
– BIS CPPS asset segregation/portability (Principle 14) ((see BIS CPSS
„Principles for financial market infrastructures „ (March 2011)) „
– Zero-hour‟ rules
• BIS 190 („Capitalisation of bank exposures to central counterparties‟):
– incentives for BRC structures which will have no capital charge compared
to proposed 2 percent capital charge when moving derivatives to CCPs
(without any BRC structures).
• The demand for BRC structures suggests that there is concern about the failure of CCPs to
warrant such schemes. Many end-users of OTC derivatives (Pimco, Blackrock, etc.) are
reluctant to post collateral with certain CCPs that do not have CB backstopping (e.g.
LCH/Clearnet).
– A non-member bank is only eligible to claim the reduced capital charges
associated with a CCP exposure under certain conditions !
– Should Clients become clearing members? How costly ? E.g. Each
Fidelity fund as opposed to Fidelity the firm....
13
Default Waterfall - How a CCP protects itself
1. Liquidate defaulters position to see what remains
2. Liquidate defaulter‟s initial and variation margin
3. Liquidate defaulter‟s contribution to the CCP‟s loss-sharing pool
4. Loss sharing among surviving GCM/participants
5. CCP‟s equity, retained earnings
6. Other possible financial resources:
1. Insurance
2. Financial guarantees, e.g. from bank, parent of CCP, etc
7. Government bailout and moral hazard
1. Monetary Authorities (BoE “no”, ECB/Fed/SNB “maybe”),
2. Fiscal Authorities
• Considerations:
– Should governments levy an insurance/bailout premium on CCPs?
– Which countries should host CCPs?
14
Has a clearinghouse ever failed?
• “I still believe that clearing houses could – and should – make the
derivatives world safer. In practice, though, they could also end up
creating new dangers if they are not put on a sound footing,
particularly if the fact that no clearing house has ever failed
before creates a false sense of complacency.”
– source: „Insight: The clearing house rules‟, by Gillian Tett, Financial
Times, November 5, 2009
• It is true that no clearinghouse in the US has failed, but there were
near misses in the US and clearing houses outside the US have
failed
• Considerations:
– Are banks (CCPs) international in good and national in bad times?• EMIR: „Where a CCP risks insolvency, the fiscal responsibility may lie predominantly
with the Member State in which it is established‟
– How volatile an economy / a financial system do we want?
15
Source: „Push to underpin clearing house foundations‟, by Jeremy Grant,
Financial Times, June 7, 2010
16
Conclusions and Key Takeaways
• Increased use of CCPs can be socially beneficial in presence of appropriate risk
management, inter-operability and international coordination (competition, capital
requirements, legal, contingencies)
• Inter-operability must be carefully thought through before being implemented
• Benefits and costs of CCP depend on outcome of many regulatory initiatives ( EMIR,
BIS CPSS, CRD4, MIFID, CPSS/ IOSCO T2S, CCBM2, SEPA)
• Trade-off between competition and natural monopoly (capital efficiency and systemic
risk)
• Theoretical discussion of benefits and costs of CCP must take into account current real-
world under-collateralization of OTCD
• Clash between BIS CPSS demand for asset portability/segregation/BRC and
enforceability of netting arrangements
• BIS CPSS 190 capital charge proposals for using CCP members change incentives of
membership and raises issues
• Competition on price may lead to less robust CCPs, in particular in countries with higher
moral hazard (i.e. with central bank back-stop)
• Considerations: “Which countries should host CCPs?”, “Are CCPs international in good
times but national in bad times?”
17
Appendix:
• The following slides contain
– Definitions and common abbreviations
– Relevant regulatory initiatives
– Select references and sources
18
Common Abbreviations
• CCPs central counterparties
• CSDs - central securities depositories
• SSSs - securities settlement systems
• OTC - over-the-counter
• TRs - trade repositories (TRs).
• FMI – Financial Market Infrastructure
• GCM – General Clearing Member
• NCM – Non-Clearing Member
• TM – Trading Member
• BRC – Bankruptcy Remote Collateral
• SIFIs - systemically important financial institutions
• ECB (European Central Bank), CESR (Committee of European Securities Regulators),CEBS
(Committee of European Banking Supervisors)
• CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors)
• ESMA (European Securities and Markets Authority)
• TARGET2 - real-time gross settlement system (RTGS) for the euro/Eurosystem.
• T2S(Target 2 Securities): http://www.ecb.europa.eu/paym/t2s/html/index.en.html
• CCBM2 (Collateral Central Bank Management)
• SEPA (Single Euro Payments Area ) Project
19
Regulatory Initiatives Relevant for CCP
• EMIR (European Market Infrastructure Regulation)
• Framework vs rulemaking (level 1 vs level 2)
– Clearing exemption (participant): In EU for non-financial counterparties, exemption only to
the extent institution‟s positions in qualifying derivatives fall below certain thresholds,
whilst the US approach does not have thresholds but instead has exclusions for particular
behaviors.
– Clearing exemption (asset class): In US, FX exempted. EU not decided but parliament
and commission not in favour
– Governance: US contemplating numerical limits on clearing firm ownership of CCPs to
avoid conflict of interest. EU focusing on governance.
– Repository recognition: The US requirements do not specifically provide for the
recognition of non-US repositories.
– Repository indemnity: Required in the US, not in the EU
– Ultimate goals: Avoid arbitrage, Avoid commercial disadvantage, Avoid tit for tat
• MiFID (Markets in Financial Instruments Directive regulates
• trading and exchanges/MTFs)
• CRD IV: capital requirements (transposition of Basel III)
• CSDs: central securities depositories
• January 2001, CPSS published the Core principles for systemically important payment
systems (CPSIPS)
• T2S, CCBM2, SEPA
20
References
• Acharya, Viral and Alberto Bisin, “Centralized versus Over-The-Counter Markets," New YorkUniversity,
Working Paper, 2009.
• Allen, Franklin and Douglas Gale, \Financial Contagion," Journal of Political Economy, 2000,108 (1), 1-33.
• Bliss, R. and C. Papathanassiou, 2006, Derivatives clearing, central counterparties and novation: The
economic implications, http://www.ecb.int/events/pdf/conferences/ccp/BlissPapathanassiou_final.pdf
• Brunnermeier, Markus, “Deciphering the Liquidity and Credit Crunch 2007-08," Journal of Eco-
• nomic Perspectives, 2009, 23 (1), 77-100.
• Diamond, Douglas W. and Philip H. Dybvig, “Bank Runs, Deposit Insurance and Liquidity,“ Journal of
Political Economy, 1983, 91 (3), 401-419.
• Duffie, D. And Zhu, H., 2011, Does a Central Clearing Counterparty Reduce Counterparty Risk?,
Forthcoming, Review of Asset Pricing Studies
• ECB Payments & Markets: http://www.ecb.int/paym/html/index.en.html
• FSA website on CRD 4: http://www.fsa.gov.uk/pages/About/What/International/basel/index.shtml
• Pirrong, Craig, “The Economics of Clearing in Derivatives Markets: Netting, Asymmetric Information,
• and the Sharing of Default Risks Through a Central Counterparty," University of Houston, Working Paper,
2009.
• Singh, M. , 2011, Making OTC Derivatives Safe―A Fresh Look,
http://www.imf.org/external/pubs/ft/wp/2011/wp1166.pdf
• Stulz, Rene M., \Credit Default Swaps and the Credit Crisis," NBER Working Paper, No. 15384, 2009.
• TABB Group, 2010, The Global Risk Transfer Market: Developments in OTC and Exchange-Traded
Derivatives, A TABB Group Study by E. Paul Rowady, Jr.
• Zawadowski, A., 2011, Entangled Financial Systems, Working Paper, Boston University,
people.bu.edu/zawa