Abstract
Once a trade is executed, further actions are essential to finally settle it. At this point in the value chain—that is, post-execution—clearing is the next step. Clearing is the general term for the risk management and operational processing needed to ensure that the commitment made from the trade execution is concluded on the settlement side, a final step involving the exchange of shares for money and other critical procedures. In this final step, a central counterparty, or CCP, steps in between the original trading parties, becoming the new seller to the original buyer, and the new buyer to the original seller.
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Notes
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The Group of Twenty (also known as the G-20 or G20) is an international forum for the governments and central bank governors from 20 major economies.
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The Committee on Payment Systems and Settlements, since then renamed to Committee on Payments and Market Infrastructures, and the International Organization of Securities Commissions are international bodies which bring together national and regional regulators and central banks to coordinate and outline joint policies and standards.
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Legal trade means that there is a contractual obligation between two parties.
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In the agency model, the end user of the trade legally holds a position at the CCP. The direct clearing member guarantees the trade and acts as agent of the client towards the clearing house, wherefrom the name.
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LSOC = Legal separated, operationally comingled, i.e., a form of “tagged” omnibus segregation.
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Compression is basically the replacement of (mostly) offsetting trades, and possible a large group of them, with a lower number of trades. In some cases, lower number is taken to mean smaller notional.
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The CCP’s “waterfall” is the sequence in which financial resources provided by the members, CCP, and possibly other stakeholders are used to cover losses from a member default.
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A prudential authority is responsible for oversight of capital markets and their actors in a macro-sense. Often, a prudential authority defines its responsibilities in terms of “systemic risk,” that is to say, risk which is realized through the interaction between various institutions and their behavior, rather than the (micro) regulation of a particle entity. Following on from the financial crisis in 2008, various systemic risk boards, such as the FSOC or ESRB, have been created, and other regulators, such as the Bank of England, have developed a function to address this feature of markets.
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Secondment means the temporary movement or placement of an individual into another role or position.
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Invoicing back means that the original counterparty to the trade is requested to take up the position directly, essentially removing the CCP from any further obligations. Allocation often denotes a similar process, although trades are not returned to the original counterpart, but across non-defaulting members of the CCP. Allocation is often performed with the members taking over obligations to rebalance the CCP in proportion to their activity.
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Mutualization is the use of common funds, often called the default fund. Using funds from non-defaulting members is rare and considered a grave event.
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Given the preference most CCPs and clearing members have for a “defaulter pays” model, most CCPs have higher confidence levels; for instance LCH.Clearnet uses a 99.7 % confidence level, and most CCP’s back-testing reveals de facto higher confidence levels on a regular basis. The European Market Infrastructure Regulation requires that CCPs maintain at least 99.5 % confidence level for OTC derivatives such as interest rate swaps.
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A concentration add-on is further margin charged to account for the discount that trading out of a large position is expected to cause. For example, as it is harder to sell 100,000 shares than 10,000, a CCP should charge a member more per share for the first position. This key feature is important to keep orderly liquidations and mitigate losses beyond the defaulter’s collateral.
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Title transfer denotes the legal transfer of full ownership. In this case, the CCP becomes the owner of the cash.
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See, for example, https://www.newyorkfed.org/medialibrary/media/research/epr/2014/1412flem.pdf for the Lehman Brothers case, and https://www.chicagofed.org/~/media/publications/economic-perspectives/2015/4q2015-part1-ruffini-pdf.pdf for MF Global.
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Many CCPs were, and some still are, jointly owned by their members. Each member often holds shares in the CCP based on their volume at the CCP.
Further Reading
Eurex Clearing / Deutsche Börse Group (2014): How central counterparties strengthen the safety and integrity of financial markets. Frankfurt / Main: Deutsche Börse AG.
Robert Schwartz, Reto Francioni. Equity Markets in Action, 2004
Peter Norman. The Risk Controllers: Central Counterparty Clearing in Globalised Financial Markets. 2011
Paul Tucker: Clearing houses as system risk managers: http://www.bis.org/review/r110608g.pdf
Jon Gregory. Central Counterparties: Mandatory Central Clearing and Initial Margin Requirements for OTC Derivatives. 2014
CPSS IOSCO Principles for Financial Market Infrastructure: http://www.bis.org/cpmi/info_pfmi.htm
European Market Infrastructure Regulation: http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A32012R0648
The Dodd-Frank Wall Street Reform and Consumer Protection Act: http://www.cftc.gov/idc/groups/public/@swaps/documents/file/hr4173_enrolledbill.pdf
Darrel Duffie. Selected papers: http://www.darrellduffie.com/
Acknowledgments
The author would like to acknowledge the valuable contribution of Mr. Teo Floor and thank him for his continued support.
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Laux, T. (2017). Clearing. In: Francioni, R., Schwartz, R. (eds) Equity Markets in Transition. Springer, Cham. https://doi.org/10.1007/978-3-319-45848-9_5
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DOI: https://doi.org/10.1007/978-3-319-45848-9_5
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