What to Consider when Choosing a Clearing House
Central clearing is fast becoming a reality. Counterparties in the US have been clearing standardised interest rate swaps and credit derivative transactions since 2013. In Europe, the first phase of clearing began on 21 June 2016. Under the Financial Markets Act, the first phase of mandatory clearing could apply as soon as the second half of 2017. Many Central Clearing Houses or Central Counterparties (‘CCPs’) have sprung up all over the globe, each one offering something slightly different – whether it’s the products they can clear, or the margin that they require. As a result, it is pertinent for potential Clearing Members (‘CMs’) to consider what is important in choosing a CCP for their clearing requirements, based on each CM’s risk policies.
Many articles have been written about CCPs becoming the most systemically important entities in the financial markets, and the risk that these entities may indeed become the new ‘too big to fail’ entities. It is therefore prudent to assess the potential risks that a CM may bear when facing a CCP. Some aspects to consider when making a choice as to which CCP to engage with are as follows:
CCPs are self-regulating entities; meaning each CCP has a set of rules, which it will impose on its CMs. One should ensure that the rules disclose the CCP’s procedures and risk management methods, and are transparent in this regard.
Regulation requires CCPs to maintain an insurance policy against defaulting CMs (usually in the form of a default fund, which CMs contribute to through the posting of Initial Margin, or ‘IM’, amounts). The CCP’s rules should be clear around how IM is calculated and how the CCP stress tests that default fund. As a CM, you want to ensure that contributions from non-defaulting CMs to ‘bail out’ a defaulting CM only kick in once all the IM of the defaulting CM has been exhausted. In other words, you want to ensure that fellow CMs’ risk is minimal.
In order to ensure the CCP has ‘skin in the game’, one would also expect that if the defaulting CM’s IM contributions were not sufficient to fulfill the defaulting CM’s obligations, a portion of the CCP’s own assets may be applied as well as contributions from non-defaulting CMs. However, it is important to balance this against ensuring the CCP does not go into resolution as a result of having to ‘bail out’ a defaulting CM. The default fund waterfall, outlining what assets are used to fulfill a defaulting CM’s obligations, and at which point, is therefore a critical assessment to make in choosing a CCP.
For South African counterparties it would also be important to assess what types of assets the CCP will accept as IM. Most of the established CCPs overseas will only accept G7 cash and a limited list of government bonds from G7 countries. This is for good reason: the CCP has to ensure it maintains liquidity at all times, and limiting IM assets to highly liquid assets is one of the ways in which it does this. However, for South African counterparties, this brings with it other risks, namely foreign exchange risk: having to enter into other transactions like repo or securities lending transactions to back on the required G7 assets that it needs. The Financial Markets Act does permit foreign CCPs to operate clearing services in South Africa, but the general feeling in the local market is that unless that CCP were to accept Rand-based collateral (especially for clearing Rand-based products), there would be limited uptake. At this point, no CCPs have been registered or granted a license under the Financial Markets Act.
Regulation requires that the CCP offer the CM different options pertaining to segregation of the IM accounts. The two main types of segregation model offered are omnibus IM account (‘OIM’) and individually segregated IM account (‘ISIM’). The OIM means that IM is segregated from the CCP’s own assets, but all CMs' IM is held in one co-mingled account. This model is usually the cheaper option, but it does increase fellow CM risk (in that if a fellow CM defaults, the IM used to fulfill the defaulting CM’s obligations is not segregated from other non-defaulting CMs' assets). The ISIM model, whilst being the more expensive option, segregates each CM’s IM both from the CCP’s own assets and from the other CMs' assets.
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