„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

11

IMF Report (Singh, 2011): Which risk will SIFIs offload to

CCPs ?

Source: Singh (2011)

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