Direct clearing could solve CCP concentration risk

Allowing more clients to self-clear can reduce CCPs’ reliance on a few firms, says ex-Chicago Fed adviser


The business of derivatives clearing lies in the hands of a small number of financial firms. Given this high level of concentration, the financial insolvency of just one of the largest general clearing members (GCMs) would have a big effect on the clearing ecosystem.

First, it would entail the liquidation of a substantial and largely directional house portfolio. Second, client positions and initial margin assets would need to be transferred to other clearing members likely in a difficult operational environment.

This activity would require the continued orderly operation of central counterparties on days of record or near-record trading volume. To this you can add the problems of price volatility, bank capital requirements under the leverage ratio, anti-money laundering rules, know-your-customer rules, and non-harmonised insolvency regimes.

John McPartland
John McPartland

One way to stave off increased concentration in the clearing space would be to move in the opposite direction: for end-users to self-clear their positions with a CCP via sponsored or non-sponsored access. A paper jointly authored by Nahiomy Alvarez of the Federal Reserve Bank of Chicago and myself expands this argument.

In sponsored clearing arrangements, end-users become the counterparties to a CCP but still rely on a sponsoring clearing member to provide operational services and/or a financial guarantee. Importantly, the end-user’s positions and initial margin are held in their own account at the CCP, separate from the sponsoring GCM’s positions and initial margin. In this way, an end-user’s positions and initial margin are protected in the event that its sponsor defaults.

This type of arrangement may protect end-users from “fellow customer risk” – that is, the risk posed by one or more of the large clearing member’s other customers defaulting on their obligations and potentially driving the clearing member itself into default.

In the non-sponsored route, end-users would become direct clearing members and self-clear their trades, so long as they meet CCP membership requirements. This could happen in one of two ways: either, large end-users could choose to become independent direct clearing members of a CCP; or a small group of market participants from the same industry could form a co-operative that becomes a clearing member at a CCP.

Sponsored access or direct clearing might present some attractive benefits if done properly:

  • Leverage: The initial margin of the customer would no longer be reflected on the balance sheet of the GCM or of the parent company, which would be particularly relevant if the GCM has a bank parent. Doing so would reduce the leverage of the parent bank and, potentially, increase return on equity, the holy grail of banking.
  • Regulatory capital: With major clients’ positions off the books of the GCM, the capital requirements (driven by the notional principal of positions) under the leverage ratio would be reduced linearly. All other things being equal, this would increase return on equity more than linearly.
  • Residual interest: With daily settlement requirements assumed by the clients themselves, GCMs’ residual interest would fall. Residual interest is the liquid funds held in reserve by GCMs to accommodate the timing differences between the GCMs’ obligations to settle with the CCPs and the clients’ obligations to settle with the GCMs. Reducing this residual interest would improve return on equity.
  • Porting: CCPs and GCMs would no longer be concerned with the potential challenges of transferring client positions and client initial margin under difficult circumstances, as the direct clearing members would already have their positions and initial margin in their own accounts with the CCP.
  • Diversification: CCPs would benefit from having a much larger and diverse base of clearing members should the CCP need to liquidate a portfolio of positions. This should produce improved auction results, benefiting all concerned.
  • Settlement: While settlement bankers would see far more settlements to honour and process, the amounts would be far smaller and arguably more manageable than they are today.

The potential to achieve all these benefits turns on a single premise: that direct clearing members outsource their post-trade processing to their GCMs on a revenue-neutral basis. This would spare direct clearing members the formidable burden of having to establish and run a back office.

Direct clearing won’t be suitable for all major market participants, particularly those that are acting in an investment management or agency capacity. For the concept to work, all the positions of the direct clearing member must be for the account and risk of the enterprise itself. The concept should work for pension plans, insurance companies, corporations, family offices and sovereign wealth funds.

Many of these enterprises will have other challenges besides wanting to avoid having to staff their own back office: for example, pension plans cannot contribute pension fund assets into a mutualised CCP guarantee fund. Our paper proposes a plausible workaround for this limitation.

Ready access to liquid funds to settle with the CCPs in the afternoon would pose a challenge for almost all potential direct clearing members. CCPs could allow sovereign debt securities to provide overnight cover for the afternoon’s variation margin obligations without having the CCP assume any excessive risk. Doing so would solve the residual interest challenges of potential direct clearing members. This is not a new concept: Eurex Clearing and LCH today provide similar overnight settlement options for their GCMs.  

All of the logical return-on-equity arguments aside, opposition to disintermediating GCMs remains. Conversations with large potential direct clearing members suggest that outsourcing post-trade processing on a revenue-neutral basis would be entirely acceptable to them. But the GCMs argue against it, apparently believing that price competition would drive insourcing revenue below revenue-neutral levels. This remains a major obstacle in advancing the direct clearing member concept. The return-on-equity message isn’t getting through.

Some have argued that direct clearing members may pose greater risk to CCPs because they would not have an established GCM to guarantee their financial performance to the CCP – but the bank-affiliated GCMs making this argument themselves hold large directional positions that are not guaranteed by another GCM, and are the largest single source of concentration margin add-ons!

CCP evolution will continue to raise new challenges for everyone involved – the process is far from over.

John McPartland is a retired senior policy adviser at the Federal Reserve Bank of Chicago

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