Journal of Financial Market Infrastructures

LETTER FROM THE GUEST EDITOR

Pedro Gurrola-Perez Head of Research, The World Federation of Exchanges

This special issue of The Journal of Financial Market Infrastructures is dedicated to papers accepted at the 2020 WFE Clearing & Derivatives Conference. This was organized by the World Federation of Exchanges (WFE), the global industry group for both central counterparties (CCPs) and exchanges. The conference aimed to bring together academics, policy makers and practitioners to share original research and to exchange ideas on the future of central and bilateral clearing in light of regulatory reforms, changes to market structure, and technological developments. Unfortunately, like many other events, the conference was cancelled due to the Covid-19 pandemic.

The good news is that, through this special issue, we can still benefit from the ideas and the research that were meant to be discussed at the conference. The papers we have selected are representative of the spirit of the conference, bringing together different perspectives to shed light on two topics that are key to current discussions about the future of clearing: access to clearing and the challenges brought by new technologies.

As the regulatory focus shifts from implementing regulations that arose following the great financial crisis toward enabling growth and market development, there is a need to evaluate and understand how reforms are interacting with and reshaping the market. The aim is to identify any negative impacts on the incentive structures in place across the clearing ecosystem, ensuring that agreed-upon principles are implemented and that any potential new sources of risk are understood.

One example of the sort of change that is happening to the market structure is the narrowed access to clearing. Since the implementation of the postcrisis reforms, we have seen that a significant number of clearing members have stopped providing clearing services. As a result, these services have become concentrated among a few large clearing members. The first paper in this special issue, “Concentration in cleared derivatives: the case for broadening access to direct central counterparty clearing” by Nahiomy Alvarez and John McPartland, explores some of the potential factors driving this concentration and reflects on its adverse consequences. The paper describes the challenges for end users of derivatives looking to become direct clearing members at CCPs, along with the potential ways of overcoming these hurdles. In particular, the authors discuss some of the initiatives that CCPs have already introduced to broaden direct clearing access by offering alternative ways of access.

Our second paper, “Too much, too young: improving the client clearing mandate” by David Murphy, reminds us that a key question when considering mandatory client clearing of over-the-counter derivatives is whether porting is likely to be achieved. Porting – the mechanism by which, in the event of a member’s default, an end user can ensure the continuity of their trades by moving their portfolio to a different clearing member – was one of the big regulatory changes that came about as a result of the great financial crisis. It was a fundamental part of the clearing mandate: while the end user was mandated to centrally clear, portability granted an additional remedy upon the default of the end user’s clearing member. This paper makes several contributions to the policy debate around porting. It shows that porting plays a key role in realizing the benefits of clearing for clients and discusses how the concentration of clearing services makes porting clients’ portfolios less likely to happen. The author also suggests two innovations for membership models to enhance portability: the use of a special-purpose clearing member for the long tail of small clients, and the enhancement of direct clearing models that will reduce the dependence of the largest clients on their clearing members. This paper also explains why the threshold for the clearing mandate should be revised so that it is framed in terms of initial margin, rather than notional.

Against this backdrop of regulatory changes, new technologies are also having an impact on the way we think about the future of clearing. Distributed ledger technologies, for example, have been seen as having the potential to reduce costs, simplify processes and increase transparency and resiliency in the post-trade industry (albeit not to replace clearing, as is sometimes assumed). The third paper in this issue, “Toward reducing the operational risk of emerging technologies adoption in central counterparties through end-to-end testing” by Elena Treshcheva, Rostislav Yavorsky and Iosif Itkin, focuses on the risks arising from implementing artificial intelligence (AI) or distributed ledger technologies within central clearing. While some aspects of the risks inherent in these technologies are well known and studied (AI trustworthiness, data privacy, platform availability), this paper’s contribution is to focus instead on the risks arising from the implementation of these technologies in existing business processes. From a software testing perspective, the platforms built with the new technologies will not only need to address the specific risks brought by these new technologies, but they will also need to do so by taking into account the complexity inherited from existing traditional technology infrastructures. One way to mitigate these risks is to perform extensive, end-to-end professional testing. In particular, this paper discusses software testing challenges for CCPs. It outlines a set of requirements for an end-to-end validation and verification solution aimed at the new generation of clearing platforms, and it takes into account the risks, biases and problems related to the new technologies.

Our final paper, “Hypothetical yield curve scenarios for credit stress testing” by Bhavin Desai and Kausick Saha, discusses the model developed by the Clearing Corporation of India Limited(CCIL)for deriving extreme but plausible hypothetical yield curve stress scenarios. CCPs model extreme but plausible scenarios to estimate the minimum size for their default fund and to assess the adequacy of the prefunded default waterfall resources on a routine basis. Therefore, a sound and prudent stress testing framework that acknowledges model risk is critical for the safety of the CCP. The model described here uses a generalized Pareto distribution for modeling extreme shifts of interest rates. It has the merit that the potential extreme shifts for different tenor points across the term structure are modeled independently of each other, instead of assuming a single extreme shift across the entire term structure, and that the methodology is free from any co-movement assumption. This paper also reminds us of the importance of identifying the associated model risks as well as the methods used for minimizing them.

On behalf of the Program Committee, I hope you enjoy reading this special issue of The Journal of Financial Market Infrastructures, and I hope to see you at a WFE Clearing & Derivatives Conference in the future.

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