OTC Clearing ‘FIX’ed Up!

Extending FIX implementations to support OTC trading and clearing

FIX is becoming a viable protocol for the trading and clearing of OTC products, as regulators usher the OTC world toward transparency and standardization. Credit Default Swaps (CDS), FX forwards and FX swaps are the latest set of financial instruments to experience a move toward standardization and are fitting nicely into the model provided by FIX while, the OTC energy market has been leveraging FIX for several years. In response, the industry is starting to see clearing service providers offer new trade confirmation and clearing solutions that allow FIX implementations to be extended from vanilla equity and listed derivatives products to standardized OTC products. CME Group’s Matt Simpson explains that this has the potential to allow significant savings for participants who can likewise extend their existing FIX implementations to support OTC trading and clearing.

Clearing houses make stride

Over the last 18 months regulators have aggressively pushed OTC markets toward standardization in order to achieve price transparency and eliminate bilateral counterparty risk. Clearing is a key component of this plan. Central counterparties such as CME Group, ICE Clear and the London Clearing House (LCH) provide clearing services which can greatly reduce the risk of default and systematic failure across the markets as well as the major players who are the investment banks, asset managers and hedge funds.

Central counterparties run clearing houses which set policies for settling markets and limiting risk. Clearing houses offer a safe harbor from this risk by ensuring that OTC markets are sufficiently collateralized and that in the unlikely event of a default the market impact is minimized. The clearing process involves carefully setting margin rates which are high enough to protect the market but not so high that trading is squashed. Margin is held in the form of collateral which can be called on in case of default. Additionally, clearing members must contribute to a default fund over and above basic margin requirements which also serves as a buffer should a default occur.

Beyond providing a safety net for the OTC high wire act, clearing houses perform other critical day to day functions that are necessary for ensuring stable markets. Valuation (also known as mark to market), cash flow calculations, and settlement price determination are part of an overall clearing service that allows all trades and positions to be fully settled each day. Taking CDS as an example, clearing houses calculate what is referred to as variation margin which is a combination of the change in the market value of a CDS position as well as the coupon accrued on a daily basis. Clearing houses hold variation margin until the CDS position matures or a coupon payment date is reached. Other types of cash flows include the full payment/receipt of a coupon on a quarterly basis and the handling of the upfront amount that is included with trades. All such cash flows are immediately banked rather than being held on a collateralized basis.

Daily settlement price

Determination is a critical process which underlies all functions of the clearing house. Without it, trades and positions could not be valued or margined. For OTC products, this tends to be a democratic process which involve “voting” on the value of a financial instrument by key participants in the form of price submission. Both bids and asks are submitted. The clearing house receives these prices, removes outliers, converges on the settlement price and publishes them to the market.

Another area worth a mention that is specific to CDS clearing is the handling of credit events. A credit event occurs when the issuer of a bond on which a CDS instrument is based fails to make payment. In effect, this is the fundamental purpose of a CDS instrument; to protect the buyer of a bond from exposure to default by the bond issuer. When this happens the clearing house must ensure that the CDS buyer is made whole and receives the unrecoverable portion of the amount held. Likewise, the clearing house must also ensure that the CDS seller delivers on the unrecoverable portion. The recoverable portion is determined by an ISDA auction. Generally, this transaction is cash settled.