Thomas Krantz, Senior Advisor Capital Markets, Thomas Murray Advisory Services; and Alex Harborne, Senior Analyst – CCP Risk Assessment, Thomas Murray Data Services, look at incoming regulation around CCPs, and what we know of these entities.
Just over two years ago, six of our global banking clients came to us and said, essentially, “It’s been two years since the G20 2009 Pittsburgh Declaration. New regulation and laws are coming into effect subsequent to the implementation of the Dodd Frank Reform Act (Dodd Frank) and European Market Infrastructure Regulation (EMIR). Can you help us to anticipate the type of commercial and capital requirement environments that we will be facing?” The reports focused on due diligence and risk assessments.
A working party was subsequently formed, and SWIFT was approached to join as an observer. A questionnaire was put together with input from IOSCO, the Basel Committee, and national regulators. The formulation of the questionnaire was a substantial project in itself, and it was necessary to make it very comprehensive. This was due to the fact that CCPs themselves would be reporting to their regulators, as well as making information available to their clearing members, so that they and their clients would be able to calculate the regulatory capital requirements.
The questionnaire was made up of the broad categories of information that are representative of a Thomas Murray financial market infrastructure risk assessment; these were then adapted to the specific workings of a CCP. The questions focused on the following risks: counterparty, treasury and liquidity, asset safety, financial, operational, and governance and transparency.
There were about 400 questions designed to enable each entity to demonstrate how it goes about fulfilling what we believe the requirements are for a CCP. The main sources of information were publicly available. To fill that in, we had help from many CCPs, as well as the bank working party. These clearing banks offered corrections and some sense of how they experience day-to-day life working with these institutions, once the trade transaction has taken place.
By the summer of 2012, we ran three pilots: SGX-DC in Singapore, CC&G in Italy, and SIX x-clear in Switzerland. The selection of these three enabled Thomas Murray to cover all asset classes that CCPs clear globally. We are nearing the point where the firm has a comprehensive body of information covering 30 CCPs; meanwhile, the risk assessment programme went live with the first 26 reports in September 2013.
In addition to the online reports, if there is an event, for example a decrease in a default fund size, then that would be published for the CCP in question and “flashed out”. The firm sends out three flashes a day on infrastructure news, some 10,000 messages in all on 80+ jurisdictions.
We do not have static reports; our clients need reviews that are evolving online. If there is an event that is “for information only,” it will be broadcast. If something happens to one of those CCPs that we believe positively or adversely affects one of the six aforementioned risk criteria, that news will be published. We then explain why the risk assessment is being adjusted, and how the impact is felt.
What we do know?
Having brought in all these data and continued to grow the information base, we are now normalizing this knowledge base. One of the things we have found, despite all that we know, is the lack of information in certain areas. For example, not every CCP has employees – some exist as legal shells and contract out work to other parts of the exchange group. Some CCPs are not legally separate entities; they may share a balance sheet with the exchange or exchange group. We cannot tell what the capital base is at some of the largest CCPs. This includes Chicago Mercantile Exchange and the Korea Exchange – both major players in derivatives clearing – but neither of them has a separate capital base. With such notable absences, there is no sector-wide total figure, either, only general estimates.
At the time of the Pittsburgh G20 summit, the authorities thought to use CCPs to net down the exposures created by OTC derivatives; exchange-traded derivatives were already centrally cleared. We assume that the partial understanding of the workings of this segment that the firm must deal with in its assessments was an equivalent handicap for officials writing the Pittsburgh Declaration.
What we can say from looking at our individual reports is that the capital bases of CCPs are all over the place, and some are very small. The Options Clearing Corporation for exchange-traded equity derivatives in the US has a paid-up capital base of $12 million, as of 31 December 2012, which strikes us as being tiny given that this one institution centrally clears all traded US equity options. It has lines of credit available to draw on, but this is still a very low level relative to its peers in much smaller markets. Other clearing house capital bases have hundreds of millions of euros/sterling paid in. For example, last year the Singaporeans, in order to meet the Basel III requirements and to affirm their attainment of the status of “Q” for qualifying CCP under Basel III, paid up an additional 100 million Singapore dollars to recapitalize. The South African exchange is recapitalizing its CCP; the London Stock Exchange increased LCH’s capital when purchasing their majority stake. We are seeing some reaction to these global regulations in the form of recapitalization, but it is irregular.
As the capital bases are either unknown or varied, it is impossible to get an industry-wide meaningful figure for return on equity, and so there is no general sense of how profitable the business is. We do see that some are indeed very profitable.
In sum, a very diverse group of generally small enterprises is being charged by the G20 with solving a good part of the OTC derivative problem. They are instructed to take on the contracts which can be “standardised.” For the institutions that transact OTC and then centrally clear their trades, the counterparty risk does go away, but in a way that takes the form of a transfer to an obliging – or obliged – entity to calculate the value of the instrument now on its books, and how to request margin in a reasonable amount to cover that exposure.
CCPs have many different operating models. SIX x-clear, for example, charges very little for clearing, but funnels collateral to its sister company, SIX SIS, a CSD. CC&G earns its living by taking a cut of the interest earned on collateral posted by their clearing members – it does not take much to make decent money on a 9 billion portfolio.
As regards interpretation of the regulations for individually segregated accounts, in particular those in the European Union’s EMIR, what we find is that the CCPs all interpreted it in their own specific ways, resulting in at least 15 different models which, according to each CCP, meet the required standards. This is part of the confusion that exists.
Where certain markets (such as Brazil and Japan) are consolidating their CCPs to cover all asset types, other markets (eg Hong Kong and China) are continuing to use a fragmented model whereby different products clear at different CCPs. There are benefits to this approach, in that it separates the risk from one asset class to another, though it does lose out in terms of efficient use of collateral. As to risk position management, the separate clearing means that it is hard to get a sense of overall institutional positions, so one must rely entirely on the margin provided contract by contract.
This differentiation of approach should not be entirely surprising. Clearing houses grew up with very different exchange products. The idea of central clearing began with commodities, then was deemed essential for financial derivatives as they were developed in the 1970s, before progressing on to cash market securities. Compared with the exchange-traded and listed products, OTC is very hard to get a feel for, and there is some very understandable defensiveness on the part of CCPs to take on the risks of instruments that are harder to value.
One question we have been asked is this, “Why did the G20 in Pittsburgh in 2009 turn to CCPs as a solution to the OTC derivative problem?”. We do not know why this small group was identified by heads of government, and it caused considerable surprise that autumn on the exchange side, the most common owners of clearing houses. If the people creating these instruments were unable to price them, and it was clear to all that they could not, particularly during 2007/2008, then how could the CCP be certain of what it was taking onto its books and the margin posted against it?
There is a public policy mystery as to how this happened. Be that as it may, we are now four years and more on, and we have entered into the policy implementation phase of Dodd Frank and EMIR.
This leads to the next point: there is today the further problem of policy conflicts. There are the somewhat differing positions taken by Dodd Frank and EMIR on market infrastructures, which are also in conflict with certain global norms. The global authorities, particularly IOSCO, tried to keep everybody at the table in order to write consistent and coherent global public policy, as was its charge post-Pittsburgh. But their effort did not work, for various reasons, to the extent we would have hoped – this is a matter of real regret for us. We do have the Principles for Financial Market Infrastructures, but principles do not have the full effect of law.
The EU Commission has begun to cordon off the European banking industry, aiming to be as comprehensive as they can in order to avoid any potential future contamination by hard-to-value OTC instruments, forcing all to use recognized CCPs as evaluated by ESMA. This does not just concern those in the EU, but affects also those outside the EU that clear for European institutions or require approval for participation in the clearing of those trades executed by EU-based banks on non-EU products. This push towards extraterritorial effect of national regulation has been causing resentment on the part of many outside Europe who find themselves caught up in this.
To elaborate on some of the pressures that these CCPs are feeling, there is considerable resistance to the EU telling non-EU, third-country CCP s that they must submit themselves to EMIR or be cut off from the very big European marketplace. We are aware of a couple of clearing banks where a CCP outside the EU did not apply to ESMA by the September 2013 deadline for recognition under EMIR, and subsequently clearing for these banks has been suspended.
We have had positive discussions with global and some national political authorities. The question we all want answered is whether there is any way to successfully handle the OTC derivatives problem by using the regulated capital markets space? We have been back over the Pittsburgh Declaration, and particularly the paragraph stating that the G20 move begins with OTC (because the exchange-traded derivatives were already centrally cleared). There were no problems with regulated exchanges and their clearing in 2007- 2009; the exchanges traded through the turmoil, with the minor exception of circuit-breakers kicking in. That was a normal part of emergency planning. The only markets that stopped for longer periods were those where the government stepped in to close the exchange.
It is relatively easy to argue that CCPs should be clearing OTC contracts; you just have to be more circumspect when you are making an argument for how this should happen.
It will take time for the industry to digest all these regulatory changes. It is important that, over time, we do not simply continue to go through round after round of regulation and re-regulation.
It is to be hoped that CCPs that are uncomfortable with taking a particular instrument onto their books will be able to tell the counterparties making the request that they do not think that instrument is sufficiently standardised to merit taking on the risk. This does of course open up the question of “what is standardised?” OTC is bespoke, so how do we work this? We have only some sense of this.
Another area of concern relating to CCPs that has come into effect in the US – and will shortly do so in the EU – is that of trade repositories for both exchange-traded and OTC derivatives. We feel this is a major distraction, because all trades are supposed to be reported; this is not the clearing, it is the reporting. People are working out what they need to report at the end-investor level, to whom they need to report it, and in what form that information should be transmitted. Our firm’s only dedicated project for trade reporting is guiding asset managers to an appropriate institution. Beyond that, it is not clear if these repositories will last long enough in their nascent form to make any other project worthwhile. CCPs have, however, been around for a while; they have proven their worth, and are being tested rigorously these days by so many reforms.
Basel III has set the global “Qualifying” CCP capital requirements. We have done some work with the CCPs that announced that they meet this central requirement – but the problem is that they have been doing so in different ways, using various hypotheses, and with or without the capital market or banking supervisor confirming this status, as is supposed to happen.
The Principles for Financial Market Infrastructures (“PFMIs”) are the other global standard for financial market infrastructures, set by CPSS-IOSCO. They are not yes/no answers, they are qualitative in nature; IOSCO and CPSS have begun to write out a quantitative supplement to them with respect specifically to CCPs. They have just completed a public consultation in this regard.
The way central clearing functions and is regarded is undergoing profound change; mainly, as far as we can see, to accommodate OTC, in some manner, rather than to have these actors use regulated marketplace options and futures to the same economic effect for their business needs.
Ultimately, looking back to 2009 and since, our main regret is that the world’s authorities did not say to enterprises and banks using OTC instruments for position management, “You are welcome to conclude private financial contracts between yourselves. That’s what the market is about. If you choose not to do so within the perimeter of capital markets regulation, it is at your risk.” Bank capital set against those positions would have been the better route.
Thomas Murray is a private firm based in London, specialising in market infrastructure assessments and advisory.