Why risk management is critical for an efficient clearing and settlement system?

Read Article

Background

The regulatory framework for post-trade infrastructure and services across global markets has become more stringent especially after the global credit crisis in the year 2008. Implementation of state-of-the-art risk management practices across Over-the-Counter (OTC) and Exchange markets to mitigate counterparty default risk has become a key determinant for global liquidity flows. Global investors prefer to invest in emerging market jurisdictions that have implemented a robust regulatory framework, set up an effective and transparent arbitration and dispute resolution mechanism, established insolvency and bankruptcy laws and incorporated best industry practices for credit and liquidity risk management.

Robust regulatory framework

In the aftermath of the global credit crisis, the Dodd Frank Act (US, 2010) enabled the Commodity Futures Trading Commission (CFTC) to oversee the USD 400 trillion (USD 595 trillion as of Jun 2018 based on BIS estimates) swaps market for mandatory clearing and settlement through the Central Counterparty (CCP) mechanism. The European Market Infrastructure Regulation (EMIR, 2012) requires OTC derivatives to be mandatorily reported to Trade Repositories as well as cleared and settled through CCPs going forward.

Several emerging market countries have increasingly aligned their risk management practices for clearing and settlement of exchange-traded derivatives based on the Principles of Financial Markets Infrastructure (PFMI) guidelines (2012) published by the Committee on Payment and Settlement Systems (CPSS) of the Bank for International Settlements (BIS) and the Technical Committee of the International Organisation of Securities Commission (IOSCO).

What is novation?

The concept of CCP has evolved gradually from the mid-nineteenth to early twentieth century onwards with the establishment of clearing corporations that facilitate novation. In this mechanism, the CCP (i.e. the clearing corporation) itself becomes a counterparty to all transactions on the exchange, thereby, effectively and efficiently mitigating credit risk for all counterparties. Clearing and settlement has evolved from direct settlement and direct offset towards a system of multilateral netting of obligations across counterparties through the CCP. Novation results in the CCP having direct risk exposure to each counterparty. The CCP guarantees fulfilment of settlement obligations in the event of a default by its Clearing Member(s) (CM). This emphasises the criticality of robust risk management practices that are required to be implemented by CCPs.

How do CCPs manage settlement risk?

CCPs continuously monitor, identify, measure and manage various types of risks using sophisticated online automated surveillance mechanism based on best industry practices. Trade data from exchanges seamlessly flow into the clearing corporation’s systems for real-time risk monitoring, surveillance and management of members’ margin requirements and mark-to-market (MTM) profit / loss. Daily settlement with pay-in / pay-out from / to Clearing Members is performed by the clearing corporations through empanelled Clearing Banks.

CCPs establish eligibility criteria for registering CMs such as minimum net-worth, deposits (cash and cash equivalents), adequate infrastructure and manpower, compliance to global KYC requirements, etc. CMs are required to maintain a minimum deposit with the clearing corporation for which no margin exposure is provided. Members may provide additional security deposits to the clearing corporation in the form of cash and cash equivalents – i.e. term deposit, bank guarantee and/or AAA-rated international sovereign securities. The clearing corporation then provides margin / exposure limits to members based on their available deposits.

The inherent settlement risk for a CCP is a function of the estimated market risk for the duration between trade execution and funds settlement on T+1 day (next Business Day) basis. CCPs block the applicable margin amount from the available members’ deposits for each trade. Margin requirement is usually calculated using sophisticated risk management techniques such as the SPAN methodology, which is based on a worst-case risk scenario for a portfolio. Each risk scenario represents the gain / loss based on a combination of change in price, volatility and contract maturity. Margins are netted across member’s proprietary positions and grossed with margins across client positions. Margin is critical for mitigating CCP’s default risk. CCPs also maintain a Default Fund, which can be readily utilised in the event that a CM fails to fulfil its settlement obligations.

Globally CCPs also clear and settle securities (e.g. debt, DR, etc.) through International Central Securities Depository (ICSD) such as Clearstream and Euroclear. Settlement instructions are securely communicated with ICSDs using SWIFT. This also enables faster execution of post-trade processes and mitigates default risk.

Key benefits for market participants

CCPs have adequate capital buffers in the form of security deposits from members, default fund, reserves and equity for risk mitigation. CCPs also have a risk-sharing arrangement with the CMs in the event of a default. Novation by CCP facilitates multi-lateral netting of members’ obligations thereby mitigating settlement risk. Clearing and settlement of OTC market transactions through CCPs results in increased transparency, standardisation of contracts, improved operational efficiency and balance sheet optimisation for market participants.

The BIS statistical release as of October 2018 estimates that during the first six months of year 2018, approx. 76% of the interest rate derivatives and 54% of credit default swaps traded in the OTC markets were cleared and settled through CCPs, thereby effectively and efficiently mitigating counterparty default risk. This is indicative of the potential for further growth and development of CCPs across the world, which is witnessing a gradual transformation of post-trade processes to ensure a more secure and risk-free environment for the benefit of market participants.

If you have an interesting article / experience / case study to share, please get in touch with us at [email protected]

Advertisement