Now is the time for a clearing house vertical

It is well-known that futures exchanges utilise a wellcapitalised central clearing house. The clearing house mitigates the risk of settlement failures by isolating the effects of failure of a market participant. This prevents credit events at a firm from cascading onto others firms. A famous illustration was when Nick Leeson, a 28-year-old trader at Barings, lost $1.4 billion on trading futures. The losses drove Barings (a 228-year-old institution and ‘Banker to the Queen’) into bankruptcy but that did not threaten the market or any counterparty. 

The clearing function of commodity exchanges in India is executed by inhouse clearing & settlement departments. However, a clearing requirement and an exchange-trading requirement are NOT the same thing. A clearing requirement necessitates that all eligible derivatives be cleared on a central clearing house whereas an exchange is a platform for trade execution. The only thing that an exchange-trading requirement adds to the clearing requirement is “pre-trade price transparency.” The need for a clearing house ‘vertical silo’ is intensifying as an increasingly important part of market reforms in the wake of the financial crisis. 

A clearing house acts as a buyer to every seller, and a seller to every buyer in transactions, stepping in to complete a trade if one party defaults. If an additional margin is required on any account, then the clearing member of that account must post the additional margin before a specific time in the next business day.

There are numerous examples of exchanges having their own independent clearing house (as it has turned into a lucrative business). A few years back, ICE severed its link with LCH to start its own clearing house. The possibility of replicating the Japanese model (different from the LCH model) is immense. The Japan Commodity Clearing House (JCCH), an independent centralised clearing house operation, began providing services for transactions of all commodity exchanges in Japan in 2005. JCCH is organised as a company owned by all Japanese commodity exchanges and the Japan Commodity Futures Industry Association, an association of the futures commissions merchants. 

One approach could be that exchanges may need to contribute capital to the clearing house or perhaps offer stocks in the clearing house to other investors. Of course, this shall require related changes in the clearing house structures including the issues “for profit”. A very large capital requirement for technology and the ability to continually advance technology and systems to stay in competition with international standards is affected by this decision. 

In an environment where Chinese walls of ownership between banks, broking companies, trading companies and commodity exchanges are rapidly vanishing, the real action may be starting to take place below the waterline in the mundane world of clearing. The regulator has already restricted brokers to trade on their exchanges. The regulator for the sake of good governance can ask ownerbankers to stop issuing bank guarantees to the members of their ‘own’ exchanges. Moreover, by having a clearing house, the ’real’ counterparties will not get intertwined in any opaque manner in the clearing function. Since the beginning, new-generation futures exchanges in India have not encountered any clearing and settlement breakdown but does that mean that going ahead we can ignore international best practices of having clearing houses. 

Published in The Economic Times 30 Aug, 2010