Clearing Houses Now Accept Gold as Alternative Currency

Clearing arrangements for commodity contracts may be viewed as a process through which market participants seek to control risk. Such arrangements include both “clearing” in the sense of reconciling and resolving obligations between counterparties and “settlement” which finally extinguishes the obligations. 

One of the largest clearing houses of the world, LCH Clearnet, will begin accepting physical gold bullion (up to $200 million per member) as collateral amid growing demand to depart from the traditional reliance on cash and other securities to cover margin requirements. 

The move follows similar steps by many exchanges to increase the use of physical gold as an acceptable deposit and reinforcing the precious metal’s allure as an alternative currency. 

In October 2009, CME allowed physical gold to be used as collateral for margin requirements. ICE followed suit in November 2010. Last month, CME allowed the cap per member for gold collateral to be increased from $200 million to $500 million. 

It is important to point out a few facts that determine how clearing houses or central counterparties (CCPs) devise their margin strategies. First, it is critical to separate CCP margins into variation margin and initial margin. The variation margin is calculated on a trade-by-trade basis and offsets changes in value, whereas initial margin provides default protection and is usually calculated on a portfolio basis to allow for the offsetting of risk. There have been concerns that as the jostle for a piece of business continues, there may be temptations to relax financial standards and asset quality. That could include reducing the collateral quality instead of lowering margin requirements for members and a move which could weaken the mechanism in the event of a default. 

What is the fair price of commodity collateral? Given the complexity of pricing derivatives and the compounded challenges of calculating initial margins, there is no clear-cut solution to measure these risks. Physical commodity collateral may have a present market value of 100. However, on forced sale, the asset may be worth 60. In such situations, when a party approaches with an offer of 80 (with no other bidders in fray), should the offer be acceptable? The standard theory will say yes as 80 is more than 60. It’s a tough call for the creditors but not as tough as a forced sale. Book value may not be always the same as forced sale value. 

Clearing houses or CCP run a perfectly matched book. Every obligation to a member is matched by a precisely equal and offsetting claim against another clearing member. Therefore, clearing houses do not incur market risk. Collateral requirements do not in themselves provide adequate protection if collateral levels are not continuously monitored and related to risks incurred. 

Most clearing houses or CCP around the world conduct a routine margin settlement per day based on positions and market prices at the end of the trading day. The fund transfers associated with these margin adjustments are typically affected the following day. An essential condition for sound clearing and settlement procedures is that incentives to monitor and control risk should coincide with the capability to fulfill the monitoring/control function. The safeguard in the Indian context is that it is monitored on a real-time basis. 

Published in The Economic Times