Why we need central counterparty clearing house

In India, futures contracts in commodities are required to be settled through clearing and settlement department of the commodity exchanges and there is no separate central counterparty clearing house. In the light of the recent “exchange collapse”, there is an impending need to guarantee execution of settlements on behalf of the respective counterparties in the exchange where a chain reaction of defaults (breaches of contract) can be prevented.

Execution venue

It is important to understand that an exchange-trading requirement has nothing to do with clearing and they are completely separate issues. The exchange is just the trade execution venue. The only thing that an exchange-trading requirement adds to the clearing requirement is “pre-trade price transparency.”

In India, people tend to think of exchanges as synonymous with clearinghouses as the transactions are cleared through exchanges’ clearing and settlement department, unlike in the US or Europe where mitigation of counterparty risk is achieved by contract “Novation”. This is a process through which a Central Counterparty or the clearing house acts as a buyer to all sellers, and vice versa.

Similar to banks’ role

The clearing house’s role as a credit risk intermediary does not require any particular relationship with any commodity.

A credit risk intermediary is similar to a banking intermediary since banks perform the role of a common counterparty to savers and borrowers, and banks do not normally benefit from narrow specialisation.

Thus, clearing house reduces complexity by reducing the number of counterparty relations and increases efficiency by establishing the margin and collateral requirements for its members, centralising the necessary calculations, automatically collecting or paying the respective amounts and preventing disputes (e.g. over the amount and quality of collateral).

A clearing house addresses operational risks by means of adequate auditing procedures (i.e. compliance with technical infrastructure requirements) that ensure the necessary operational know-how of their current and potential members.

The clearing entities’ discipline and independent roles from the exchange is indispensable for the purpose of improving commodity market credibility and develop an environment enabling trading activities by market participants with a stronger sense of security.

It is important to appropriately secure financial resources to cover breaches and reinforce the financial base of the clearinghouse (as an entity separate from the exchange) from the perspective of developing an environment in which market participants are able to participate in trading with a sense of security and reinforcing creditworthiness.

Published in The Business Line on 13 Feb, 2014

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

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