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«Comparing the pre-settlement risk implications of alternative clearing arrangements John P Jackson and Mark J Manning April 2007 Bank of England ...»

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Working Paper no. 321

Comparing the pre-settlement risk implications

of alternative clearing arrangements

John P Jackson and Mark J Manning

April 2007

Bank of England

Comparing the pre-settlement risk implications of alternative clearing

arrangements

John P Jackson*

and

Mark J Manning**

Working Paper no. 321

* Financial Resilience Division, Financial Stability, Bank of England, Threadneedle Street,

London, EC2R 8AH.

email: john.jackson@bankofengland.co.uk

** Financial Resilience Division, Financial Stability, Bank of England, Threadneedle Street, London, EC2R 8AH.

email: mark.manning@bankofengland.co.uk The views in this paper are those of the authors and do not necessarily reflect those of the Bank of England. Helpful comments and advice were received from a number of parties during the preparation of this work. In particular, the authors are very grateful to Grigoria Christodoulou, Rory Cunningham, Johan Devriese, Jennie France, Charles Kahn, Steve Millard, Jim Moser, Pat Parkinson, Victoria Saporta, Alan Sheppard, Matthew Willison, an anonymous referee, seminar participants at the Bank of England and conference participants at the ECB/Federal Reserve Bank of Chicago conference on Issues Related to Central Counterparty Clearing. This work also builds on a methodology established in earlier work on market structure undertaken jointly with Jing Yang. Finally, we are grateful for the assistance of Euronext.liffe in the provision of data on agents’ trading positions. This paper was finalised on 15 March 2007.

The Bank of England’s working paper series is externally refereed.

Information on the Bank’s working paper series can be found at www.bankofengland.co.uk/publications/workingpapers/index.html.

Publications Group, Bank of England, Threadneedle Street, London, EC2R 8AH; telephone +44 (0)20 7601 4030, fax +44 (0)20 7601 3298, email mapublications@bankofengland.co.uk.

©Bank of England 2007 ISSN 1749-9135 (on-line) Contents

Abstract

3 Summary 4 1 Introduction 6 2 The analytical framework 10 3 The risk implications of alternative clearing arrangements: comparative simulations 16 4 Exploring heterogeneity 24 5 Conclusions 30

–  –  –

Abstract In recent years, there has been a marked expansion in the range of products cleared through central counterparty clearing houses, accompanied by a trend towards consolidation in the clearing infrastructure. The financial stability implications of these developments are of considerable policy interest. In this paper, we use a simulation approach to analyse, in a systematic way, the potential pre-settlement cost and risk implications of these developments.

Our results point towards substantial risk-reduction benefits from multilateral clearing arrangements, arising from multilateral netting and mutualisation. The paper also examines individual incentives to join multilateral clearing arrangements. We suggest that arrangements with restricted direct participation and tiered membership may be a natural response to the uneven distribution of total pre-settlement costs when agents are of heterogeneous credit quality and it is costly to individually tailor margin.

Key words: Clearing, netting, financial stability, central counterparty.

Summary This paper analyses the risk implications of different arrangements for clearing securities and derivatives markets. In this context clearing refers to the set of procedures in place for calculating the net exposures arising from a set of financial market trades and managing the credit risks arising from these trades in the period prior to their final settlement.

This is a topic of considerable policy interest. For instance, there is a live debate underway in policy and industry circles regarding the potential risk-reduction benefits of centralised clearing arrangements for a broader range of over-the-counter (OTC) derivative products. Another topical issue, particularly in an EU context, is whether significant efficiency gains could be realised by merging several domestic central counterparty clearing houses (CCPs) into a single cross-market entity.

This paper provides an analytical framework for evaluating quantitatively the relative cost and risk implications of a range of clearing methods, covering different constellations of products, trader profiles and market structures. This is done by simulating agents’ pre-settlement costs and risks under a range of bilateral and multilateral clearing arrangements. Two metrics for pre-settlement risk are analysed: the magnitude of replacement cost losses; and the distribution of such losses.

Replacement cost risk arises during the period between trade and settlement and reflects the cost to a trader of replacing a trade on which a counterparty has defaulted. Agents can mitigate replacement cost risk by collecting collateral (known as margin) from their trading counterparties during the pre-settlement period; hence a trader (or CCP) will only incur a replacement cost loss if there is a coincidence of events: an adverse change in the underlying contract price in excess of the per-unit value of margin collected from a counterparty, combined with a default by that counterparty. However, the requirement to post margin may impose a significant cost on agents, which in our analysis is quantified and compared across arrangements.





We analyse three distinct clearing and settlement arrangements for futures markets: (i) bilateral

clearing; (ii) ring clearing; and (iii) CCP clearing. These may be defined as follows:

– In bilateral clearing, trading agents post margin on the basis of their net bilateral obligations. This remains the typical clearing arrangement for off-exchange and OTC trading, particularly in less standardised products.

– The second approach, ring clearing, is a way of achieving multilateral netting of exposures without requiring a CCP to become the legal counterparty to all trades. Rather, the original bilateral exposures are extinguished and multilateral net exposures reallocated, according to some pre-determined algorithm, among members of the ring. A ringing arrangement reduces collateral costs, but agents retain some counterparty credit exposure to one another. There are, to our knowledge, no formal ringing arrangements in operation at present, although services for multilateral contract terminations can achieve something similar.

– The final approach analysed, CCP clearing, takes ringing a step further by introducing novation of all trades to a central counterparty; novation refers to the process by which the CCP interposes itself as legal counterparty to both the buy and sell-side of all the trades it clears. In the absence of counterparty default, the CCP has a balanced book and does not, therefore, face any market risk. At the same time, agents are no longer exposed to their original counterparties, instead having a single net exposure in each asset with the CCP.

By providing centralised risk management and facilitating anonymous trade, CCP clearing is particularly beneficial in the case of exchange-traded assets, particularly those with long settlement periods, such as derivatives.

We identify two basic sources of replacement cost risk differentials across the arrangements under consideration: netting ratios and margin pooling. We show that replacement cost losses and the opportunity costs from posting collateral under CCP or ring clearing decline as the number of bilateral trading counterparties increases.

In the context of multi-asset clearing, we find that ‘margin pooling’ is an important effect. This is the benefit derived when an agent’s margin payments in respect of multiple positions can be pooled, such that, in the event that the agent defaults, the margin-taker can draw upon any residual margin in the pool (either from profitable, or only modestly loss-making, positions) to cover a margin shortfall arising on any individual position(s). Our simulations show how this effect can vary according to the degree of price and position correlation across assets. Our results imply that a merger of CCPs has the potential to significantly reduce the risks and costs faced by traders.

Finally we allow trader credit quality to vary in order to analyse agents’ individual incentives to adopt particular clearing arrangements. We show that restricted access or tiered clearing arrangements, where risky traders are not able to become a member of the CCP but must clear their trades through a more creditworthy agent who is a member, may then emerge naturally.

1. Introduction

This paper analyses the risk implications of different arrangements for clearing financial market trades involving securities and derivatives.(1) In recent years there have been two distinct trends in the clearing arena. First, there has been a marked expansion in the range of products cleared through central counterparty clearing houses (CCPs). For example, since 1999 the London Clearing House (LCH) has introduced CCP services for swaps, repos and, most recently, securities traded on the London Stock Exchange. Second, there has been a trend towards consolidation in the clearing infrastructure, notably the London Clearing House and Clearnet merging in 2003, and the Chicago Mercantile Exchange (CME) Clearing House taking over the clearing of trades for the Chicago Board of Trade (CBOT) in the same year.

These developments are of considerable policy interest. For instance, there is a live and active debate underway in both policy and financial market circles regarding the potential risk-reduction benefits of centralised clearing arrangements for OTC derivative products (Bank for International Settlements (BIS) (1998); Geithner (2004); Counterparty Risk Management Policy Group II (2005); BIS (2007)). With the exception of certain vanilla interest rate products, these are currently typically cleared under purely bilateral arrangements. There is also the important question of whether a CCP arrangement is feasible, or desirable, for a wider range of OTC products, and whether other centralised approaches might be appropriate.

There is a sizable literature describing the key features of alternative clearing arrangements, their historical evolution and their current roles (Moser (1998); Hills et al (1999); Kroszner (1999);

and Ripatti (2004)). These papers also identify the risks that can arise in clearing arrangements, and describe the infrastructural innovations that have emerged to deal with them. BIS (2004), in the context of CCPs, also gives a comprehensive overview of risks and risk-management issues.

However, to our knowledge, there is no established analytical framework for evaluating, quantitatively, the relative cost and risk implications of a range of clearing methods, covering different constellations of products, trader profiles and market structures. This paper seeks to provide such a framework and offer some insight in this regard, while also examining agents’ individual incentives to participate in particular arrangements.

And while the potential efficiency gains from consolidating the activity of several market-specific CCPs into a single cross-market entity have been the subject of much recent debate (for example, European Securities Forum (2000)), with competition issues also addressed in Tapking and Yang (2004), the implications for financial stability have not been addressed in any systematic study to date.

The approach we take here is to construct an analytical framework for the simulation and quantification of agents’ pre-settlement costs and risks under alternative bilateral and multilateral clearing arrangements. Simulation facilitates the examination of a richer array of scenarios than would be possible with a purely analytical approach. Importantly, this approach yields some quantitative comparisons and allows us to both introduce several sources of ex-post heterogeneity (1) BIS (2003) defines ‘clearance’ as the ‘process of calculating the mutual obligations of market participants, usually on a net basis, for the exchange of securities and money’. It is recognised that the term is sometimes also used with reference to the process of transferring securities on settlement date, but our focus here is on arrangements for the management of risks arising during the pre-settlement period.

and examine some complex interactions, such as that between ex-post heterogeneity in trading positions and the concentration of replacement cost losses.

We restrict attention to two metrics for pre-settlement risk: the magnitude of replacement cost losses; and the distribution of such losses. To capture the relevant factor in the decisions of risk-neutral agents, we also compare total pre-settlement costs borne by agents, which include both replacement cost losses and the opportunity cost of posting margin/collateral.(2) Replacement cost risk arises during the period between trade and settlement and reflects the cost to a trader of replacing a trade on which a counterparty has defaulted. Consider a bilateral trade between agents i and j: should agent i default prior to settlement, agent j does not incur a loss on the principal, because the asset has not yet been delivered and no money has changed hands; but, should the market price of the asset have moved adversely since the deal was struck (or since the trade was last marked-to-market and variation margin collected), agent j may face a loss from replacing the trade.(3) Agents can mitigate replacement cost risk by collecting margin from their trading counterparties during the pre-settlement period; hence a trader (or CCP) will only incur a replacement cost loss if there is a coincidence of events: an adverse change in the underlying contract price in excess of the per-unit value of margin collected from a counterparty, combined with a default by that counterparty. However, the requirement to post collateral may impose a significant cost on agents, which in our analysis is quantified and compared across arrangements.

In this paper, we do not explicitly model spillover effects from an agent’s default; ie the extent to which losses incurred by an agent due to the default of a counterparty lead to knock-on default or liquidity dislocation. This would require potentially arbitrary assumptions, related, for example, to the size of individual banks’/traders’ exposures relative to their total capital or liquid resources.



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