Mutualised clearinghouse risk evolves beyond the age of all-for-one

John McPartland has been a central banker, settlement banker, senior executive of two FCMs and deputy manager of a major CCP during a 45-year career in the industry.

A complete understanding of central counterparties (CCPs) should include the evolution of these financial market infrastructures. Fortunately, the late Jim Moser wrote extensively on how today’s CCPs evolved from those of the 19^th century. This article draws heavily on Dr. Moser’s research (See also this 2019 paper).

Moser and Peter Norman both discuss the development of central clearing as we know it today. Some of the earliest precursors of CCPs can be traced as far back as the 19^th century and were described as ring systems. Under these systems, the exchange would determine and conspicuously post end-of-day closing prices for each commodity. Exchange members would then exchange bank checks bilaterally with each member with whom they had traded. These bank checks reflected the difference between the price at which their contracts were executed and the posted settlement price for the day. Although participation was voluntary, it was also quite substantial. Members placed a great importance on participating in this arrangement. Notably, each member incurred financial exposure to the members with whom they had traded.

As markets matured, this resulted in thousands of bank checks being exchanged. Over time, consistent with a desire to be cost-efficient, many exchanges created clearinghouses. The early clearinghouses were not much more than centralised post offices that calculated the net obligations of members by offsetting bank checks that their members would otherwise receive against checks that they would otherwise be obligated to pay. Neither the ring system nor these early clearinghouses eliminated counterparty risk. While the ring system and early clearinghouses added some efficiency to the settlement process and lowered costs, both had one fatal drawback: The framework was only as strong as its weakest participating member. If any member could not settle its net financial obligation, the advantages of multilateral netting broke down completely, and with disastrous results.

As centralised clearinghouses matured, members realised that they needed some financial protection against the non-performance of another member to settle. Members voluntarily deposited collateral with the clearinghouse to provide some assurance to fellow members trading with them that they could honour their trading obligations. Interestingly enough, the early clearinghouses were simply custodians of this collateral. The clearinghouse itself made no guarantees to the members other than safely holding their collateral. Posting collateral was an added expense to clearinghouse members, yet as more members agreed to do so, the certainty that trades between members would settle properly was increased and, therefore, the value of clearinghouse membership was enhanced.

Throughout much of the 19^th century, organised markets across the globe migrated through a continuum of credit risk mitigation techniques. Eventually, European markets – and North American markets soon thereafter _– introduced “complete clearing” frameworks in the late 1800s. Coined by Moser in his pioneering research at the Chicago Fed, the term “complete clearing” is well established in the literature as a reference to clearing including counterparty substitution. Guillaume Vuillemey finds the first known complete clearinghouse for commodities was the Caisse de Liquidation des Affaires en Marchandises, which was formed in 1882 in Le Havre, France.

Greater certainty, less autonomy

The practice eventually took hold in North America after the first known CCP in the United States, the Minneapolis Chamber of Commerce Clearing Association, was formed in 1891 to support the markets at the Minneapolis Chamber of Commerce. Under a complete clearing framework, a clearinghouse was capitalised by the members, with the capital of the clearinghouse often serving as a guarantee fund available to cover the financial obligations of the clearinghouse. Uniform initial margin levels were determined and collected by the clearinghouse. The clearinghouse also collected the difference in payments made and received by each member – the precursor to today’s daily payments of variation margin (VM) that account for changes in contracts’ value over time.

Once contract terms were standardised, members no longer cared about the member they had traded with, as performance on their trades was guaranteed at least up to the capital amount of the clearinghouse. This development meant that there was now loss mutualisation among the members as their collective contribution to the capital of the clearinghouse was exposed to the non-performance of any member. In this way, clearinghouse members were sacrificing some autonomy and incurring higher costs, but gaining far greater certainty of contract performance.

This model of clearing became widely adopted (while being incrementally improved) in the 20^th century. The members owned and operated the exchange, and as such, also owned the clearinghouse, either directly or indirectly through the exchange. Membership criteria were quite important as the members knew all too well that the failure of any member to perform would reflect adversely upon the exchange, themselves, and their clearinghouse as a whole. This “all for one and one for all” approach prevailed throughout most of the 20^th century.

Late in the 20^th century and early in the 21^st century, exchanges and their clearinghouses incorporated as publicly traded corporations (with a profit motive). This represented a significant departure from the member-owned and member-controlled model. Nonetheless, these complete clearinghouses continued to be supported by a mutualised guarantee fund contributed by their members. Today, market participants looking to clear their trades must be either a clearing member or a customer of one that can clear on their behalf. Dr. Moser’s comprehensive paper on this fascinating subject is well worth the read. One should not think that CCPs will not continue to evolve going forward.