Central counterparties (CCP) have long been a feature of the financial markets. As a result of the post-2008 regulatory reforms, they have assumed a larger role. Specifically, they have become central to the over-the-counter (OTC) derivatives markets. The trigger for this market evolution was the G20 leaders’ statement in 2009 that “All standardized OTC derivative contracts should be . . . cleared through central counterparties by end-2012 at the latest”. This led authorities to introduce rules requiring that eligible OTC derivatives transacted between qualifying counterparties must be cleared. These clearing mandates have been implemented in all major jurisdictions (for instance, the clearing mandate was implemented in the EU by EMIR (2012), and in the US, by Title VII of the 2010 Dodd-Frank Act).
Clearing mandates were, of necessity, introduced before it was possible to observe how the OTC derivatives market would change after the Global Financial Crisis. Indeed, they were a major cause of market evolution, as official sector reports evidence. Given the scale of the regulatory effort and the intent to transform the markets, it is not surprising that there were unanticipated consequences of regulation. Some of these potentially pose challenges to the clearing mandate as it was originally written, given the importance of a process known as porting. This is an operation whereby a client moves their trades and their margin from one clearing member to another. Porting is particularly useful in the event of clearing member distress: if a clearing member fails, and their clients can port within an acceptable window of time, then trade continuity is assured. If a client cannot port, the CCP must close out their cleared portfolio. Clearing members must have completed their due diligence on clients (including know your client and anti-money laundering checks) before they can accept them porting in. The period to do this (or porting window) may be as little as one or two days, so in practice porting usually requires that the client has a prior relationship with the accepting clearing member.
Historically, porting in exchange traded markets has been more likely than not, and even in the event that a client was not ported, positions were liquidated quickly, and typically at close to their market value, allowing the client to re-establish their positions in the market with little or no loss of value.
However, the OTC derivatives market is different. It features concentration in client clearing. Five client clearing service providers have accounted for over 60% of all initial margin for OTC derivatives since the CFTC began collecting statistics (See Commodities Futures Trading Commission, Customer Initial Margin Requirements, percentage at 5 largest parent firms for details). This concentration means that clients are likely to have some or all of their cleared trades with one of the big five. If one of them was unable or unwilling to continue to provide clearing services, a large fraction of the total initial margin in the system would be affected. In these circumstances, the likelihood that all or nearly all of the affected clients would be able to swiftly port is reduced: the remaining four could not support the load.
The potential for trade continuity despite counterparty distress is one of the big advantages of using CCPs for clients, so the fact that it might present challenges could reduce the attraction of OTC derivatives central clearing for them. The situation is made worse by the fact that it is not only clearing member failure without porting that could result in a client’s cleared trades being closed out: most client clearing service agreements allow the provider to withdraw after giving a short notice period, often of 90 days. It can take substantially longer than 90 days to negotiate a new client clearing service agreement, so this means that clients can potentially have their trades closed out if their provider makes the business decision to withdraw from client clearing.
Time to reassess clearing policy
If a client’s cleared trades do have to be closed out, the CCP will manage the process. Some clients have large and risky portfolios. Therefore, closing out client positions has the potential to make the default management process complex and risky for the CCP: it is not just the affected clients who could suffer from the challenges of porting.
These issues mean that the benefits of mandating client clearing could be significantly different from those anticipated when clearing mandates were being written. It is good time to reassess clearing policy as many of the post-crisis regulations are being reviewed, and fine tuning is in progress. In particular, in the EU, an important temporary exemption to mandatory clearing for pension fund clients is under discussion. This offers the opportunity to reflect upon the client clearing mandate as a whole before these discussions conclude ( See paragraph 30 of the EMIR Refit (2019) for the current pension fund exemption from the clearing mandate. This is in addition to a three-year exemption set out in Articles 85 and 89 of EMIR).
In a related paper, a detailed account of the distribution of client risk at a leading CCP is presented. It is found that client initial margin follows a power law. There are a lot of low-risk clients, who are unlikely to have multiple clearing members and who in aggregate will be difficult to port in a short window due to the operational complexity of establishing so many new relationships. The much smaller number of medium risk clients form a reasonable target for porting should their clearing member fail, and these parties are more likely to have multiple clearing members. The small number of high-risk clients are difficult to port due to their risk characteristics; a clearing member porting even a fraction of their portfolio in would significantly increase the risk and balance sheet usage of their client cleared portfolio, and it could cause challenges for CCP default management if it had to be closed out.
This suggests both that the clearing mandate for smaller clients should be revisited and that direct membership mechanisms should be developed to reduce the dependence of very large clients on credit intermediation by their clearing members and hence make it unnecessary to port them.
The views expressed in this article are those of the author alone and do not reflect those of the Bank of England or the London School of Economics