Clearing broker

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Hedge Funds & Prime Brokerage Anatomy™

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There is no industry standard prime brokerage agreement, so this is not so much an anatomy as a collection of resources about an amorphous subject.

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Template:M tldr prime brokerage futures clearing

Introduction

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One who clears. An arranger, designer and seller of clearings. The kind of broker who clears transactions that have been executed by itself or a different executing broker. A concept of particular relevance to ETD contracts.

Quick overview of futures clearing

Executing broker versus clearing broker

The executing broker is the dude you give your order to, who gets you the best price available on the exchange. You pay this person a trade commission, but then you move on, the job being done.

The clearing broker is the person with whom you face for the duration of the future - as long as you hold it. This person is more like — and often is — a prime broker they are effectively financing you against the value of your future: therefore you pay them margin, they get a financing fee based on the size and duration of your position.

You might be a clearing and executing broker, too, which is both. The larger institutions tend to do this.

Contract set up

When a clearing broker accepts a client order, it creates two contracts: a “Firm/CCP Contract” — a principal contract, on exchange, between broker and exchange governed by the exchanges rules (which apply to all exchange participants) and a “Client Contract” — an identical off-exchange contract between Broker and client governed by the Broker’s Terms of Business (which are based on an FIA standard form). In the UK and Europe these two contracts are both principal-to-principal contracts, and the clearing broker is a “riskless principal”. In America, the broker acts as an agent. In practice, because of the the way the margin works, and the over-riding client protection, both models in practice work the same way.

Margin

Because there are two contracts, there are two separate margin arrangements. But they’re kind of linked, in a spooky, quantum-entangled kind of way.

Broker margin

A clearing broker calculates initial margin for each client based on the client’s own net position under its client contracts. Client margin can comprise margin that the Exchange imposes under its rules on the corresponding Firm/CCP Contract, and optional additional margin that Broker does, or may, impose on individual customers to reflect the specific risks they present.

Unless the clearing broker is itself a bank, it must hold the client margin it is posted in a commingled “client money” pool with designated banks subject to FCA client money rules. This is an omnibus account held to the order of the broker’s clients and should be isolated from the Broker’s insolvency. If the number of CASS compliance minions running around operations busting everyone’s chops is anything to go by, it damn well better be.

A clearing broker has some access to the client money pool: it can use it to meet Exchange margin calls (see below) and to close out positions against individual should they default. Any “excess client margin” (i.e., margin over and above what is posted to Exchanges, and any cash the client just leaves in for the hell of it) must be held in the client money pool.

Exchange margin

Under Exchange Rules, Broker must pay margin up to the Exchange on its net client position under its Firm CCP Contracts. There is a definite capital efficiency here: if a Broker has offsetting long and short positions on the same Futures Contract, most exchanges only require it to margin its net position, not the gross long and short position. But assuming those gross longs and shorts will be coming from different clients (because, common sense, right?) the broker will effectively receive margin gross. It is all held in client money accounts, so safe from most harm, but it is an interesting thing to bear in mind, still.

Therefore there is no necessary 1:1 relationship between a client’s margin paid to the clearer, and the margin the clearer pays in connection with it to the exchange. This is just one of the fabulous operational complexities that keep so many people employed in the futures industry, and which won’t be solved by blockchain.

Contracts

The Firm CCP Contract is governed by Exchange rules. The Client Contract whcih mirrors the economics of the Firm CCP contract, is governed by Broker’s terms of business.

The Exchange rules are generic to the futures contracts themselves (dealing with settlement, terms etc), and also regulating the behaviour of clearing and executing brokers, in particular providing for what should happen if a clearing broker should blow up (default fund contributions from other brokers, porting of trades, assumption by solvent brokers of open positions and so on). They are published by the Exchange.

The clearing broker’s terms of business are on a standard form published by the Futures Industry Association. This deals with the clearing broker’s rights to call margin from the client, its rights to close out, its rights of use over margin posted by the client, and its pricing and charges.

See also

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References

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