How OTC to CCP clearing works: Difference between revisions

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The above diagram looks at the clearing process, from execution to settlement. (There are a number of different ways in which execution and clearing can be effected.) The {{ccp|end user}} (acting as a trader on its own account, or acting through a {{ccp|broker}}) enters into a trade with a market participant. That trade is then submitted by each party for clearing through its respective {{ccp|clearing member}}. When the trade is accepted for clearing, a give-up or novation of the original contract takes place through which the {{ccp|clearinghouse}} is substituted as the counterparty on both sides of the trade.  

{{ccp|end user}}s will need to examine whether a {{ccp|clearinghouse}} operates on an agency basis or a principal-to-principal basis as part of their risk analysis before choosing clearing platforms. The basic proposition is that under an agency clearing model the {{ccp|end user}} takes greater exposure to the {{ccp|clearinghouse}}, and in a principal-to-principal clearing model there is greater exposure to the {{ccp|clearing member}}. However, matters are likely to be complicated by both the {{ccp|clearinghouse}} rules and the underlying documentation between the {{ccp|clearing member}} and the {{ccp|end user}}.  

The structure of documentation which an {{ccp|end user}} will enter into will depend on a variety of factors including to what extent the clearing platform adopts a futures clearing approach, and indeed whether an OTC contract is ‘exchanged’ for a futures trade before being submitted for clearing, or whether the contract remains an OTC contract during the clearing process.  

Margining/collateral maintenance procedures for OTC derivatives will be different in the clearing environment. A unilateral credit relationship will apply whereby {{ccp|clearinghouse}}s will require that {{ccp|collateral}} is posted with them to cover their exposure, but not necessarily with a parallel requirement to deliver collateral the other way.  

{{ccp|end user}}s will need to examine whether they are required to {{ccp|margin}} their trades with their {{ccp|clearing member}} on a ‘gross’ or ‘net’ basis, and whether their {{ccp|clearing member}} is required to post {{ccp|margin}} to the {{ccp|clearinghouse}} on a gross or net basis. In general, gross margining should improve the portability of positions between {{ccp|clearing member}}s, although posting margin on a net basis is a more efficient use of capital because it allows offsetting risks to decrease the margin required.  

A {{ccp|clearinghouse}} may hold {{ccp|collateral}} in different pools for different groups of customers. Collateral deposited by {{ccp|clearing member}}s for their own proprietary positions should in any event be held in a separate ‘house’ account. Customers may be offered the ability to margin on a gross or net basis, or a combination of the two, with collateral being held in separate pools, one for ‘gross margining customers’ and one for ‘net margining customers’.  

To take this analysis a step further, certain buy side participants have been pushing for a further level of segregation which would involve each buy side participant’s collateral being ring-fenced from collateral provided by other participants, to avoid exposure to a default by those other participants. In this way, customers may require segregated accounts on a ‘per fund’ basis or perhaps a ‘per manager’ basis – in the latter case a fund would accept default risk against other funds, but only those within its own ‘stable’.  

However, a rise in segregated accounts could lead to increased costs – if {{ccp|clearinghouse}}s are not able to tap into omnibus accounts in a default scenario, the extra ‘shield’ provided by the omnibus accounts is taken away, with the result that the {{ccp|clearinghouse}}’s default fund (i.e. reserve capital) needs to increase. Such increased costs would be borne predominantly by the {{ccp|clearing member}}s, and may be passed on to {{ccp|end user}}s.  

The existing {{ccp|clearinghouse}}s such as CME, ICE, LCH and IDCH are working on developing their platforms for OTC derivatives in response to the new regulatory environment. The existing technological resources and expertise of these operators give them a head start, and the extent to which new entrants appear remains to be seen. The major clearing operators are looking to expand their product offering, from the present variety of energy derivatives, interest rate swaps and credit default swaps, to “multi-asset OTC clearing”. In theory, all OTC derivatives are capable of being cleared. In practice, only the most standardised contracts will be cleared until the industry has developed sufficiently to overcome the relevant operational and technological hurdles.  

{{ccp|end user}}s such as hedge funds are likely to choose their {{ccp|clearing member}} relationships based on their existing futures clearing and prime brokerage relationships.  

For {{ccp|end user}}s, some key ‘legal’ consequences of moving their OTC derivatives trades to a central {{ccp|clearinghouse}} are likely to be as follows:  

   

{{ccp|End user}}s will need to consider whether they should maintain multiple {{ccp|clearinghouse}} relationships (to ‘diversify’ their risk in terms of central counterparties) and whether they should maintain multiple {{ccp|clearing member}} relationships (for credit risk as well as product reasons)  

{{ccp|end user}}s will need to conduct a thorough independent legal/contractual risk analysis through their legal counsel in order to be able to make their own overall risk analysis.