The trading on organised exchanges of derivative financial instruments, that is, futures and options on interest rates, exchange rates and equities and equity indices, has grown enormously over the past decade or so. These markets are now a critical component of the financial infrastructure of the G-10 countries and a growing number of other developed and developing countries. In particular, when they measure the market risks associated with their activities, many financial market participants, including the major banks and securities firms that serve as market-makers for securities and over-the-counter (OTC) derivatives, assume that markets for exchange-traded derivatives will provide sufficient liquidity to allow them to offset their market risk exposures quite promptly, even during episodes of market volatility when other financial markets may be relatively illiquid. Furthermore, although on a daytoday basis the amounts of payments and securities deliveries associated with exchangetraded derivatives are typically relatively insignificant, during periods of market volatility these amounts can increase by an order of magnitude, and financial market participants may depend critically on the timely completion of such payments and deliveries in managing their liquidity risks. Consequently, when markets are already under stress, the loss of an exchange's market liquidity or a delay in the completion of exchange-related payments or deliveries could well lead to systemic disturbances - the liquidity of other financial markets could be seriously impaired, and payment systems and other settlement systems could be disrupted.
Both the liquidity of exchange-traded derivatives markets and the timely completion of payments and deliveries associated with these markets are critically dependent on the financial integrity of an exchange's clearing house, in which are concentrated the credit and liquidity risks of exchange trading and the responsibility for managing those risks. To be sure, a default by a member of the clearing house that intermediates between the clearing house and many other trade counterparties could, by itself, cause losses to its clients and perhaps shake confidence in the exchange. But if the clearing house were able to cover any losses it might suffer from the default and continue to meet its obligations on schedule, the likelihood of systemic problems would be greatly diminished. Thus, this report focuses primarily on risks to an exchange's clearing house.
More specifically, the primary objective of the Study Group's work has been to develop a clearer understanding of the sources and types of risk to clearing houses for exchange-traded derivatives and of the techniques that such clearing houses utilise to manage those risks. In particular, the Study Group has sought to identify weaknesses in clearing house risk management practices that could, in principle, be the source of systemic disturbances and also to identify steps that clearing houses might take to address any such weaknesses. Special attention has been paid to weaknesses in clearing houses' money settlement arrangements and to opportunities for strengthening those arrangements.
An exchange's clearing house may be a department of the exchange or a separate legal entity. In several cases a single clearing house provides clearing services to more than one exchange. In all but a very few cases the clearing house acts as the central counterparty to all trades on the exchange. The clearing house's counterparties are its clearing members, which generally are a subset of the exchange's members. Other trade counterparties, both non-clearing exchange members and non-members of the exchange, must become clients of one of the clearing members, either directly or through another intermediary. The clearing house typically has a principal-to-principal relationship with its clearing members. Thus, it looks to the clearing members for performance on trades for their own account and on trades for the account of their clients. In most cases a clearing member has a principal-to-principal relationship with its clients, but in some cases it is characterised as an agency relationship.
In addition to the clearing house and its clearing members, another key element of the settlement infrastructure for exchange-traded derivatives is the bank or network of banks through which money settlements are effected. The central bank acts as settlement bank in about half of the G10 countries. In the other countries networks of private settlement banks are utilised. The use of different models in different countries appears largely to reflect a combination of differences in financial industry structure and in central bank policies regarding access to accounts, hours of operation and provision of liquidity.
As central counterparty to its clearing members, the clearing house is exposed to the risk that one or more clearing members will default on their contractual obligations. This would generally expose the clearing house to replacement cost risks and also to liquidity risks. In addition, principal risks may exist if contracts provide for delivery (rather than exclusively for cash settlement) and if a delivery-versus-payment mechanism is not utilised to effect deliveries. In those cases in which clearing houses use private banks rather than central banks to effect money settlements, another source of credit and liquidity risks is the possibility of failure of a settlement bank. Clearing houses face other risks relating to the financial resources they typically maintain to help cover losses and ensure timely settlements; the investment of such resources usually entails some credit risks, liquidity risks, market risks or custody risks. And, like any other payment and settlement system, exchange clearing houses face various operational risks. Finally, clearing houses face legal risks. For example, bankruptcy laws or other laws may impede the operation of safeguards that the clearing house relies upon to limit its credit and liquidity exposures, and ambiguities in money settlement arrangements may lead to disputes regarding the obligations of the various participants in the event of a default.
The Study Group's review of the risk management procedures of exchange clearing houses in the G-10 countries has revealed that a common set of safeguards are typically utilised to limit the likelihood of defaults by clearing members and to ensure that if defaults do occur, the clearing house has adequate resources to cover any losses and to meet its own payment obligations without delay. These include: (1) financial and operational requirements for membership in the clearing house; (2) margin requirements that collateralise potential future credit exposures and either collateralise current credit exposures or limit the build-up of such exposures by periodically settling gains and losses; (3) procedures that authorise prompt resolution of a clearing member's default through close-out of its proprietary positions and transfer (to a non-defaulting clearing member) or close-out of its clients' positions; and (4) the maintenance of supplemental clearing house resources (capital, asset pools, credit lines, guarantees, or the authority to make assessments on non-defaulting members) to cover losses that may exceed the value of the defaulting member's margin collateral and to provide liquidity during the time it takes to realise the value of that margin collateral.
Clearing houses that utilise private settlement banks typically limit risks of settlement bank failures by selecting only the most creditworthy commercial banks. In addition, some clearing houses have structured their settlement agreements with the banks to minimise the clearing house's potential losses and liquidity pressures in the event that a failure should occur. Specifically, the agreements provide that transfers between clearing members and the clearing house on the books of each settlement bank are effected simultaneously and are final, and that final transfers of funds between settlement banks are effected as soon as possible. Together, these steps can reduce substantially the amount and duration of a clearing house's exposures to any one settlement bank.
The combination of risk management safeguards employed by exchange clearing houses has generally proved quite effective in particular, there have been relatively few defaults by members of clearing houses in the G10 countries, and none by settlement banks. Furthermore, in no case has the default of a clearing member caused the financial integrity of any of those clearing houses to be significantly impaired. In several cases, however, sharp movements in market prices have triggered events that raised doubts about the financial integrity of clearing houses, and in so doing, revealed sources of vulnerability. Examples include the global collapse of equity prices in October 1987, which triggered concerns about the integrity of clearing houses for stock index futures and options, especially in the United States, and the sharp decline in Japanese equity prices in early 1995, which triggered defaults by units of Barings Plc that were clearing members of exchanges' clearing houses in Japan and Singapore.
More generally, analysis of these approaches to risk management suggests that clearing houses simply cannot be made fail-safe. With respect to risks of clearing member defaults, neither the capital requirements that are intended to limit the likelihood of clearing member defaults, nor the margin requirements that seek to limit potential losses in the event of defaults, are designed to cover extreme price movements. Thus, such an extreme price movement could lead to a clearing member's default, and the default could impose losses and liquidity pressures on the clearing house that could not be met fully by liquidating the defaulting member's margin collateral. In such circumstances, the clearing house would be forced to rely on its supplemental resources (including various contingent claims on its members) to cover the losses and meet its own payment obligations on schedule. However, the amounts of such supplemental resources at clearing houses in the G10 countries vary considerably. While a growing number of clearing houses periodically reassess their need for such resources, there are no widely accepted methodologies or standards for assessing their adequacy.
Clearing houses may also experience unanticipated credit exposures to clearing members because they have only limited capabilities for monitoring and controlling intraday risks. To be sure, improvements in recent years in the speed with which clearing houses can match trades and compute open positions have enhanced their capacity to monitor intraday exposures. Moreover, most clearing houses now have the authority to conduct intraday margin calls, which offer a mechanism for managing intraday risk. Nonetheless, some clearing houses still measure their exposures to clearing members only at the end of the trading day.
Clearing houses also may be vulnerable to weaknesses in money settlement arrangements. The specific potential problems differ, depending on whether the central bank is used as the settlement bank or private settlement banks are used. Nonetheless, where those weaknesses exist, they have two common underlying sources: (1) the use of interbank payment systems that entail the risk of unwinds of provisional funds transfers late in the day; and (2) a lack of clarity regarding the obligations of the various parties in the settlement process the clearing house, clearing members and settlement banks in the event that a clearing member (or settlement bank) were to default.
Clearing houses that use central bank funds in settlements avoid the risk of settlement bank failure. However, in some countries in which central banks are used, the clearing house could receive a provisional payment from a clearing member early in the day but have the payment unwound late in the day because the clearing member could not cover a net debit balance at the central bank. In the interim, the clearing house's credit exposure to the defaulting clearing member could increase substantially as a result of price changes or new trades that increase the defaulting member's open positions. Moreover, if the payment system does not settle until late in the day (when money markets tend to be illiquid) and the defaulting member owed a substantial amount, the clearing house could have considerable difficulty meeting the resulting liquidity pressures. The risk of liquidity problems could be quite significant if the clearing house does not clearly recognise the provisional nature of transfers in the payment system (or incorrectly assumes that the central bank will take action to prevent any unwinds) and, therefore, has not made adequate preparations to cover the resulting shortfall.
When commercial banks are used as settlement banks, transfers on their books from clearing members to the clearing house may be final prior to transfers in the interbank payment system. However, transfers between settlement banks usually are not final until the central bank payment system achieves finality. Thus, the clearing house is exposed to settlement bank failure from the time its account at a settlement bank is credited until the time the payment system achieves finality. As in the case of an unwind of a payment from a clearing member, if a provisional payment from a settlement bank is unwound, the clearing house could have considerable difficulty covering the resulting liquidity shortfall. Furthermore, because settlement banks may receive payments from multiple clearing members, the credit losses and liquidity pressures from the unwinding of a settlement bank payment could be considerably larger than those from the unwinding of a payment from a single clearing member. Thus, as when the central bank is used as settlement bank, it is critical that the clearing house does not misperceive provisional payments as final payments. In addition, if a clearing house's legal agreements with its settlement banks and clearing members are not drafted clearly, there is a potential for disputes to arise in the event of a default of a clearing member or of a settlement bank. In particular, if it is unclear when and under what conditions the settlement banks will make (or irrevocably commit to make) final transfers from clearing members to the clearing house, the clearing house could underestimate its credit and liquidity exposures to those members. Similarly, a proper assessment of the risks of settlement bank failures requires a clear understanding of when and under what conditions interbank funds transfers are considered final.
To the extent that individual clearing houses in the G10 countries are vulnerable to the potential problems that have been identified, the Study Group has identified certain steps that they could take to reduce their vulnerability. The Study Group does not mean to imply that systemic risk considerations require any individual clearing house to take any of these steps. Nonetheless, the Study Group believes that clearing houses should carefully consider whether implementation of the steps discussed below could produce benefits that exceed the costs. The Study Group notes that public benefits in terms of reduced systemic risk would accrue from these steps and that each of the steps has already been taken by some clearing houses in the G10 countries. The steps that the Study Group believes worthy of consideration are: (1) "stress testing" to identify and limit potential uncollateralised credit exposures and liquidity exposures to clearing members from extreme price movements, and to ensure that the clearing house's financial resources are of adequate size and liquidity; (2) enhanced intraday risk management through more timely trade matching and more frequent calculation of margin deficits and through the development of the capacity to conduct more frequent settlements of margin deficits or variation losses; and (3) strengthening of money settlement arrangements by utilising payment and securities settlement systems that provide real-time or at least intraday finality of funds transfers and by eliminating uncertainty about the obligations of the various participants in settlement arrangements in the event of a failure of a clearing firm or a settlement bank.
Stress testing is the selection of extreme price scenarios, that is, price movements not covered by margin requirements, and the simulation of potential losses and liquidity pressures that could result if such price movements led to a clearing member's default. Such tests can be used both to identify and to limit exposures to individual clearing members and to gauge the adequacy of the clearing house's financial resources. If the simulated credit exposures to one or more members approached or exceeded the amount of a clearing house's resources, it could either reduce the exposures (by requiring the individual members to reduce their open positions or increase their margin assets) or increase the size of its own resources. If the simulated liquidity needs exceeded available liquidity, the clearing house could require the members in question to post margin assets of greater liquidity or it could alter the composition or size of its own resources to provide greater liquidity.
Until recently many clearing houses in the G10 countries had only limited ability to monitor their intraday exposures to clearing members and no effective mechanism to control those exposures. In such circumstances, clearing houses were vulnerable to unanticipated increases in exposures from new trades and extreme intraday price movements. However, with recent improvements in trade matching and processing capabilities, many clearing houses now have intraday information on exposures and some have real-time or near real-time information. And, with the recent or prospective introduction by central banks in many G10 countries of real-time gross settlement (RTGS) payment systems, clearing houses in those countries could develop the capacity to actively manage their exposures to clearing members on an intraday basis through collection of cash margin. If securities settlement systems permit final intraday transfers of securities, clearing houses might also allow clearing members to cover margin deficits through deliveries of securities.
Clearing houses that still rely on interbank payment systems that permit the unwinding of provisional transfers late in the day will be able to reduce credit and liquidity risks substantially as central banks implement new RTGS payment systems or extend the hours of operation of existing systems. If a clearing house uses the central bank as settlement bank, by using the RTGS system it will be able to reduce the duration of its credit exposures to clearing members and eliminate the spectre of unmanageable liquidity pressures from an unwind of a large payment late in the business day. However, to ensure that it can make timely settlement in an RTGS environment, a clearing house would need to review its capacity to mobilise liquidity resources quickly should a clearing member default. With adequate planning, the availability of RTGS payment and securities settlement systems should, in fact, make it easier to mobilise resources quickly. If a clearing house uses private settlement banks, by requiring those banks to effect interbank transfers promptly over the RTGS system it will be able to reduce the duration of its credit exposures to the failure of a settlement bank and avoid the potentially traumatic consequences of an unwind of a payment from a settlement bank. This will require modifications to a clearing house's legal agreements with its settlement banks and clearing members, which will provide an opportunity for it to review whether those agreements address obligations in the event of a default by a clearing member or settlement bank with sufficient clarity and, where necessary, to eliminate any existing uncertainty.
The rapid growth of exchange-traded futures and options in recent years has been accompanied by an increasing internationalisation of the markets and their clearing arrangements. Many clearing houses now clear foreign exchange contracts or contracts denominated in foreign currencies and often effect money settlements in those foreign currencies or accept foreigncurrencydenominated collateral as initial margin. Also, most have clearing members that are units of foreignbased firms. Finally, as exchanges have looked to alliances with foreign exchanges to boost trading volumes, several clearing houses have developed links to facilitate the clearing of the resulting trades.
The Study Group has undertaken some preliminary analysis of the implications of these increasingly important cross-border elements in clearing arrangements for clearing houses. In general, these cross-border elements individually may make risk management more complex and potentially more difficult and, when combined, may compound the complexity and difficulty. When contracts are denominated in foreign currencies, money settlements must be effected in those currencies. Time zone differences and the need for banks to confirm receipt of payments by correspondent banks abroad may result in relatively longer delays before final foreign currency payments from clearing members to the clearing house are received (or before the clearing house can confirm that final payments have been received). When a clearing house accepts margin collateral in foreign currencies, in the event of a default a foreign exchange transaction may be necessary to convert the proceeds of the sale of the collateral into the currency needed by the clearing house, and time zone differences may make a same-day foreign exchange transaction impossible. When a clearing house accepts units of foreign firms as members, it may have difficulty assessing their creditworthiness and monitoring changes in their financial condition. In the event that a foreign member were to fail, its liquidator might challenge the clearing house's actions to implement its default procedures, although such a challenge would seem unlikely to succeed if the default procedures are supported by the clearing house's local law. However, if the clearing house is holding a defaulter's collateral in a foreign jurisdiction (especially the jurisdiction in which the defaulter or its parent is chartered), there is a more serious risk that the clearing house could be prevented from liquidating the collateral to cover its losses or meet liquidity pressures.
Links between clearing houses take two forms: clearing links and mutual offset systems. A clearing link involves a "home" exchange which is the primary exchange for the trading of the contract subject to the link (usually the exchange which introduced the contract) and an "away" exchange whose members may also trade the contract. The away clearing house acts as counterparty when a transaction is first initiated, but soon thereafter the home clearing house is substituted as counterparty to all transactions in home exchange contracts. By contrast, a mutual offset system allows exchange members to execute trades on both exchanges but to hold their positions with a single clearing house by transferring positions from one clearing house to the other. All clearing houses involved in cross-border clearing agreements face and must manage the risks that a clearing house faces in a domestic context. In addition, however, they face risks unique to these agreements. In a clearing link, a clearing house may face losses on positions that the other clearing house seeks to transfer to one of its members that is in default, or on positions that it seeks to transfer to a member of the other clearing house that is in default. In a mutual offset system, the clearing houses are exposed to loss from each other's default.