3.1 Role of the clearing house7 |
Clearing houses provide a range of services related to guarantee of contracts, clearance and settlement of trades, and management of risk for their members and associated exchanges. In providing these services, clearing houses can be organised in a wide variety of forms: some clearing houses are organised as departments of their affiliated exchanges, others are independent legal entities. Some clearing houses provide services to only one exchange, others serve a group of exchanges. Some clearing houses are owned by their member clearing firms, others are owned by exchanges or are public corporations. Despite these organisational differences, clearing houses typically have a core set of common features. Most important, with very few exceptions, clearing houses in the G-10 countries serve as the central counterparty to deals struck between exchange members8. That is, the clearing house becomes the buyer to every seller of a contract and the seller to every buyer.
A critical issue for both clearing members and the clearing house is the time at which the substitution of the clearing house as counterparty occurs. The rules of some clearing houses provide that substitution does not take place until a trade is matched or until it has been registered on the books of the clearing house. Under such rules, unmatched (or unregistered) trades are, in principle, the responsibility of the counterparties involved, subject to the rules of the exchange and the exchange's arbitration procedures. In many cases, however, market participants may not be able to utilise the most basic protection against the counterparty risks that accompany such responsibility, that is, the ability to avoid trading with counterparties that they view as uncreditworthy; to maximise market liquidity and to ensure that client orders are treated fairly, exchanges often require trades to be executed at the best price available, regardless of the creditworthiness of the counterparty. In the event of a default by a counterparty, a clearing house could well make a business decision to assume the obligations arising from all trades that were ultimately matched, even if substitution had not occurred prior to the default. Still, when a clearing house's rules allow it to decline to be substituted, it is apparent that the clearing house is preserving the option to force the counterparties to bear any counterparty losses on such trades. Although improvements in the speed and accuracy of trade matching and registration systems have diminished such direct exposures to counterparties, the timing of substitution of the clearing house as central counterparty continues to have important implications for the distribution of counterparty risks between the clearing house and its clearing members.
As central counterparty to trades on the exchange, the clearing house is exposed to counterparty risks and it must establish procedures to control those risks. As will be discussed in greater detail in Section 4, a basic risk control mechanism and another common feature of clearing houses is restriction of access to the clearing process. Clearing members typically are a subset of the exchange members that usually must meet financial and operating standards that exceed regulatory and exchange minimums9. This structure of clearing houses creates the need for intermediary relationships between various participants in the clearing process; non-clearing exchange members must arrange for a clearing firm to assume financial responsibility for their trades and those of any non-members of the exchange for whom they execute trades. The clearing house has a principal-to-principal relationship with its members; the clearing house typically asserts that it has no legal relationship with the clients of its member clearing firms, including those clients that are exchange members.
3.2 Clearing members and their clients
Clearing members serve as intermediaries in their provision of clearing services to clients, which may include non-clearing exchange members or individuals or firms that are not members of the exchange. However, the nature of the legal relationship between clearing members and their clients is not always clear. In most cases the relationship between clearing members and their clients is also principal-to-principal, but in other cases it is characterised as an agency relationship. However, the implications of the legal relationship between clearing members and their clients are not clear in some jurisdictions or, at least, have not been tested in the relevant courts.
In most markets, tiered relationships that are often varied and complex have developed between the firms that provide clearing and the ultimate parties trading in the market. In the case of a trade by a non-member of the exchange (for example, a retail client), the clearing of that trade can take place through different paths (Exhibit 3). The retail client might choose to have its trade executed by a firm that also is a clearing firm; the trade might then be executed and cleared through that one firm. Alternatively, the retail client might desire to have its trades executed by a non-clearing exchange member. That firm would be able to provide trade execution services to the client, but it would have established a relationship with a member of the clearing house for the provision of clearing services. From the perspective of this clearing firm, both the retail client and the non-clearing firm are clients, and their accounts are afforded the client protections required in the market. (Client accounts of the non-clearing firm are often commingled and carried on the books of the clearing firm in what are known as omnibus accounts. Individual clients thus are not separately identified on the books of the clearing firm unless they are a direct client of that clearing firm.) Even more complex arrangements between firms and clients are possible. For example, a client might direct its broker to have the trade transferred from the broker's clearing firm to a different clearing firm that the client prefers10.
3.3 Money settlement procedures: the role of settlement banks
Another key element in the clearing arrangements for exchange-traded derivatives is a bank or a group of banks through which money settlements are effected. Settlement bank arrangements at selected individual clearing houses in the G10 countries are described in Annex 3. Although the details vary considerably, two basic models can be identified: a central bank model and a private settlement bank model. 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. Specifically, private settlement banks may be used because: (1) the clearing house or many of its members lack access to central bank accounts; (2) private settlement banks are willing to provide credit (especially intraday credit) to clearing members or to the clearing house in amounts or on terms (uncollateralised) that the central bank is unwilling to provide; or (3) the clearing house seeks to complete settlements with its clearing members earlier in the day than is possible under the operating hours and finality rules of the central bank payment system.
Relationships between the clearing house, clearing members,
non-clearing members and clients
In the central bank model, money settlements between the clearing house and its clearing members are effected in central bank funds (top of Exhibit 4). Use of this model requires the clearing house and its clearing members to have access to central bank funds accounts11. In some countries, both the clearing house and its members are organised as banks, which ordinarily have access to central bank funds accounts. In some other countries, the clearing house or its members are organised as special types of non-bank entity but are nonetheless permitted access to accounts by central bank policies. But, in other countries the clearing house and most of its members are organised as nonbanks, and central bank policies do not permit access for such entities.
In this model settlements can be effected only during the operating hours of the central bank payment system. Currently, most central banks operate their payment systems only during local business hours. In most cases transfers of central bank funds associated with clearing house settlements are final when effected. However, in some cases the central bank payment systems utilised are deferred net settlement systems that achieve finality only at the end of the day and could unwind transfers from a participant that failed to cover its net debit position12. In order to enhance efficiency in the settlement process, some central banks provide liquidity facilities to clearing houses or their clearing members. These facilities typically require the borrowers to post collateral or to enter into securities repurchase agreements. However, other central banks do not provide such liquidity facilities. The availability of liquidity from central banks often depends on whether the borrowers are organised as banks.
The other model for money settlements is the use of private settlement banks (bottom of Exhibit 4). In this model each clearing member is required to establish a banking relationship with one of a group of commercial banks specified by the clearing house13. The clearing house itself has an account at each of the settlement banks14. Settlements between the clearing house and its members are effected by transfers between their accounts on the books of each of the settlement banks. These transfers are typically final at the time they are effected, which is often early in the business day and prior to the earliest time at which the central bank payment system allows final transfers of central bank funds15,16., However, when multiple private settlement banks are utilised, transfers between settlement banks are usually necessary to balance the clearing house's accounts at each settlement bank. These interbank transfers are typically made through the national payment system and, therefore, cannot be effected until the payment system opens, and generally do not become final until the payment system achieves finality, which may not occur until the end of the business day (or, in one case, until the next business day).
Private settlement banks often extend intraday credit to clearing members, generally on an uncollateralised basis, especially in arrangements in which settlement occurs before the opening of the national payment system. In such arrangements, without credit from their settlement banks, the clearing members would be forced to incur the opportunity costs and credit risks of holding balances with the banks on the night prior to the settlement that were sufficient to cover their obligations to the clearing house17. Private settlement banks also often extend unsecured intraday credit to the clearing house by allowing it to overdraw its account in anticipation of a subsequent balancing transfer of funds from another settlement bank.
7 Annex 2 provides information on the structure of clearing arrangements for selected exchanges in each of the G10 countries.
8 Among clearing houses in the G10 countries, the only exceptions are the Tokyo Stock Exchange and the Osaka Securities Exchange.
9 As indicated in Table 2 of Annex 2, some clearing houses have several classes of clearing member that differ in terms of the types of party for whom they are allowed to clear.
10 Such transfers of trades between clearing firms (often called "give-ups") have become increasingly common as traders using multiple exchanges have often opted to hold their positions with a single global clearing firm while utilising multiple executing brokers to take advantage of their specialised knowledge and expertise regarding particular markets.
11 In some clearing houses most clearing members have their accounts at the central bank, but others have only indirect access to central bank funds through banks with access to the payment system.
12 Moreover, in some European countries, funds transfers are currently subject to a "zero-hour" rule that allows the unwinding of any transfers initiated by an insolvent entity after 00:00 on the date of its failure. However, a draft European Union directive on settlement finality would require countries to eliminate application of the zero-hour rule to payment systems and possibly also to securities settlement systems.
13 In the case of the EOCC Clearing Corporation (Netherlands), all clearing members must establish a relationship with a single private settlement bank.
14 In the case of OMLX, the London Securities and Derivatives Exchange, the clearing house has an account at some but not all of its settlement banks. The other settlement banks must arrange for interbank payments to be made to a bank with an OMLX account.
15 Alternatively, in some arrangements settlement banks do not effect transfers on their books until after the opening of the national payment system, but make irrevocable commitments to effect the transfers.
16 Here again, statements about finality of payments are subject to the caveat that in some jurisdictions all funds transfers from an insolvent entity are currently subject to a zero-hour rule.
17 In many cases members would not know the amount of their obligations until after the close of the previous business day. Consequently, without access to credit from the settlement banks, very large precautionary balances might be needed to ensure that adequate cover was available.