The trading on organised exchanges of derivative financial instruments, that is, futures and options on interest rates, exchange rates and equity indices, began in the United States in the 1970s and early 1980s1. In the mid1980s financial derivatives were introduced on exchanges in each of the other G10 countries and in many other countries. As shown in Exhibits 1a and 1b, as late as 1986 exchanges in the United States still accounted for around 80% of total exchange-traded derivatives, both in terms of amounts outstanding and in terms of turnover. However, in the 1990s trading activity on non-US exchanges grew far more rapidly than that on US exchanges. By 1995, turnover of financial derivatives contracts at non-US exchanges exceeded that at US exchanges, and the value of outstanding contracts at non-US exchanges was only slightly smaller. Activity in 1994 had been boosted by exceptional volatility in global bond markets. Since then, turnover has fallen off in the aggregate and in most individual countries, while the value of outstanding contracts has grown much more slowly2.
The availability of financial derivatives - both standardised contracts listed on exchanges and tailor-made contracts privately negotiated with banks or other derivatives dealers (over-the-counter (OTC) derivatives) - has allowed financial market participants to unbundle financial risks and to manage the various risk components more effectively. In measuring and managing market risk, market participants must make assumptions about how promptly risk positions can be adjusted through market transactions. Markets for individual financial instruments, especially for tailor-made OTC derivatives, are often rather illiquid3. Nonetheless, when measuring market risks, market participants frequently use quite short time horizons. In part, the use of such short horizons4 is often based on the assumption that the market risks associated with illiquid instruments can be promptly offset with positions in more liquid markets. In particular, it is assumed that markets for exchange-traded derivatives will provide sufficient liquidity to allow positions in less liquid instruments to be offset quite promptly, even during periods of market volatility when other financial markets tend to be relatively illiquid5. In this way, the exchange-traded financial derivatives markets have come to constitute a critical component of the financial infrastructure of the G10 countries and a growing number of developing countries.
Exchange-traded derivatives can also have important implications for the management of liquidity (funding) risk. As shown in Exhibit 2, daily average money settlements associated with exchange-traded derivatives are quite modest in absolute terms and, certainly, relative to the size of payment systems and money markets. However, peak settlement amounts are typically a multiple of the daily averages. Moreover, as shown in the right-hand column, historical peaks have reached levels an order of magnitude larger than the daily averages. Most important, as indicated by the dates of the historical peaks, in most cases they have occurred during periods when financial markets are undergoing significant stress, for example during the October 1987 stock market break or following major realignments of exchange rates or turning-points in global bond markets. During such periods market participants tend to be experiencing significant liquidity demands in cash markets as well as derivative markets. In such circumstances, they may depend critically on the timely receipt of funds and securities from exchange clearing houses to meet their liquidity needs.
During such periods of market stress, the loss of an exchange's market liquidity or a delay in the completion of settlements could well lead to systemic disturbances - the liquidity of other financial markets could be seriously impaired, or payment systems and other settlement systems could be disrupted. A loss of market liquidity could result in substantial unanticipated trading losses to dealers in OTC derivatives or in other financial instruments that had assumed the ability to offset positions promptly in measuring potential losses. The experience of unanticipated losses and the unavailability of efficient hedging vehicles could lead dealers to pull back from other financial markets, thereby adversely affecting the liquidity of those markets. Delays in completing money settlements associated with exchange-traded derivatives could cause the intended recipients to be unable to meet their obligations to other payment and settlement systems.
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. To be sure, a default by a member of the clearing house, especially by a firm 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. The relationships and related risk exposures between clearing members and their clients are generally discussed only to the extent that they are relevant to the financial integrity of the clearing house6.
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. Finally, the Study Group has also undertaken a preliminary analysis of the implications of the growing internationalisation of the trading and clearing of exchange-traded derivatives.
The next section outlines the basic structure of clearing and settlement arrangements for exchange-traded derivatives, including the relationships between the clearing house, its clearing members and their clients, and the role of settlement banks in money settlement procedures. Section 4 discusses the sources and types of risk faced by the clearing house. Section 5 identifies what are, in effect, the generic elements of the approach that clearing houses take to managing the risk of clearing member defaults. It also describes approaches to limiting the risks of settlement bank failures. Section 6 points to potential weaknesses in clearing houses' risk management procedures, and Section 7 identifies steps that can be taken to address those weaknesses. Finally, Section 8 considers some issues raised by the internationalisation of the trading and clearing of exchange-traded derivatives. Annex 1 is a glossary. Annex 2 provides information on key features of 16 clearing houses, including at least one in each of the G10 countries. (This information summarises the results of responses by these clearing houses (or the exchange for which they clear) to a questionnaire drawn up by the Study Group.) Annex 3 provides information on money settlement arrangements employed by the individual clearing houses. Annex 4 presents a brief overview of various arrangements that are employed to protect the interests of clients of clearing firms. Annex 5 illustrates the mechanics of two different types of margin system "futures-style" and "options-style" margining. Annex 6 is a bibliography.
1 Options and warrants on individual equities had been traded earlier in many countries.
2 Outside the G-10 countries, the countries with the most active financial derivatives markets are Singapore, Brazil, Australia, Spain, Hong Kong, New Zealand, South Africa and Denmark.
3 Unlike exchange-traded derivatives or securities, OTC derivatives typically cannot be transferred or terminated without the consent of the original counterparty. The negotiation of a termination or transfer is inherently a timeconsuming process.
4 For example, many market participants measure market risk using value-at-risk (VAR) measures that are calculated on the basis of one-day price movements.
5 Nonetheless, prudent risk managers perform stress tests that seek to quantify potential losses in abnormal market conditions, including protracted periods of market illiquidity.
6 The mechanisms that can be utilised to protect clients of a clearing firm or broker from the intermediary's insolvency have already been analysed in a paper on Client Asset Protection published recently by IOSCO's Technical Committee. See Technical Committee of the International Organization of Securities Commissions (1996a).