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Clearing Arrangements for Exchange-Traded Derivatives

4. Sources and Types of Risk to an Exchange Clearing House

4.1 Overview

By substituting itself as the counterparty to trades, the clearing house assumes a variety of risks that must be managed. The clearing house typically assumes no market risk because, as central counterparty, for every long position it holds there is a corresponding short position, and vice versa. It is, however, exposed to the risk that one or more of its clearing members might default on their outstanding contracts. This exposes the clearing house to credit risks (replacement cost risks) and also to liquidity risks. Principal risks may also exist if contracts provide for delivery (rather than cash settlement) and if a delivery-versus-payment mechanism is not utilised to effect deliveries. In those cases in which clearing houses utilise private settlement banks rather than central banks to effect money settlements, another source of risk is the possibility of failure of a settlement bank. Clearing houses also typically maintain their own financial resources to help cover losses and ensure timely settlements, and the investment of such resources usually entails some risk of loss or illiquidity. Like other payment and settlement systems, exchange clearing houses face various operational risks. Finally, legal risks are also a concern; it is important, for example, that the clearing house's default procedures be supported in all relevant legal jurisdictions.

4.2 Defaults by clearing members

Replacement cost risks. If a clearing member were to default, the clearing house would face replacement cost exposure because the member's default does not relieve the clearing house of its obligation to the clearing member on the other side of the contract. The clearing house would generally replace the contracts by going into the market and purchasing or selling contracts identical to those on which the clearing member defaulted. The nature of the replacement cost risk that the clearing house faces varies from product to product. Derivatives exchanges list two basic types of contract: futures and options (including options on futures). A futures contract is essentially a standardised forward contract, that is, a contract that obligates one counterparty to buy, and the other to sell, a specific underlying asset at a specific price and date (the delivery date) in the future18. An option contract gives the buyer of the option the right, but not the obligation, to buy (a call option) or to sell (a put option) a specific underlying asset at a specified price (the strike price) on or before a specified future date (the expiration date). The seller of the option has an obligation to make delivery (a call option) or to accept delivery (a put option) at the specified price if the buyer chooses to exercise its right to buy or to sell.

Futures contracts initially entail no replacement cost exposure because contracts are struck at prevailing market prices. As time passes, however, prices will tend to move away from the level at which the deal was struck, and the clearing house will be exposed either to the buyer (if the market value of the contract decreases) or to the seller (if the market value increases). In other words, at inception a clearing house has no current exposures on futures contracts but faces potential future exposures vis-à-vis the buyer and the seller.

The clearing house's exposures on options depend on whether the buyer pays the premium upfront, that is, at the time the contract is executed (or shortly thereafter), and on whether the premium, if collected upfront, is passed through to the seller. If the buyer pays the premium upfront, it has satisfied its obligation to the clearing house and, therefore, the clearing house has no credit exposure to the buyer. If the premium is passed through to the seller, the clearing house is exposed to the seller for the amount of the premium, and its exposure to the seller will increase or decrease as the market value of the option increases or decreases. In other words, when option premiums are paid upfront and passed through, the clearing house has no exposure vis-à-vis the buyer, but has a current exposure at inception to the seller as well as a potential future exposure. On the other hand, if the premium is not paid upfront and passed through to the seller, the clearing house initially has no current exposure to either the buyer or the seller, but has a potential future exposure to both. If the market value of the option increases, the clearing house will be exposed to the seller; if it decreases, it will be exposed to the buyer19.

Liquidity risks. By substituting itself as counterparty to its clearing members, the clearing house exposes itself to liquidity risks; it must fulfil its payment obligations to non-defaulting members on schedule, even if one or more members default. Indeed, it is particularly critical that a clearing house perform its obligations without delay so that questions about its solvency do not arise. Depending upon the design of the clearing arrangements and the functions it performs, the clearing house may obligate itself to make a wide variety of payments: pass-throughs of profits on outstanding contracts, pass-throughs of option premium payments, reimbursements of cash initial margins, or payments for deliveries. In the event of a default, a clearing house would typically look to assets of the defaulting member and its own financial resources to raise the necessary funds. However, because clearing houses typically seek to minimise the opportunity costs of membership, in most cases few of these assets are cash assets20. Non-cash assets must be liquidated or pledged before the clearing house can meet its obligatory transactions, which may be difficult or costly to complete in the time required. Furthermore, for clearing houses that effect settlements in multiple currencies, foreign exchange transactions might also be necessary to convert the proceeds of such borrowings or asset sales into the required currency.

Principal (delivery) risks. Clearing houses can incur large credit exposures on settlement days, when the full principal value of transactions may be at risk. This can occur if upon maturity (futures) or exercise or expiration (options) contracts are settled through delivery and delivery versus payment (DVP) is not achieved. If a commodity or underlying instrument is delivered prior to receipt of payment, the deliverer risks losing its full value. If payment is made prior to delivery, the payer risks losing the full value of the payment. In some cases, the sequence in which deliveries and payments will occur is known in advance and principal risk is clearly asymmetric. In other cases, the sequence is not known in advance; indeed, even on settlement day the counterparties may lack real­time information on the status of deliveries and payments. Many products traded by derivatives exchanges call for cash settlement rather than delivery, and principal risk is thereby eliminated. These cash settlements are generally handled through the same channels as other cash payments. However, certain contracts that are settled through physical delivery ­ foreign exchange contracts in some G­10 countries and base metals contracts in others ­ have resulted in quite substantial deliveries in recent years. In these cases, where a DVP mechanism is not available clearing houses have used other techniques (prepayment, third-party guarantees) to limit the size of exposures or the risk of loss.

4.3 Settlement bank failures

As discussed in Section 3, clearing houses effect money settlements through one or more settlement banks. Clearing houses in some countries use the central bank as the sole settlement bank, which effectively eliminates the risk of settlement bank failure. However, clearing houses in other countries use private settlement banks and, therefore, are exposed to the risks of settlement bank failures. Such failures could pose both credit risks and liquidity risks to a clearing house.

The size of the clearing house's credit and liquidity exposures to its settlement banks may be quite significant. However, whether this is so depends critically on: (1) the amounts owed to the clearing house by clearing members that utilised the settlement bank on the date of its failure; (2) the timing of the settlement bank's failure; and (3) the terms of the settlement agreement between the clearing house and its clearing members and settlement banks.

The amounts owed by clearing members in any particular money settlement at any one settlement bank depend primarily on the positions held by those clearing members and on changes in the market value of those positions21. In a particular settlement, a given clearing member may owe the clearing house money or may be owed money by the clearing house. The amount owed to the clearing house, if any, by a single clearing member can vary quite considerably from day to day. Moreover, because multiple clearing members use the same settlement bank, the total exposure to a settlement bank could far exceed the largest exposure to any single clearing member.

But, a clearing house would suffer losses and liquidity pressures from the failure of a settlement bank only if the failure occurred after the clearing house's account with the settlement bank had been irrevocably credited (and the clearing members' obligations to the clearing house were thereby discharged) but before the settlement bank had irrevocably transferred the clearing house's balance to another settlement bank. Even in those circumstances, the clearing house's legal agreements governing the use of its accounts at its settlement banks may significantly reduce or even eliminate the clearing house's exposures. For example, amounts owed to clearing members using a settlement bank may effectively be netted against amounts owed by clearing members to the clearing house. Or, the agreements may shift the risks of a settlement bank's failure from the clearing house to the other settlement banks that were scheduled to receive transfers from the failed bank in order to balance the clearing house's accounts.

4.4 Investment of clearing house funds

Clearing houses have financial resources (equity, reserves, other sources of funds) that are typically invested in order to generate revenues to partially offset the costs of clearing house operations. Clearing houses usually invest these funds in very short-term bank deposits or placements or in highly liquid, short-term securities. Thus, market risks on these investments tend to be negligible. However, the clearing house faces credit and liquidity risks vis-à-vis the banks with which it places funds and possibly also vis-à-vis the securities issuers.22 In addition, securities investments may expose the clearing house to custody risks.23

4.5 Operational risks

Operational risk is the risk of credit losses or liquidity pressures as a result of inadequate systems and controls, human error or management failure. With respect to systems, the clearing house faces the potential breakdown of some component of the hardware, software or communications systems that are critical to its risk management system. Of particular concern is the breakdown of hardware that would impair the clearing house's ability to calculate money settlements, creating potential liquidity pressures both for itself and for clearing members. Breakdown of a key operational component could also heighten credit risks to a clearing house in at least two ways. First, it could hamper its ability to monitor its credit exposures. For example, a breakdown in communications with an exchange's trading floor could deprive the clearing house of timely information on the open positions of clearing members or changes in the market value of such positions. Second, it could hamper the clearing house's efforts to control its exposures to its members. As already discussed, replacement cost exposures increase with the passage of time. Thus, any operational problem that delays settlement or prevents the clearing house from resolving a default can substantially increase the clearing house's credit risks vis-à-vis its members. With respect to human error or management failure, clearing houses are dependent on their staff to implement their rules and procedures. If the staff are negligent, the efficacy of a clearing house's risk management approaches can be compromised.

4.6 Legal risks

Clearing houses for exchange-traded derivatives may face a variety of legal risks that have the potential to substantially increase losses from a default, either by a clearing member or by a settlement bank. In the event of a clearing member's bankruptcy, perhaps the most significant is the legal risk that the multilateral netting arrangement between clearing members and the clearing house would not be upheld under the national law. Clearing houses in many jurisdictions have been afforded special legislative protection to ensure that their netting is valid. Another significant potential source of risk is that bankruptcy administrators might challenge a clearing house's right to close out (or transfer) positions and liquidate (or transfer) a defaulting member's assets.24 Here again, national legislation often seeks to protect clearing houses from such challenges. However, as will be discussed in Section 8, when the defaulting participant has the bulk of its assets in a foreign jurisdiction, conflicts of law may arise that could cause difficulty for a clearing house. As another example, in the event of a clearing member's failure, a legal dispute might arise between the clearing house and a settlement bank over the finality of transfers (or the irrevocability of commitments to make transfers) between deposit accounts of clearing members and the clearing house. Likewise, in the event of a private settlement bank failure, legal disputes might arise between the clearing house and its clearing members or other settlement banks regarding the finality of transfers on the books of a settlement bank or between settlement banks. If the agreements between a clearing house, clearing members and settlement banks are unclear, it may be very difficult to determine who bears the risks of such defaults and failures and, therefore, these risks may be very difficult to control.


18 However, the substitution of the clearing house as counterparty and the imposition of various risk controls by the clearing house (to be discussed below) make the values and risk characteristics of futures differ from those of forwards.

19 However, the potential exposure to the buyer is limited to the premium, while the potential exposure to the seller is, in principle, unlimited.

20 Those clearing houses that hold substantial amounts of cash typically reduce the opportunity costs to their members by paying interest on the cash balances. However, this requires the clearing house to invest the cash in non-cash instruments.

21 As noted earlier, money settlements cover a variety of obligations between the clearing house and its members.

22 The securities purchased by clearing houses are often domestic government issues, which are essentially without credit risk.

23 As will be discussed in Section 5, clearing houses impose initial margin (collateral) requirements to protect themselves from losses from clearing member defaults. If initial margin is posted in cash and the clearing house invests the cash margin, it faces risks similar to those faced when investing its own resources.

24 The effectiveness of margin requirements depends on whether the collateral can be liquidated.

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