The rapid growth of futures and options trading on organised exchanges over recent years has been supported by an increasing internationalisation of the markets and their clearing arrangements. The activities of most clearing houses now feature cross-border elements: many clear foreign exchange contracts or contracts based on foreign financial instruments; most have some clearing members that are units of foreign-based firms. Also, clearing houses now often accept collateral denominated in currencies different from that of the contracts being cleared, and some of this collateral may be located abroad. Finally, links have been established in recent years between clearing houses located in different countries. This section explains how these cross-border elements individually may make the management of the risks faced by clearing houses more complex and potentially more difficult and how combinations of them may compound the complexity and potential difficulty. |
8.1 Contracts and collateral denominated in foreign currencies
Foreign contracts are broadly of two types: futures and options contracts based on a foreign interest rate, instrument (such as a government security) or stock index; and futures and options on foreign exchange rates, including those between two foreign currencies. Such contracts may be denominated in the local currency of the clearing house and collateralised with local currency assets; in such cases, settlements are effected in the same way as for domestic contracts. In other cases, contracts are denominated in, and money settlements are effected in, the currency of the instrument on which the contract is based. Regardless of whether the contracts are denominated in the local currency or the foreign currency, assets denominated in the foreign currency may be accepted as margin collateral.
When clearing houses conduct money settlements in foreign currencies, they sometimes use foreign currency accounts at domestic banks, which in turn depend upon their correspondent banking relationships abroad, to complete any interbank transfers on behalf of the clearing house. Alternatively, clearing houses may maintain accounts with banks located in the country of the currency's issue. Time zone differences and the need for banks to confirm receipt of payments by their correspondents abroad may result in longer delays before foreign currency payments from clearing members to the clearing house become final (or before the clearing house can determine that final payments have been received) than exist for domestic currency payments. Likewise, if the clearing house uses multiple foreign correspondent banks for a single foreign currency, the same factors may delay completion or verification of interbank transfers, thereby lengthening the duration of the clearing house's credit exposures to the correspondents.
When the clearing house accepts margin collateral in currencies different from the currency in which a contract is denominated, it would need to convert the proceeds through a foreign exchange transaction to meet the liquidity demands arising from a default. Depending on the time zones involved, a foreign exchange transaction for same-day value may not be possible. The consequent delay in obtaining the currency required would need to be taken into account in assessing the usefulness of such collateral as a liquidity resource and the adequacy of other liquidity resources available to the clearing house.
Finally, as with domestic contracts, settlement of a foreign contract by physical delivery rather than by cash may expose clearing houses to principal risk. In the case of foreign exchange contracts, the clearing house is potentially exposed to principal risk vis-à-vis its clearing members because of the lack of any mechanism to achieve simultaneous exchange of value in two currencies.75 The clearing house may manage this risk by requiring clearing members to pre-deposit the currency due to be delivered to the clearing house or by requiring a guarantee from a settlement bank that the clearing member will make the delivery, thereby transforming its exposure to the clearing member into an exposure to the settlement bank. Contracts based on foreign instruments such as government securities may also expose clearing houses to principal risk if the settlement system for the foreign instrument is not a delivery-versus-payment system. If so, the clearing house may need to consider developing arrangements similar to those used to manage principal risks on foreign exchange contracts.
8.2 Foreign participants
The membership of most clearing houses includes units of foreign-based institutions. In most cases, such members are local subsidiaries or branches of a foreign institution; but membership without a local presence is possible in some G-10 countries.76 Even where the clearing member is a locally incorporated subsidiary of a foreign company, the parent may in some cases provide a guarantee to the clearing house to cover the subsidiary's obligations.
From a clearing house's perspective, the key issue is whether it is depending on resources located outside its own jurisdiction to support the foreign-based member's performance of its obligations. If so, the evaluation of the member's financial capacity can become more complex. In principle, a clearing house can apply the same membership requirements to such foreign-based members as to domestic members. In practice, however, differences in the legal, accounting and regulatory arrangements applying in the foreign member's home country may make the application of those standards problematic. In particular, the extent and nature of home supervision of the foreign clearing member may be unclear, and, in some cases, there may be obstacles to the exchange of information with home-country regulators or market authorities. Together, these factors may make it more difficult for the clearing house to monitor the credit standing of the member (or its parent company if it provides a guarantee) and thereby to assess the risks posed by the member's positions at the clearing house. For example, the difficulties that clearing houses have in assessing whether a member has adequate liquidity resources to meet money settlement obligations resulting from sharp changes in market prices may be compounded for foreign clearing members. These firms' capital may be an especially poor indicator of their access to liquidity in the local currency.
Foreign membership may expose clearing houses to increased risk in the event of a default by a foreign member. In such cases, the foreign member, its liquidator or a creditor may seek to challenge the action of the clearing house in operating its default procedures. A liquidator may be able to obtain a ruling from a court in the jurisdiction of the defaulting member that the action of the clearing house was contrary to the principles of insolvency law in that jurisdiction. Whether the liquidator would also be able to enforce that judgement in the jurisdiction of the clearing house would normally depend, however, on whether the default procedures of the clearing house were open to challenge under local law.
Clearing houses seek to manage these additional risks in the application of their membership requirements and in their surveillance of foreign members' activities. They may seek to contain their legal risk in admitting foreign members by obtaining legal advice on potential conflicts between their own default procedures and the insolvency law in the jurisdiction in which the foreign participant is located. Clearing houses are also increasingly seeking to develop information-sharing agreements with foreign regulators and market authorities as well as with foreign clearing houses. Such agreements will allow clearing houses to obtain information related to the clearing member's compliance with its home-country regulatory requirements and the scale of its positions in other markets.
8.3 Collateral held in foreign jurisdictions
Most clearing houses hold some collateral most often cash or foreign government securities in foreign jurisdictions. When foreign government securities are accepted as initial margin, they are typically immobilised or dematerialised in the country of issue. A clearing house may hold those securities directly with a custodian in the country of issue or indirectly through a depository or global custodian located in the clearing house's jurisdiction or in a third country (e.g. Cedel or Euroclear).77 Foreign cash balances are likely to be held in the home country, although holding eurocurrency deposits in the clearing house's own jurisdiction may be a feasible alternative.
Holding collateral in a foreign jurisdiction may expose a clearing house to additional risks in the event of a default of a clearing member. A liquidator may be able to obtain a ruling from a court in the jurisdiction in which the collateral is located freezing the assets held on behalf of the clearing house and preventing the clearing house from realising the defaulting member's collateral to meet any losses. This risk may be particularly acute where the defaulting clearing member (and its creditors) is incorporated in the jurisdiction where the collateral is being held. But it could also be a problem when the collateral is held in a third jurisdiction, for example that of a global custodian or clearing system. Holding collateral in a foreign jurisdiction may also pose operational difficulties: time zone differences may make it impossible for the clearing house to have immediate access in the event of a default.
Clearing houses seek to manage these risks by using custodians or other intermediaries to ensure that they have met the legal and other requirements necessary to establish their interest in collateral located abroad. Before agreeing to accept collateral located in foreign jurisdictions, they may obtain advice on whether the laws in those countries ensure that their interest in the collateral can be enforced. In some cases, clearing houses may require foreign clearing members to post collateral which is located in the jurisdiction of the clearing house.
8.4 Links with foreign clearing houses
As exchanges and their clearing houses have looked to cross-border alliances to boost trading volumes and to provide clearing members with secure and efficient means of trading and settling contracts in multiple time zones, several links between clearing houses in different countries have been developed and more are planned.78 Links between clearing houses have taken two forms: clearing links and mutual offset systems.79 In addition, exchanges may establish electronic trading links that do not involve a clearing relationship. As will be described below, clearing links and mutual offset arrangements differ in terms of the roles and responsibilities of the clearing houses. Selected examples of clearing links and mutual offset systems are listed in Exhibit 5. These arrangements should be distinguished from electronic trading links, in which positions in any one contract are held exclusively with one clearing house and its clearing members.80
Selected links between clearing houses1
|Clearing house ||Type of link ||Products covered |
|BOTCC-LCH (planned) ||Clearing link ||US Treasury bond futures and options, German government bond futures and options2 |
|CME-SIMEX ||Mutual offset ||Eurodollar futures, euroyen futures |
|LCH-TIFFE ||Clearing link ||Euroyen futures|
|LCH-SIMEX ||Mutual offset ||Brent crude oil futures |
|OM-OMLX ||Clearing link3 ||All products traded on both exchanges |
|OM-OMLX-NOS ||Clearing link3 ||Futures and options on Norwegian equities index (OBX), options on certain Norwegian stocks.4 |
|OM-OMLX-SOM ||Clearing link3 ||Finnish fixed income bond derivatives |
1 Acronyms for clearing houses are identified in Annex 2, with the exception of NOS (Norwegian Options Market), SIMEX (Singapore International Monetary Exchange) and SOM (Finnish Options Market). 2 Ten-year and five-year Treasury note futures and options to be introduced for trading in London; long-term UK gilts and Italian government bond futures and options to be introduced for trading in Chicago. 3 Trades in contracts covered by the link are cleared at the local clearing house of each counterparty to the trade and are not returned to a single clearing house. 4 Swedish equity-based products will be added.
Clearing links. These links involve a "home" exchange which is the primary exchange for the trading of the contract subject to the link (generally the exchange which introduced the contract) and an "away" exchange whose members may also trade the contract. The away clearing house assumes counterparty risk, but only for a limited time. It becomes the central counterparty to trades executed on its exchange until the positions are transferred to the home clearing house, generally at the end of each trading day. Before the positions are transferred, the away clearing house will typically make and receive variation margin payments based upon the difference between the trade price and the price at the close of trading on the away exchange. If the home exchange is closed, the away clearing house may also collect initial margin from its clearing members to manage its risks from products in the clearing link. Many of the products subject to clearing links are denominated in foreign currency (from the perspective of the away exchange). Clearing houses must generally make adjustments to their risk management procedures when money settlements occur in currencies other than the domestic currency. One such approach is to rely on commitments from settlement banks that they will provide the necessary funds on behalf of the clearing members when the payment system for the relevant currency opens. These procedures are similar to those used by clearing houses when they trade a contract that is not subject to a link agreement but is denominated in a foreign currency.
Positions transferred under a clearing link are assigned to clearing members of the home clearing house according to prior agreement. Once the position has been transferred, the home clearing house calculates additional variation margin based on the difference between the price at which the transfer was made and the settlement price at the home exchange. Positions are thereafter margined according to the normal requirements of the home clearing house. Deliveries and options exercises generally occur only through the home clearing house.
Mutual offset systems. In contrast to a clearing link, a mutual offset system allows participants to choose the clearing house with which the position will be held. Positions can be transferred between one clearing house and the other, and the transfer may result in each clearing house acting as a counterparty to a contract with one of its own clearing members and to an offsetting contract with the other clearing house. Both clearing houses in a mutual offset system clear the same contracts, and they are exposed to risks vis-à-vis each other arising from the institutional arrangements that allow positions to be transferred from one exchange to the other. These institutional arrangements can involve the clearing houses becoming a special type of clearing member in each other's organisation. Thus, there is no longer a clear distinction between the two clearing houses in the services provided and the associated risks.
As part of a typical mutual offset arrangement, the clearing houses maintain accounts with each other holding equal but opposite positions. (The act of transferring a position from one exchange to the other means that the clearing house where the trade was executed now has a position at the other clearing house. Similarly, the second clearing house must become a counterparty to a position at the clearing house where the trade occurred in order for the clearing house where the trade occurred to have a long position for every short and vice versa.) The clearing houses must post initial margin with each other to cover the risks from holding these positions. These margin requirements are generally met with bank letters of credit. Also, a single bank account is typically used for variation margin payments between the clearing houses. This account does not always balance to zero, and overdrafts are subject to collateral requirements.
Risks unique to cross-border clearing. 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, the away clearing house guarantees the trades of its clearing members and faces the risk of default by a clearing member until the clearing member's positions are transferred. Moreover, a clearing house may also encounter problems either if the other clearing house seeks to transfer positions to one of its members that is in default or if it seeks to transfer positions to a member at the other clearing house that is in default. Responsibility for the trade and how the situation is resolved will depend on the detailed arrangements of the link. In a mutual offset system, the clearing houses are exposed to each other. Thus, each must be satisfied with the risk management safeguards at the other clearing house. Clearing houses in mutual offset systems are also exposed to the failure of the bank that they rely upon for making variation margin payments to each other. Finally, in both types of link, clearing houses face operational risks related to the technology supporting the link, including potential incompatibilities between the technologies used by the two organisations.81
75 See Committee on Payment and Settlement Systems (1996).
76 In the European Union, foreign participation may become more common as a result of the Investment Services Directive; this requires governments to ensure that firms authorised by another EU country to undertake certain activities, including derivatives activities, can become members of, or have access to, clearing and settlement systems for markets in their countries that are designated as regulated markets.
77 The risks involved in settling cross-border securities transactions and in holding securities abroad via intermediaries are discussed in Committee on Payment and Settlement Systems (1995).
78 The first major link was a "mutual offset system" established in 1984 between the Chicago Mercantile Exchange and the Singapore International Monetary Exchange.
79 In practice, existing links are quite diverse and some do not conform neatly to either of the two forms identified here. Nonetheless, a distinction is often drawn between the two types and has analytical value.
80 Globex, which for several years linked trading on MATIF and the CME, is an example of such a system.
81 Operational risks from the technology supporting links also arise in trading-only arrangements.