Although clearing houses generally do not recognise the existence of any counterparty relationship with clients, an important function of many clearing houses is the protection of clients. Clearing houses establish procedures or implement regulatory policies for the handling of client positions and funds, and their rules often include separate margin policies applicable to clients. Many aspects of clearing houses differ from country to country, reflecting prevailing market practices and legal regimes. Arrangements for protecting clients are no different. Indeed, greater diversity is probably found in this area than in any other aspect of clearing houses. This annex provides an overview of several important issues related to client protection, and it is not intended to be an exhaustive treatment.

Segregation and accounting issues for client and house positions

A common protection for clients used by many regulatory regimes is the requirement that client positions be segregated, accounted for separately from the clearing member's house positions, or both. Segregation usually entails the physical separation of client positions on the books of both the clearing house and the clearing member. Some regimes may not require segregation but may nonetheless call for a separate accounting of client and house positions. As an example of the distinction between separate accounting and segregation, the clearing member might be required to maintain separate records of client and house accounts but these positions might be carried in a single commingled account at the clearing house.

Segregation or separate accounting of positions can be an important tool protecting clients if the firm carrying their positions fails. In that event, positions in house accounts would typically be liquidated by the clearing house. Segregation or separate accounting makes the identification of client positions easier and more reliable and thereby facilitates the transfer of a defaulting clearing firm's client positions to other clearing firms in countries that handle client positions in that manner.

Segregation and accounting issues for assets supporting client and house positions

In the same manner that client positions are often segregated or accounted for separately from house positions, client assets are also segregated or accounted for separately from house assets in many countries. Regulations in this area address how firms handling client assets must treat them. For example, regulations may specify that one client's assets cannot be used to meet another client's margin requirements; thus, if one client's margin account is deficient, excess margin in another client's account cannot be used to meet that deficit. It is the responsibility of the clearing firm to provide the needed collateral if a client's account is undermargined, or to close out the client's position.

In countries that require the segregation of client assets at the clearing house, client assets may be held in an account that is separate from the account holding house assets. Cash and other assets posted as collateral are generally deposited with, or held in custody by, commercial banks. Although assets posted by individual clients may be commingled physically in this custody account, on the clearing firm's books they are accounted for separately. The clearing house has control over movements of funds and collateral out of the custody accounts. This segregation offers protection to clients because it provides for a clear identification of client assets and can facilitate the transfer of client assets to other clearing members in the event of a clearing firm's failure. Furthermore, because the clearing house usually controls movements of collateral into and out of the accounts, the ability of the clearing member to improperly use client assets is limited.

Gross versus net margining

In the account structures found in many clearing systems, clients do not deal directly with a clearing member. These tiered relationships have implications for the ways in which some risk management tools are implemented. A good example relates to the posting of collateral (initial margin requirements) as a way to mitigate the replacement cost risk that the clearing house faces when it substitutes itself for counterparties in the clearing process. The clearing house establishes minimum collateral requirements both for clearing members and for their clients. It also requires certain portions of the collateral posted by clients to be passed through by firms so that it can be held directly by the clearing house.

Clearing houses have adopted two different approaches to this process, known as gross margining and net margining. The possibility for these two approaches arises because clearing houses generally do not recognise individual clients. Thus, when a clearing firm is passing collateral through to the clearing house, one approach is to pass through the collateral required to support the net client positions. (That is, if one client has two long positions and another client has one short position, the risk to the clearing house is one long position because it does not recognise the individual clients.) Alternatively, a clearing house can require that collateral be posted with it reflecting the gross positions carried in the client account. In either of these systems, the same amounts of collateral would be required of clients. The key difference between them is where the collateral is held: in a net margining system some of the collateral posted by clients is held by the firms carrying the accounts. In a gross margining system, all of this collateral is passed through and held at the clearing house. (In either a gross or a net margining system, firms can always require collateral above the minimum levels set by the clearing house, and this collateral would be held by the firm.)

Both net and gross margining systems have advantages and disadvantages. A gross margining system gives the clearing house direct control over larger amounts of collateral than does net margining. Such a system may provide more client protection if one believes the clearing house would be more careful in its handling of client funds than the clearing firm. Gross margining comes at the cost, however, of greater information demands. Individual trades must be identified as to whether they are opening or closing positions in order for the clearing house to be able to calculate gross positions and gross collateral requirements. This sometimes slows down the calculation of collateral requirements relative to a net margining system.

Differences in acceptable margin collateral

As part of their risk management procedures, clearing houses specify the types of collateral that can be used to meet initial margin requirements (and also required contributions to guarantee funds). This collateral usually has very low credit risk and is highly liquid. For example, it might be limited to cash or specific types of government securities. Clients are required to post margin collateral with their clearing firms, a portion of which is passed through to the clearing house. Clients would generally be required to post the types of collateral acceptable to the clearing house. However, several clearing houses allow clients to post broader ranges of assets as collateral with the clearing firms than they themselves will accept. For example, clients might be allowed to post government securities from a broader set of countries with their clearing firm than the clearing house accepts. If clients elect to post collateral that the clearing house itself does not accept, the clearing firm must substitute acceptable collateral for the portion that is passed through to the clearing house.