Counterparty Credit Risk (“CCR”) for listed derivatives products had been managed for many decades using collateral in the form of margin, however, managing CCR using margin practices is relatively new in OTC derivatives products. It is fair to say that this new way to manage CCR is a consequence of the GFC and the implementation of the G20 derivatives reform which introduced mandatory clearing for a big part of derivatives products, and margin for uncleared derivatives (UMR). For this reason, understanding CCR management for OTC derivatives products has been a challenge for many markets participants and regulators, and the tension is visible every time regulators and market participants push CCPs to incorporate more own resources in the default waterfall, or when discussions about margin models are held.
In this case study, a personal testimony of dealing with CCR management and the struggle to implement a local CCP in Chile (a jurisdiction outside of the G20 countries) is presented. At the same time, it shows how Chile was able to experience the benefits of a local CCP during a financial crisis, like the one created during the Chilean unrest crisis (2019) and the Covid crisis (2020).
The USD/COP Spot market in Colombia has an average traded volume of over 1.5 billion per day. Until early 2021, this market operated under a clearing mechanism that allowed multilateral netting of cash balances in COP and USD, but without a central counterparty. Despite the benefits provided by multilateral netting through FCH, the lack of a central counterparty in this market generated two undesired outcomes. On the one hand, each member was required to assign credit facilities to those counterparties it was willing to trade with, and, on the other hand, there was no anonymity, as members knew who their counterparty was in each trade. The need for credit facilities caused asymmetry in the access to execution prices, as both the seller and the buyer needed to have enough facilities among them to trade. Since having two CCPs in Colombia was not economically efficient, in 2019 FCH and CRCC decided to merge under the existing CRCC structure so that FCH would cease to exist, and the local FX USD/COP Spot market could become a new segment within the CRCC, receiving all the benefits of a central counterparty. This eliminated the undesired effects mentioned above, generating further cost efficiencies to clearing members. We will use a network analysis to assess whether the elimination of credit facilities between members in the FX USD/COP Spot market derived from the introduction of the CCP resulted in a more accessible market for all members, regardless of their size and overall credit worth and whether the expected synergies could be passed on to participating members.
In 2012, the Financial Markets Act (“FMA”) replaced the outgoing Securities Services Act of 2004 (“SSA”), to become the primary legislative instrument regulating the activities of exchanges and clearing houses operating in South Africa. The promulgation of the FMA introduced a new licencing construct for local clearing houses – namely the concept of an Independent Clearing House (“ICH”) – and a further piece of legislation (2018’s Financial Sector Regulation Act) introduced the obligation that any clearing house that wished to be licenced as a CCP would also have to secure an ICH license by no later than 1 January 2022. As the only recognised CCP operating in South Africa, JSE Clear undertook a 4-year programme of work to be licensed as an ICH.
This case study provides an overview of the different characteristics that define an Independent Clearing House in terms of South African law, and describes the process undertaken by JSE Clear to secure its ICH licence – both in terms of the engagement model with local regulators during the application process, as well as the changes introduced to the clearing house’s operating model in order to satisfy the new licencing requirements.
In further support of the goal to protect the financial markets, this case study shows how NSCC has continued to strengthen its liquidity risk management strategy over time, including growing and diversifying its liquidity resources.
As a CCP, NSCC’s liquidity needs are driven by the requirement to complete end-of day money settlement, on an ongoing basis, in the event NSCC ceases to act for a Member. NSCC seeks to maintain qualifying liquid resources in an amount sufficient to cover this risk. These resources historically included cash deposits and a credit facility, and they have expanded to include debt issued to support default management and Supplemental Liquidity Deposits (SLDs). SLDs improve NSCC’s ability to measure and monitor its daily liquidity exposures and allow it to collect additional qualifying liquid resources from Members whose activity poses the largest liquidity exposure to NSCC in connection with their daily settlement activity.
Eurex & SGX
Each central counterparty has appropriate policies and procedures in place to handle the default of one or more of its clearing members. According to CPMI-IOSCO PFMI Principle 13 “[t]he periodic testing and review of default procedures is important to help the FMI and its participants to fully understand the procedures and to identify any lack of clarity in, or discretion allowed by, the rules and procedures…” Default management exercises are regularly performed on at least an annual basis, to ensure readiness of the default management practices of the CCP.
Given the interconnectedness of the financial markets, a failure of a large common clearing member across multiple CCPs could have a significant impact on the financial system. In October 2020, an authority led default exercise was conducted in parallel across multiple CCPs, simulating a default of a large hypothetical common clearing member. The exercise was the fourth of its kind, comprising the largest number of participating CCPs and regulatory authorities to date. Both Eurex and Singapore Exchange (SGX), among other CCPs, participated in the default exercise. The multi-CCP default exercise achieved its objectives and its observations are used to refine and improve the CCPs’ existing default management procedures.
The case study of JSCC reviews its risk management for listed commodity derivatives. It shows how JSCC managed large price movements in Japan’s commodities markets, especially in the electricity market in 2021 where the volatile price moves were observed.
The relative degree of safety offered by different account structures at CCPs is clearly understood. It is widely accepted that individual segregation of positions and collateral provides the highest degree of safety to the customers. However, under traditional technological capabilities, individual segregation had operational and other challenges and was therefore costly. This case study discusses how modern technology was leveraged by CCPs in India to offer universal individual segregation to all classes of investors. The solution achieves transparency, superior protection from both participant and fellow customer default, and improves the likelihood of portability.
In April 2022, the National People’s Congress of China approved the final version of the Futures and Derivatives Law. The new law will take effect on August 1, 2022.
The Futures and Derivatives Law expressly recognizes the legal enforceability of close-out netting for futures and derivatives markets in China, including OTC derivatives transactions cleared through CCPs. It also provides legal certainty for the finality of the settlement and use of margin and other settlement assets involved in the futures and OTC derivatives transactions.
The recognition of close-out netting is a historic milestone in China’s derivatives market legislation process. We believe the Futures and Derivatives Law will lay a solid legal foundation for the opening-up of China’s futures and OTC derivatives markets, and further promote the openness and cooperation among global financial markets.