Norman, P. (2011). The Risk Controllers
PAST VS. PRESENT
The post-trading activities seen in modern CCPs such as registration, matching, verification and netting, have their origins dating centuries ago, with some archaeological discoveries suggesting the first futures and options were traded around 1750BC in Mesopotamia. The evolution of the financial infrastructure to cater to the increase of demand at several commercial markets throughout the years has led to the current version of Central Counterparties. Some of the key moments in the development of post-trading techniques include:
The fairs of Lyons (Lyon, 1463 AD)
After the 100 Year War ended, Louis XI of France authorised four trade fairs per year at Lyons to enable merchants from all Europe to trade. Each fair was followed by a day of settlements when bills of exchange were presented and claims cleared, with outstanding debts being settled by cash, thus allowing to lower the cost of doing business.
The Dutch Golden Age (Amsterdam, 17th century)
The Dutch East India Company was founded in 1602, and granted a monopoly by the Dutch government to trade with Asia. From 1641, it was the only European company allowed to trade with Japan, which made its shares a favourite for speculation. To avoid confusion and disorder upon settlement, special brokers in trading clubs acted as intermediaries to balance the claims and act as the buyer to every seller, and seller to every buyer. An official called the General Cashier would bookkeep the transactions and calculate outstanding transactions based on the traded value of the large company shares.
The Dojima Rice Market (Osaka, 1730)
The Dojima rice market in 1730 became the world’s very first commodity futures exchange resembling a similar structure to CCPs. Due to the development of a money-based economy, the market was turned into an official exchange where contracts should be standardised and of limited duration, the grade of rice should be agreed ex-ante, and receipts against future deliveries were offered. Additionally, all trades were centrally cleared and each trader must possess a line of credit, which would allow hedging positions.
Clearing in Chicago (Chicago, 1848)
The spread of grain cultivation and the increasing trade between the west and east of the US was followed by rapid infrastructure development in the state of New York, opening a route for eastern settlers to reach the north-central states of the Union. Financial and commercial infrastructures followed, and exchanges were set in transport hubs, such as the Board of Trade (BOT) in Chicago in 1848. As Chicago became the grain hub in the Midwest, the BOT established a system of grades and inspections, followed by a market regulation that allowed to set rules for business conduct and to settle disputes, including margin requirements and suspensions to protect against counterparty default. By the 1870s, the BOT was already considered a futures exchange able to facilitate the netting, clearing and settlement of trades.
The role of Banking in England (London, 1854)
Central clearing in the UK became popular in 1773, when banking clerks would meet at a rented room at the Five Bells tavern to exchange bills and settle debts. While a permanent committee was formed in 1821 to regulate its activities, it was not until 1854 that the Bank of England became a member, allowing balances to be settled by transfers within the bank accounts.
Following the Global Financial Crisis in October 2008, the G20 tasked the global standard setting bodies with creating a new regulatory regime that would ensure the safety, transparency, efficiency and increased resilience of the financial sector. Since the bilateral markets (uncleared) OTC derivatives were highly opaque, the policy makers and regulators mandated that all standardized OTC derivatives should either be:
- Centrally cleared through a Central Counterparty (CCP); or
- Come under stringent bilateral risk management standards.
Modern day CCPs have evolved into technology driven nodes at the heart of the financial markets. CCPs have progressed to become a mature bedrock of the Financial Market Infrastructure (FMI) ecosystem where they legally interpose themselves between the buyers and sellers in the market in order to neutralize counterparty credit risk among market participants. The daily exchange of margin (collateral) are part of an array of mechanisms to mitigate the counterparty risks inherent in the bilateral world. Subsequently, Qualifying Central Counterparties (QCCPs) are seen as crucial nodes in the financial network.
A QCCP is a legal entity that is licensed to operate as a central counterparty and is regulated by a specific regulator/authority to operate in accordance with the products offered. The CCP must be based in the jurisdiction of the regulator/authority for it to have QCCP status. Furthermore, the domestic regulatory landscape must be consistent with the CPSS-IOSCO Principles for Financial Market Infrastructures.
For further information on the benefits CCPs bring to the market, please see our section: Benefits of a CCP