Central clearing: A new world emerges

Central clearing: A new world emerges

By Alan Bardwell, Chief Risk Officer, ASX Limited.

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With central clearing taking a more fundamental role in stabilizing global financial markets, regulators around the world are keenly interested in ensuring that clearing houses strive for – and maintain – high risk management standards. At ASX, we believe that the highest standards are critical to achieving confidence; in our clearing house, in the Australian economy and in the global markets. 

Regulators around the world are interested in ensuring that central clearing houses maintain high risk management standards.

Central clearing demonstrates its value

Coming out of the global financial crisis, one thing was clear; had it not been for the stabilizing effect of central clearing, the initial shocks of the crisis could have been much worse. Essentially, by standing between buyers and sellers, central clearing acts like a systemic risk shock absorber, protecting the rest of the market when one or more participants collapse. ASX operates two clearing houses: ASX Clear primarily for equity and equity options and ASX Clear (Futures) for exchange-traded and over-the-counter derivatives markets.

When MF Global collapsed worldwide in 2011, for example, their futures positions in the Australian market were managed by ASX’s clearing house which effectively cushioned the impact on the other participants in the market. This was the first recorded default of an active clearing participant in the Australian market. In that case, a year after the collapse, ASX was able to return to the administrator substantially all of the margin that ASX originally held. Similarly, with MF Global and the earlier collapse of Lehman Brothers in 2008, US and UK clearing houses were able to effectively manage exposures and avoid market contagion. 

In May 2015, BBY Limited, a medium-sized clearing participant on ASX’s equity and equity options markets, collapsed. Again, ASX’s clearing house met its primary objective to protect the rest > of the market from the impact of the collapse by managing out BBYs exposures within margins held.

Central clearing also plays an important role in improving market liquidity and capital efficiency. Indeed, as both exchange and over-the-counter (OTC) derivatives are traded, buyers and sellers build up exposures between each other. The higher the exposure, the more collateral and capital will be required to cover that exposure. What central clearing does is net out that exposure on a multilateral counterparty level, essentially sharing the risk to reduce the exposure. As a result, participants are able to reduce the amount of both collateral and capital they need to hold against those exposures. 

Higher standards for a higher purpose

Not surprisingly given the significant role that central clearing plays in stabilizing financial markets, regulators have become increasingly focused on ensuring that clearing houses are striving to achieve and maintain the highest possible risk standards. 

Led in 2011 by the Committee on Payments and Market Infrastructures (CPMI) and the Technical Committee of the International Organization of Securities Commissions (IOSCO), regulators around the world are now implementing the Principles for Financial Market Infrastructure (PFMIs) which are designed to ensure that the infrastructure supporting global financial markets – such as clearing houses – is robust and well-placed to withstand financial shocks.1

While the previous standards (issued in 2001) had held up reasonably well during the global financial crisis, there was broad recognition that the PFMIs would need to include more demanding standards. For example, rather than requiring clearing houses to hold enough capital to cover the default of their largest single exposure (i.e. participant) in stressed market conditions, the PFMIs require them to hold enough to cover the default of their two largest participants under ‘stress’ conditions (otherwise known as the shift from ‘Cover 1’ to ‘Cover 2’). 

Going above and beyond

However, as with any multilateral regulatory initiative, the PFMIs have been interpreted somewhat differently in each market as they are passed into legislation. And as a result, there is some variation in the way clearing houses are regulated from one market to the next. In Australia – much like in Europe – regulators have viewed the implementation of the PFMIs as an opportunity to improve their market’s stability and to enhance the role that clearing houses play in the financial markets. Regulators are currently undertaking a review of the global implementation of the new standards.

We believe that it’s appropriate to strive for globally uniform high standards while keeping in mind that the majority of large exposures are with global companies who participate in multiple central clearing houses at one time. We believe there are four areas where, globally, clearing houses and regulators can work together to achieve the right standards:

  • Margining and stress testing: The new PFMIs including the shift from Cover 1 to Cover2 require clearing houses to reset their margins and create significantly larger default funds in order to cover the new capital requirements. At ASX we recognized this shift was coming and raised over $500 million a year before regulation required it. Both ASX clearing houses now operate to Cover 2 capital and liquidity standards. 
  • Skin in the game: Regulators are currently assessing what proportion of a clearing house’s default fund should be contributed through the capital of the clearing house itself rather than through contributions from participants. We believe it is appropriate that clearing houses have significant ‘skin in the game’ as an incentive to maintain a strong focus on risk management standards. As such, the resources of ASX’s clearing houses comprise over two-thirds of the default funds. Feedback from participants has been positive – not only do they need to contribute less, they can also be more confident in ASX’s approach to risk management.  
  • Recovery: While shifting to Cover 2 is a significant improvement, regulators also want to know that clearing houses have robust recovery plans that can be enacted to meet a loss that exceeds the size of the default fund, even though the likelihood of such an event is extremely remote. At ASX, we have already completed consultation with participants on a range of tools we established to respond to this requirement, ranging from additional contribution assessments on participants and haircuts on payment obligations including variation margin, through to partial or full contract termination.  We expect these tools to be formalized in the clearing house operating rules shortly, and believe that formalizing and communicating recovery plans to regulators and participants is key to driving increased market confidence. 
  • Disclosure: It is clear that greater transparency is a fundamental theme in recent financial services regulation and the PMFIs contain a number of principles on transparency and disclosure. ASX supports the push for clearing houses to be more transparent than ever before through both qualitative and quantitative disclosures, while recognizing this has to be a level playing field globally in its application by regulators. We plan to start disclosing a wider variety of quantitative measures at the start of next year, and expect our risk management standards to compare strongly with our global peers.  

ASX firmly believes that clearing houses have a responsibly to strive to achieve the highest possible standards of risk management. The reality is that – when a global financial crisis hits – we are only as strong as our weakest link. Therefor for clearing houses to serve their systemic risk absorption purpose, all players must hold themselves equally accountable and to equally high standards. ASX is also investing heavily in its risk management systems over the next two years to help fulfill this objective, announcing recently it is partnering with Nasdaq OMX to implement “Sentinel” to deliver a single, real-time risk management system across both ASX clearing houses and all asset classes, including real-time margin calculation and related customer risk analytics.

We look forward to working with regulators, global peers and our customers to make sure that clearing houses continue to function as valuable stabilizers of the world’s financial markets. 

About the author

Alan Bardwell, Chief Risk Officer, ASX Limited

Mr. Bardwell has been Chief Risk Officer of ASX since July 2010. He is responsible for ASX’s Clearing Risk Policy, Clearing Risk Quantification, Clearing Risk Management, Portfolio Risk Management, Enterprise Risk Management and Internal Audit functions. Mr. Bardwell was previously Chief Financial Officer at ASX, a role he commenced in December 2006. 

Michael Cunningham, Partner, KPMG

Michael is a Partner in KPMG’s Financial Risk Management practice having joined from Chief Risk Officer, Treasurer and Market Risk Management roles with Bank of Tokyo Mitsubishi UFJ, Goldman Sachs, Citigroup and Westpac in Australia and Asia. Michael has both a broad and detailed, practical and proven successful knowledge of enterprise risk management, with particular emphasis on treasury, balance sheet, ALM practices and processes including interest rate & FX risk, liquidity risk, funds transfer pricing, conduct risk and OTC derivatives reform and regulatory requirements.

KPMG perspective

Central clearing entities’ role as a systemic risk shock absorber will become even more significant in the future due to regulatory requirements to better manage capital and liquidity under Basel III. The challenge for the industry is that regulators need to act in a coordinated and consistent fashion in the prudential supervision of this activity, so as to avoid a counterproductive Balkanization of the regulatory framework.

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