The role of Central Counterparties (CCPs):
A Comparative Analysis of How a CCP Could Reduce Counterparty Risk & Advantages & Disadvantages of a CCP.
Terence Kaushalya
Introduction
The collapse of Lehman Brothers Holdings Inc., one of the four largest investment banks was an eye-opener and since then continuous improvements are taking place in the global financial industry to avoid such a crisis. This was one of the largest bankruptcies in the global financial markets history triggered mainly due to counterparty risk.
The quick responses by Central Counter Parties (CCPs) were able to reduce the substantial losses to the majority of Lehman Brothers’ clients and central counterparties. These actions reemphasized the benefits of the central counter-party model by giving assurance to the trading counterparties and Lehman Brothers’ clients to carry out their day-to-day operations with a minimum impact of the bankruptcy of Lehman Brothers Inc.
To strengthen the global financial market infrastructure following the crisis in 2008, CCPs are recognized as the solution to make over-the-counter (OTC) derivatives markets safer and sounder, and to help mitigate systemic risk.
This project report provides an overview of Central counterparties, how a CCP could reduce counterparty risk, advantages and disadvantages, risks faced by a CCP, and risk management of a CCP. Additionally, it discusses the impact of the CCP on the global financial industry and how the CCP can improve its efficiency.
What is a Central Counter Party (CCP)
A CCP is a financial institution or entity that acts as an intermediary in exchange-traded and over-the-counter (OTC) securities and derivatives markets to facilitate the clearing and settlement of transactions between various parties involved in trading. The CCP has the potential to reduce significant risks associated with trading activities to market participants by imposing more robust risk controls on all participants and enhancing the efficiency of financial markets.
The effectiveness of CCPs in acting as firewalls has been proven in other markets, especially during the global financial crisis in 2008, where they successfully controlled the spreading of losses made by certain financial institutions due to counterparty risk.
The first step of the process is that the two parties, such as buyers and sellers, agree to a trade (e.g., buying and selling stocks, derivatives, or other financial instruments) and submit their orders to the relevant exchange or trading platform. Then exchange or trading platform matches the buy and sell orders based on a given criteria, and once the trade is matched, it is confirmed to the involved parties.
When both parties have decided to deal through a CCP instead of the two parties dealing directly with each other, the CCP becomes the central counterparty to both sides of the trade. Both the buyer and the seller have a contractual relationship with the CCP.
The CCP mitigates the risk by imposing certain risk management mechanisms. It requires both the buyer and seller to deposit a margin, which serves as a security against potential losses in case of adverse price movements. The CCPs also practice risk models to assess potential risks and ensure that parties have enough collateral to cover their positions. Novation is a key concept in CCP operations. It involves the CCP inserting itself between the two parties and becoming the buyer to every seller and the seller to every buyer. This eliminates the counterparty risk, where one party might default on its obligations. After the trade is confirmed, the CCP ensures that the financial instruments or assets are transferred from the seller to the buyer and vice versa. This process is known as settlement.
In case a participant defaults and its margin is insufficient to cover losses, the CCP may have a guarantee fund to cover these losses. This fund is built from contributions by all participants.
By acting as a central intermediary, a CCP contributes to reducing counterparty risks, increasing transparency, and improving the overall stability of financial markets. This is particularly important in complex and highly interconnected markets where the failure of one participant could have domino effects throughout the system.
How a CCP could reduce counterparty risk
CCPs require an initial margin to maintain against any losses of the defaulting clearing member. CCPs reduce the potential domino effects of the failure of a major counterparty because the impact can be controlled and absorbed by the CCP’s default protection scheme, including the guarantee fund made up of all the clearing members’ contributions to use in case of any losses when the margin posted by the defaulting member be insufficient.
Margin Requirements
CCPs typically require participants to post collateral, known as margin, to cover potential losses due to adverse market movements or default. The CCP calculates and enforces these margin requirements based on factors such as the risk profile of the traded instruments and the market volatility. Adequate margin requirements ensure that participants have sufficient funds to cover potential losses, reducing the risk of default.
Novation
“Novation” replaces two new contracts with the buyer and the seller to reduce the counterparty risk (see figure 1). The figure 2 shows how multilateral netting reduces the amount of counterparty risk in the system. The first figure of the figure 2 shows bilateral contracts across four counterparties.
The numbers on the arrows indicate the net current replacement costs, for example, if the contract between A and B closed out immediately, B would owe A $5. The E with those letters indicates the maximum counterparty exposure for the counterparty. For example, EC = $10 because it will cost C $10 to replace the contracts with A and D if they both fail, etc. If all of these contracts are novated to a central counterparty, it eliminates all of A’s and B’s counterparty risk exposure, leaving C and D each with $5 of exposure to the central counterparty.
Guarantee Fund
CCPs often maintain a guarantee fund funded by contributions from their participants. This fund acts as an additional layer of protection against losses in case of a participant default that exceeds the available collateral. It provides a buffer to cover unexpected or extreme events.
Risk Management
CCPs implement sophisticated risk management processes. They monitor market activity and positions in real time, allowing them to assess potential risks quickly. If a participant's positions or trades start to pose a risk, the CCP can take appropriate actions, such as demanding additional margin, implementing position limits, or even liquidating positions to prevent further losses. The exposure of counterparties to each other can be further reduced by requiring the counterparties to post collateral against outstanding exposures.
Predefined Procedures
If a participant defaults on its obligations, the CCP has predefined procedures in place to manage the situation. These procedures might include auctioning off the defaulted positions, using the defaulting participant's collateral to cover losses, and distributing losses among non-defaulting participants. Having well-defined default procedures ensures the impact of a default is controlled and does not spread throughout the financial system.
Netting
A CCP streamlines the clearing and settlement process by netting trades. Instead of every participant settling their trades individually, the CCP nets out offsetting positions, reducing the overall number of transactions and minimizing settlement risk.
Transparency
CCPs provide transparency by publishing regular reports on their financial health, risk management practices, and the status of their participants' positions. This transparency helps participants make informed decisions and build confidence in the stability of the clearing process.
By implementing these measures, a CCP significantly reduces counterparty risk, ensuring that financial transactions are settled smoothly and minimizing the likelihood of systemic disruptions caused by individual defaults. However, it is important to note that while CCPs mitigate certain risks, they also introduce new types of risks, such as concentration risk (due risk of multiple participants' being centralized) and interconnectedness risk (due to the domino effect of potential impact of a CCP's failure on the financial system). As such, effective regulation, oversight, and risk management practices are crucial to maintaining the stability of CCPs and the financial markets they serve.
Advantages and disadvantages of a CCCP
A CCP plays a crucial role in financial markets, particularly in clearing and settling trades between market participants. There are several advantages and disadvantages associated with the use of a CCP:
Advantages:
Risk Management
CCPs employ robust risk management practices, including margin requirements, stress testing, and collateral management. These measures help ensure that the CCP is well-equipped to handle unexpected market events or participant defaults.
Reduce Exposure
One of the primary advantages of a CCP is its ability to reduce counterparty risk. It acts as an intermediary between buyers and sellers, becoming the counterparty to all. This reduces the risk of default since participants are exposed only to the CCP's credit risk rather than the credit risk of individual traders.
Standardization
CCPs typically enforce standardized contract terms and procedures, which helps in creating a consistent and transparent trading environment. This reduces the potential for misunderstandings and disputes among market participants.
Netting
A CCP streamlines the clearing and settlement process by netting trades. Instead of every participant settling their trades individually, the CCP nets out offsetting positions, reducing the overall number of transactions and minimizing settlement risk.
Liquidity
By providing a centralized platform for trading and clearing, a CCP can enhance market liquidity. It encourages more participants to engage in trading, knowing that counterparty risk is reduced, which can lead to increased market activity.
Efficiency
Centralizing clearing and settlement processes can lead to increased operational efficiency. This is because a CCP can leverage economies of scale and employ advanced technologies to manage and streamline the clearing process.
Disadvantages:
Domino Effect
While CCPs aim to reduce counterparty risk, they also introduce a form of systemic risk. If a CCP were to fail or experience financial difficulties, it could have widespread consequences for the entire financial system due to its central role in clearing and settling trades.
Overconfidence of participants
The presence of a CCP can lead to moral hazard, where market participants might take on riskier positions than they would otherwise because they perceive the CCP as a safety net. This could potentially increase systemic risk if not managed properly.
Operational Risks
CCPs are technologically sophisticated entities, and any operational failures or disruptions could have significant implications for market stability. Cyberattacks, software glitches, or human errors can disrupt clearing and settlement processes.
Limited Flexibility
Standardization enforced by CCPs might limit the flexibility of trading contracts. This could be a disadvantage for market participants who require customized derivatives or other financial instruments.
Costs
While CCPs offer benefits like risk reduction and operational efficiency, they also come with costs. Participants usually have to pay fees for using the services of a CCP. Additionally, the implementation and maintenance of technology and risk management systems can be costly.
In summary, while Central counterparties provide important risk reduction and operational benefits to financial markets, they should carefully manage their own set of risks and challenges to ensure the stability and integrity of the financial system.
Risks faced by a CCP and risk management of a CCP
While CCPs have advantages in terms of efficiency, transparency, standardization, risk management and valuation techniques, and counterparty risk reduction, they are also exposed to credit and operational risk associated with their failure. The collapse of a CCP is a rare occurrence and if it happens, it can lead to a systematic failure.
One example was that The French Caisse de Liquidation clearing house was shut down in 1974 as a result of unmet margin calls by one large trading partner firm due to a drop in sugar prices on the futures exchange. The main reason for the failure was that the clearing house did not increase margin requirements in response to market volatility. The problem was further aggravated when the clearing used questionable prices and nontransparent methods to allocate losses among counterparty members. The Malaysian Kuala Lumpur Commodity Clearing House was closed down in 1983 due to unmet margin calls after a crash in palm oil futures prices on the Kuala Lumpur Commodity Exchange.
Central Counterparties play a crucial role in financial markets by acting as intermediaries between buyers and sellers of financial instruments, guaranteeing the completion of trades, and managing associated risks. However, they are exposed to various risks due to their central position in the market. Here are some of the key risks faced by CCPs and the risk management strategies they employ.
Credit Risk
CCPs are exposed to the risk that one or more clearing members may default on their obligations. CCPs employ various measures to mitigate credit risk, such as:
• Clearing members are required to post an initial margin (collateral) to cover potential losses.
• CCPs maintain a default fund to cover losses in case of a clearing member default. This fund is financed by clearing members.
• Positions are marked to market daily, and adjust the margins to cover potential losses.
Operational Risk:
CCPs can experience operational failures due to technology mishaps, cyberattacks, or human errors. To address operational risk, CCPs:
• Implement advanced technology infrastructure to minimize operational failures.
• Employ robust cybersecurity measures to protect against cyber threats.
• Have plans in place to ensure business continuity in case of disruptions.
Liquidity Risk:
CCPs can face liquidity shortfalls if the default of a clearing member triggers significant losses that exceed available resources.
To manage liquidity risk, CCPs:
• Have access to emergency liquidity facilities, including central bank support.
• Conduct regular stress tests to assess the CCP's ability to handle extreme market conditions.
Legal and Regulatory Risk:
CCPs are subject to changing regulations and legal challenges that can impact their operations.
To manage the risk,CCPs:
• Up-to-date with regulatory changes and adjust their operations accordingly.
• Conduct regular legal reviews to ensure adherence to relevant laws.
Overall, CCPs employ a combination of risk management practices, financial safeguards, technology investments, and regulatory compliance to mitigate the various risks they face and maintain the stability and integrity of financial markets.
Model Risk:
CCPs rely on risk models to estimate potential losses, but these models may not accurately predict extreme events. To manage the risk,CCP:
• Employ multiple risk models to gain a more comprehensive view of potential risks.
• Conduct scenario analysis to assess the impact of different stress scenarios on the CCP's risk exposure.
Systemic Risk:
If a CCP fails, it can have systemic implications for the broader financial system due to its interconnectedness.
CCPs are identified as systemically important and are subject to higher regulatory standards. They work together with regulators and other market participants to minimize systemic risk.
Conclusion
A global framework for CCP risk management and other mitigating measures to eliminate systemic risks should be initiated to level the playing field and discourage regulatory arbitrage. If not there is a possibility that CCPs could compete with each other by reducing margin threshold requirements and clearing fees by exposing counterparty members and their customers to greater risks.
Although fewer CCPs lead to more concentrated credit and operational risks, some of the benefits of a single CCP can be achieved by interlinking several CCPs. This process, however, can only take place once sound CCPs are in place, and the CCPs agree on common risk management models, which will be difficult to achieve.
CCPs must learn from past lessons of risk management failures and not be tempted to become less conservative after long periods of low default rates.
References
(2010) Imf.org. Tge Role of Central Counterparties, Available at: https://www.imf.org/-/media/Websites/IMF/imported-flagship-issues/external/pubs/ft/GFSR/2010/01/pdf/ chap3pdf.ashx#:~:text=It%20shows%20that%20soundly%20run,among%20OTC%20derivatives%20market%20participants. (Accessed: August 29, 2023).
Gregory, J. (2010) Pros and cons of central counterparty clearing, Cvacentral.com. Available at:https://cvacentral.com/wp-content/uploads/2014/05/CCP_Incisive-Presentation.pdf (Accessed: August 29, 2023)
Copies of publications are available from: Bank for International Settlements Press & Communications CH (2004) Bis.org. Recommendations for Central counter Parties, Available at: https://www.bis.org/cpmi/publ/d61.pdf (Accessed: August 29, 2023)
Hancock, J., Hughes, D. and Mathur, S. (2016) Sources of financial risk for central counterparties, Available at: https://www.rba.gov.au/publications/bulletin/ 2016/sep/pdf/ rba-bulletin-2016-09-sources-of-financial-risk-for-central-counterparties.pdf
(Accessed: August 29, 2023)
