The emergence of CCPs as
crucial intermediaries
The use of a CCP, once optional, will become mandatory
for the majority of over-the-counter (OTC) transactions as
a result of G20 recommendations—forever changing the
OTC derivatives markets. Regulatory initiatives such as
mandatory clearing required by Dodd-Frank and European
Market Infrastructure Regulation (EMIR) will reshape the
role of CCPs. From their inception as industry utilities
meant to deliver process efficiencies, CCPs will evolve to
become core business enablers that allow regulators to
isolate certain risks in fewer institutions.
As a result, buy-side clients in particular will want to
understand how the new role of the CCPs will change
the market risk profile. In the bilateral market, a firm
collateralizing a transaction is exposed to that single
counterparty. The new CCP model transforms multiple
bilateral exposures into a single exposure to a CCP or
clearing broker, thus creating another potential risk—
namely that a participant's collateral would be exposed to a
mutualization risk and thus share in any losses should the
margin posted by a defaulting member be insufficient.
In response, regulators have started to define new customer
collateral segregation models (such as the "Legal Segregation
With Operational Commingling Model" or LSOC) that
will mitigate some of those risks. Regulators are presently
redefining the risk equilibrium, which traditionally meant
that central risk management coincided with loss sharing
between the clearing participants and their clients.
This process is not yet complete. Recently, new international
principles have been issued that will make market
infrastructures such as CCPs subject to additional capital
requirements to cover business risk beyond requisite
coverage for liquidity and credit risk that already exists.
Together, these represent a shift in how CCPs are viewed.
CCPs have traditionally been subject to a minimal level of
internationally agreed standards of supervision. Regulators
have stayed neutral to the form and degree of market
consolidation and their business models.
Now, however, the increased importance of CCPs to
financial stability is likely to trigger even more changes,
given that so much activity will be concentrated in relatively
few institutions. For example, sources and composition
of revenues and CCPs' profit structures will become
increasingly relevant to regulators as different revenue
streams pose different risks to the organization.
| Key Considerations in Evaluating CCPs |
A market participant faces an important choice when it
selects a clearing partner for its business. In making this
decision, it's important to understand clearly the obligations
of the CCP during business-as-usual market conditions and
during times of market stress. While CCP defaults have
been rare, they are not unprecedented, and understanding
how the CCP will meet its obligations is an essential part of
making an informed decision.
Within the present regulatory framework, CCPs employ a
number of risk mitigation tools including access restrictions,
collateralization, capital and loss mutualization (through the
default fund contribution) that collectively are referred to as
the "risk waterfall."
This establishes a priority to how available funds are used,
and may differ by CCP, which may have different available
financial resources. Dodd-Frank and EMIR both contain
detailed provisions setting forth, for example, minimum
capital requirements for CCPs and the size of the default
fund. However, CCPs do not present a uniform risk profile
to participants as they are not required to have a uniform
structure.
In assessing the risk profile of individual CCPs, institutions
will want to understand:
- The reinvestment policy: CCPs are principally allowed to
reinvest the collateral received by the participants, which
can then (partly) be executed in unsecured form.
- Handling of non-cash collateral: Traditionally, accepting
non-cash collateral was not considered to be a strength
of CCPs. The implementation of more robust solutions,
perhaps utilizing tri-party models, will reduce operational
risk for the parties involved.
- Adoption of international messaging standards:
Historically, CCPs have relied on proprietary
communication formats. The incremental option of
international standards (such as SWIFT) may help to
reduce the risk of processing errors.
- Insolvency law: The effectiveness of asset segregation
models for CCP collateral, as well as the feasibility of
portability, depends on the legal framework.
Regulations recognize that there can be differences in
terms of safety, even after Dodd-Frank and EMIR are
implemented. For example, proposed Basel III rules
concerning the capitalization of exposures to CCPs clearly
distinguish between qualifying and non-qualifying CCPs.
These rules require banks to hold higher capital for cleared
exposures if the CCP does not meet certain operational and
business requirements (for example, regarding collateral
arrangements).
As market participants take a prudent approach to picking
the right CCP that offers them the best risk-reward profile,
this can have an important effect on the overall market
structure. There is a general concern that too many CCPs
may undermine netting and operational benefits and thus
increase the cost to the market. High selection standards for
CCPs would seem to be an effective means of discouraging
excess proliferation, as those CCPs who operate in the
safest possible way are likely to accumulate most of the new
clearing activity that is likely to result from OTC reforms. |
Increased utilization of collateral by
government or quasi-government agencies
Although CCPs are garnering significant attention, they are
by no means the only new players that seek to complement
their business activities with more robust arrangements
to manage non-cash collateral. Increasingly, government
agencies, central banks and monetary authorities are
turning to tri-party repo or other collateralized transactions
to support international expansion or to support monetary
policies, while government-sponsored pension funds are using collateral to safeguard against market volatility and
counterparty defaults.
These relative newcomers as clients in the collateral
management space are reaping the time-tested benefits
of tri-party repo, including the flexibility that is the
hallmark of this structure, to meet very particular needs.
For example:
- The Hong Kong Monetary Authority (HKMA)
recently employed tri-party repo and collateral in order to support the international expansion of the
Hong Kong repo financing market. In partnership with
J.P. Morgan, the HKMA developed a repo financing
collateral management program that connects members
of Hong Kong's Central Moneymarkets Unit (CMU) with
international financial institutions. This offers members
an enhanced liquidity platform for local currencies—
Reminbi (CNH), EUR, HKD and USD &mdask; against a broad
spectrum of international securities. The ability to utilize
Hong Kong's Real Time Gross Settlement system for cash settlements gives repo buyers and
sellers the ability to settle cash during
Hong Kong business hours. According
to Kirit Bhatia, J.P. Morgan head of
technical sales, Asia ex-Japan, "The
HKMA expects this program to grow
substantially over time across Asia and
globally. A key objective of the program
is to support the internationalization
of the CNY (offshore) by providing
market participants with direct access
to local liquidity. In practical terms, this
allows program participants holding
assets outside of Hong Kong to use
those positions as collateral to obtain
RMB in Hong Kong." It is expected that
this infrastructure will assist in further
developing the secondary RMB securities
market.
- Also in Asia-Pacific, central banks and
monetary authorities are collateralizing
their repo and OTC derivatives trades
and using an independent agent to
manage the associated risks. Increasingly,
the emphasis is on ensuring that
transactions are properly collateralized
throughout their tenure, managing daily
mark-to-market and variation margin
calculations, and ensuring an efficient
and accurate margin call process.
In addition, contributions to pension
funds are mandatory for workers in
certain Asia-Pacific countries. These
funds seek to effectively use derivatives
to manage against market volatility and
utilize collateral to manage counterparty
risk (including the potential risk of a
counterparty default).
New trends, new players
As markets continue to change in response
to global pressures and new regulations,
participants face a heightened need to find
effective tools to manage their non-cash
collateral. For non-traditional participants,
such as government agencies and quasigovernmental
institutions, the answer is
to seek assistance from collateral agents
who have time-honored and efficient
solutions to manage operational, credit and
counterparty risk on an enterprisewide
basis, regardless of the underlying
transaction or security.
For others, the advent of mandatory clearing introduces a new and more complex market |
| Support for Asia-Pacific Pension Funds |
| Four large superannuation funds in Australia and New Zealand recently engaged
J.P. Morgan to support their efforts with end-to-end third party derivatives collateral
management. The funds are looking to manage their exposure and expenses while
mitigating operational, credit and counterparty risk. According to Blair Harrison,
J.P. Morgan's head of collateral management for Asia-Pacific, this was a key consideration.
"Recent volatility and counterparty defaults have reinforced the need for timely and
appropriate collateralization of counterparty exposures, both for superannuation funds
and asset managers," he notes. "Investors are seeking quality collateral that is constantly
valued and administered against their obligations." |
|
paradigm. As CCPs replace bilateral collateralization for certain transactions, they effectively become counterparties in their own right. This puts additional pressures on the CCP to manage a substantially increased volume of collateral, a challenge that the tri-party structure is uniquely suited to address. In sum, a heightened need to effectively manage all assets is creating a newly diverse group of counterparties, as institutions seek to manage specific exposures by linking into established, flexible and scalable collateral management solutions. |
