RDP 2013-12: Central Counterparty Links and Clearing System Exposures 1. Introduction

Since the onset of the global financial crisis, a range of regulatory reforms have been introduced that focus on financial system interconnectedness and collateralisation of financial exposures. A significant element of the international reform agenda has been the effort to push financial markets towards central counterparties (CCPs).^[1] CCPs can be systemically important components of the financial market infrastructure, taking on the role of buyer to every seller and seller to every buyer in the particular products they clear. In so doing, they can significantly mitigate the bilateral counterparty default risk that arises when market participants trade directly with each other. These arrangements also allow market participants to reduce a network of bilateral exposures to a single multilateral net exposure to the CCP, allowing for potentially significant reductions in the capital and collateral required to support trading activity.

But precisely how this transition occurs will determine whether the policy delivers on its objectives. For example, the multilateral netting benefits of central clearing are larger the more concentrated is central clearing. Other crucial factors include the products amenable to central clearing, and whether trades will flow to domestic or international CCPs.

With central clearing of OTC derivatives in its infancy, the eventual market outcome is uncertain. This has led to research interest in the effects of market structure on the size and location of counterparty risk. Netting and unnetting of exposures are core themes in this work, and lead to an uncertain conclusion about the overall effect of the G20's OTC derivatives reforms. Indeed, Duffie and Zhu (2011) find that mandated central clearing could increase systemic risk if activity is fragmented across multiple CCPs. Pirrong (2012) also warns that systemic risk could increase, noting that such fragmentation will increase the demand for CCP-eligible collateral. Since the supply of assets suitable for collateral is largely inelastic to financial institutions' demand for them in the short run, this could result in significantly higher liquidity costs in the financial sector and disrupt market functioning in the transition period.

One proposed solution to mitigate the costs of fragmentation of clearing activity is to link competing CCPs, thereby allowing netting of obligations that a participant accrues at different CCPs. In Europe's cash equity markets, this has taken the form of interoperability, where a participant in one CCP can clear its trades in a given product at any linked CCP. Other forms of CCP links include cross-margining and mutual offset arrangements. Under cross-margining, CCPs combine their risk management arrangements to offer discounts on collateral to participants using multiple CCPs concurrently. In a mutual offset arrangement, a participant can transfer positions from one CCP to another (Garvin 2012).

While CCP links allow for the netting of participant exposures in a way that approximates the outcome of using a single CCP, they create exposures between CCPs. This is because in the event of default of one of the CCPs in the linked arrangement, a portion of its obligations would be assumed by the surviving CCP(s). This could give rise to significant losses. As noted by Singh (2013), it is therefore uncertain whether interoperability or similar link arrangements will reduce aggregate counterparty exposures. For the same reason, it is also unclear whether linking CCPs would increase or lower the collateral requirements associated with participating in centrally cleared markets.

In this paper, we consider this question quantitatively, treating exposures as expected losses given counterparty default. Using the approach in Duffie and Zhu (2011), we examine the effects of interoperability in a multiple-CCP landscape, comparing increased netting benefits to the cost of inter-CCP exposures. The results indicate that under quite general conditions, the netting benefit is likely to dominate. This in turn suggests that interoperability is unlikely to increase CCP participants' collateral requirements, relative to participating in markets with multiple CCPs that are not linked. This paper looks only at expected exposure and does not consider other possible implications of interoperability, such as complexity and contagion in periods of stress.

We find that the reduction in expected exposures brought about by a link:

• increases with the total number of participants involved in the linked CCPs
• increases with the asymmetry in the number of participants using each CCP
• increases as the correlation between participant obligations in the products cleared by the two CCPs decreases
• is greatest where participant obligations in the products cleared by two linked CCPs are similarly volatile, and decreases with the asymmetry in these obligations' volatility (either because of participant heterogeneity or differences in the products' characteristics)
• is maximised when participants of linked CCPs concentrate their clearing in one CCP only.

The analysis sheds light on the implications of interoperability for the structure of exposures in markets such as the European cash equity market, where CCP links have already emerged. It also increases the information available to regulators and CCP participants about the netting and exposure effects of introducing interoperability into new markets. European regulators have to date not entertained interoperability in derivative markets, owing to the longer duration and greater risk of these contracts. However, this issue is now being looked at more closely – under the European Market Infrastructure Regulation, the European Securities and Markets Authority must submit a report in 2014 on whether interoperability should be extended to derivative markets. While there are a number of collateral offset arrangements currently available in derivatives markets, full interoperability in either exchange-traded or OTC derivatives markets has not yet emerged.

The structure of the rest of this paper is as follows. Section 2 provides a basic overview of central counterparty interoperability and the relevant literature. Section 3 introduces a model of interlinked CCPs and Section 4 discusses the results of this model. Section 5 then develops extensions to the model to demonstrate its usefulness in a richer array of scenarios. Section 6 concludes.^[2]

Footnotes

In 2009, the G20 members committed to ensuring that all standardised OTC derivatives contracts were cleared through a CCP. Australia's implementation of these measures has been overseen by the Council of Financial Regulators, with new legislation effective January 2013. [1]

All code used in this work has been written in Matlab and is available on request. [2]