Central Counterparties (CCPs) and Credit Risk Management — An Overview

Primer to risk in capital markets:

As commonly understood, credit risk explains the probability of loss on a trade due to the counterparty’s non-fulfillment of a contractual obligation. For example, assume two parties namely A and B have entered into a derivative swap transaction. Let’s assume party B has run into financial difficulties and is unable to meet its obligations, then there may either be a part OR full default on its payments that are due to party A. Thus, party A is exposed to the risk of losing potential cash flows under the contract. This is a simple example of credit risk.

Let’s extend this analysis to the Over the Counter (OTC) market, where notional exposures worth trillions of dollars are currently outstanding on the books of market participants. In the absence of a Central Counterparty (CCP), the onus of clearing and settlement of trades lies with the parties involved in the transaction. Post the lessons learn during 2008, there has been a shift in the way OTC trades are getting cleared and settled. During the meltdown, the market witnessed that no one was “too big to fail”. With the view to avoid repeating the issues that marred the market in 2008, market participants are increasingly using the CCP platform for their trades.

Understand bi-lateral netting in OTC markets:

What are CCPs, why do we need them:

Clearing: The process of clearing of trades begins at trade initiation and will continue until the maturity date of a derivatives trade (this may last up to a few years to a decade for OTC derivatives).

Settlement: Settlement of trade happens at the trade maturity/expiry.

Collateral Management: Collateral management involves asking transacting counterparties to post cash or cash equivalents as collateral. In case of member defaults, the collateral posted by the members is used to make up for the loss from default. Related concepts like pricing of trades by CCPs and margining are explained in the subsequent portions of this article.

The above activities are necessary to complete any trade’s life cycle. CCPs provide guarantee of clearing and settlement of trades thereby helping market participants mitigate credit risk inherent in OTC transactions.

In the absence of CCPs parties have to depend on the technique of bi-lateral netting in order to mitigate the credit risk in the transaction. However, the onus of credit risk mitigation then lies with the transacting counterparties under their bilateral netting agreements.

In presence of CCPs, the CCP becomes a seller to every buyer and a buyer to every seller. In other words, parties see CCP as their counterparty. CCPs perform this action through a technique called as Novation. One can imagine novation to be similar to a transaction wherein CCP breaks the original trade between parties A and B, and creates or novates trades between itself and the respective counterparties which is exactly equivalent to the original trade between A and B.

The presence of CCPs enhances confidence of transacting counterparties as well, because they know that the CCP is there to ensure clearing and settlement of their trades and thus their credit risk has been taken care of to a considerable extent.

Margining and Funding arrangements:

Initial Margin (IM): This is the initial amount that is to be posted by the transacting counterparties with the CCP at the time of entering into the trade. Without posting IM at the start, CCPs won’t allow parties to use the CCP platform for their trades.

Variation Margin (VM): This is similar to the daily MTM mechanism observed on Exchange traded futures, whereas, the trading counterparties are required to post margin payments depending on whether they are in the money or out of the money on that particular day. VM is done on a daily basis. For computing the VM, CCPs use their own pricing models to arrive at trade MTMs

Default fund: Every member of the CCP is expected to contribute a specific amount of fund that is classified as the default fund of that member. The default fund is used for protecting against losses that may not be covered by the margins posted by members.

Member’s equity: Members purchase equity of the CCP. This is done to provide an additional layer of protection to cover for defaults.

To understand how member default is handled: assume a member has defaulted on its commitment, then the initial margin will absorb the initial credit losses, if that is not enough then variation margin is consumed. Assuming both the margins are not enough to meet the credit losses, the defaulting member’s default fund amount gets used. Further, in the event of a complete default by a certain member, CCP may resort to measures like trade auction of defaulted trade and loss mutualization.

The idea behind member’s equity in CCP is to discourage members from defaulting, as in the event of that member defaulting, they stand to lose their equity too.

The point to be noted is CCPs are not eliminating the credit risk from the system, rather they are re-distributing this risk to its network of members. Through efficient management of collateral and ample amount of margining coupled with default fund provisions, CCPs are expected to contain systemic risks that may build up.

Regulatory efforts towards OTC derivatives and their effect on CCPs:

· CCPs should clear all vanilla swaps and CDS products with the view of eliminating risk of default from bilateral transactions

· Trades done on OTC markets should be reported to repositories so that regulators will have better access to such information in an otherwise opaque OTC market

· Suggested greater capital requirements for OTC transactions that are not done on a CCP

Way Forward:

Banks have already begun benefitting from certain actions including periodic trade compression performed by CCIL. Further, banks are moving a greater number of their OTC trades onto CCIL platforms thereby helping banks reduce their counterparty exposures and as a result free up certain portion of their capital. Globally as well, it is expected that the volume of transactions on CCPs will continue to see an uptrend. Market demands that CCPs continue to function as entities that can limit the impact of systemic risk thereby improving market confidence and supporting further growth of the market.

This article was originally published on the Institute of Risk Management (IRM) India Blog: https://www.theirmindia.org/blog/central-counterparties-ccps-and-credit-risk-management-an-overview/



Founder: FinQuest Institute | Ekspert Consulting; www.finquestinstitute.com; www.ekspertconsulting.com

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