In this RMA Journal Q&A, Jim Malgieri, a strategic advisor for the London-based financial service technology firm Pirum, speaks of the value, workings, challenges, and likely future of central counterparty clearinghouses. Malgieri was interviewed by Fran Garritt, RMA’s director of global markets risk. Malgieri’s comments are his own and do not necessarily reflect the views of Pirum.
GARRITT: How are central counterparty clearinghouses [CCPs] formed? Do they generally start as industry consortiums funded by a few players?
MALGIERI: Yes. For example, the National Securities Clearing Corporation clearly did. They generally start from a crisis, unfortunately. CCPs get formed through the needs of the market participants when they realize that their market can’t grow because of overall volumes and the participants’ ability to raise capital.
GARRITT: What risk management benefits do CCPs provide?
MALGIERI: CCPs are generally good for the marketplace. Their risk mitigants include not only the vetting of counterparties allowed into the CCPs but, more importantly, the calculations of margin that needs to be posted within the CCP. Margins, and how they are assessed and enforced, are key. How are they calculated? What types of collateral are taken in margin calls? How often is collateral being called? If there are multiple daily calls, what time during the day? How these questions are answered and the overall monitoring and volumes of the marketplace all go into the risk mitigation and risk management CCPs employ.
GARRITT: What are some of the concerns surrounding CCPs?
MALGIERI: A frequent question concerns their viability as an ongoing enterprise if one of their participants were to cause a CCP to suffer a loss. At issue is not only the default-management process that takes place if a participant were to default, but is there enough capital to protect the CCP itself? We have learned in the past that, in central clearing, if the default fund gets depleted and you require members to post additional money to shore up the CCP, some companies may not have the money to post. That’s one of the systemic risk issues regulators worry about. The only way to manage that is to make the default fund bigger up front. Firms don’t like to do that, though; this is where the costs of a CCP clash with the risk-mitigation aspects of a CCP. Firms put transactions into a CCP to allow them to conduct more transactions, because they get a netting benefit from a balance sheet perspective; there’s an economic incentive to join. The disincentive is the default fund contribution participants must put up and/or the margin that they need to put up to do the trades. If those numbers get too large, firms will find no cost benefit from putting transactions in a CCP. It is a delicate balance. Many think CCPs are the right thing to do, but how do you make them cost effective and safe for market participants?
GARRITT: Lost capital and the liquidity would certainly be an issue for a firm that is considering whether to participate.
MALGIERI: It’s an expense. It comes down to what the cost is in relation to continuing to do transactions bilaterally. A lot of firms are struggling with that. It’s a matter of critical mass. Consider the securities lending market; the more participants in a CCP, the greater the benefits for everyone. You get more netting for the participants and the more netting you do, the more benefits you get vis-à-vis cross-margining a much wider pool of participants.
GARRITT: Besides expense, what are some other factors that prevent CCP participation?
MALGIERI: The charters of some buyside participants such as asset managers and hedge funds don’t allow them to join a CCP, and some don’t have the capital to join a CCP. That’s hindered growth of CCPs because it tends to be the large broker-dealer sell-side firms that do participate; most participate on behalf of their clients.
GARRITT: How do CCPs evaluate the risk of each participant?
MALGIERI: That is based on sound risk management practices including credit. The CCP would have certain standards that the participant would need to meet, such as minimum capital requirements. Like anything else when you are doing business with a counterparty, a credit risk structure is paramount.
GARRITT: Is the decision that is based on the credit check an “either/or”? In other words, either you qualify to participate, or you don’t. Or are certain margins and requirements applied depending on the creditworthiness of each participant?
MALGIERI: The latter. For example, CCPs could base margins on capitalization: The smaller the capitalization of the participant, the larger the contribution. The contribution can also be based on the value of trades. Think of that as the initial margin [IM]—the ante the participant puts up to participate. The risk management process would determine the margin that is taken: how much cash, high-grade government debt, etc. It’s an independent credit check done by the CCP and its risk management department.
GARRITT: What issues are raised regarding the interplay of CCP margin calls and the intraday liquidity of participating firms?
MALGIERI: If products that come into CCPs are inherently volatile, you raise your initial margin requirement. That protects the CCP and so if the variation margin [VM] swings wildly, and it could, at least there is more protection. Which leads to a discussion of how often those margin calls are done. You could do two a day. Certain clearinghouses do: morning and afternoon. I would encourage that same methodology for many CCPs. The more times you do a margin call, the better it is and the more of a risk mitigant it is for the clearinghouse. The industry learned this through the tri-party process. Too much intraday liquidity injects more risk into the process. The more transparency and the more often that you make these calls, the better for everyone because firms can manage their intraday liquidity better. They don’t necessarily need to go to a bank to borrow because they should have the cash on hand to make the call. Historically, the clearing banks had been providing all of the intraday liquidity for the clients. The crux of tri-party reform was to make all market participants
less dependent on the clearing banks’ intraday credit. CCPs have that same level of responsibility. They need to make it transparent for their participants in terms of how the process is going to work and not rely on lines of credit or banks to provide the liquidity or to shore up the default fund. In the past, you had letters of credit backing a lot of clearinghouses. But in a crisis, those letters of credit were worthless because the banks wouldn’t have the money to pay for them. CCPs need to be cognizant that if there was a dislocation in the market, they themselves need to make sure they have that liquidity and not rely on others.
GARRITT: If a firm had a liquidity issue, what could it do to get liquidity out of the CCP to keep going?
MALGIERI: Unwind its trades. You would have to take the trades down and offset them. Then the CCP’s margin call goes away on the participant because you’ve closed the trades out. If there is a loss, then the CCP takes
the loss from either the VM or IM and hopefully there’s enough to make it an orderly wind-down.
GARRITT: Would such a firm have to completely back out of the CCP?
MALGIERI: It’s a transparent process. It would have to make a margin call. If you’re having liquidity issues and you don’t make that margin call, the remedy the CCP will take to satisfy its claim is going to be to unwind the trades. A CCP’s default process is all about risk mitigation—it needs to be robust. In this example, it would begin to close out the position of the firm having those liquidity issues right away. Done the right way, a wind-down essentially prevents a run on the CCP. That’s why that default-management process and that closeout process need to be robust. It’s no different than what a bank does. If you’re a banker and you lend money to somebody who doesn’t pay you back, you close them out. You sell the asset, you go claim other assets from them, assuming that you have a lien. A CCP is no different from a risk-mitigation point of view; that’s to protect the CCP. There are different levels of risk mitigation that the CCP has to be beholden to. One is protecting itself and the membership.
GARRITT: How much activity will we see shifting to CCPs?
MALGIERI: Coming out of the credit crisis, everybody thinks CCPs are the way to go for all products; I don’t necessarily sign up to that. The uncleared margin rules are fantastic. Market participants were writing credit default swap insurance on the outstanding paper in the mortgage-backed market, and none of the participants accepted margin or ever, more importantly, had to post margin. If margin was posted on all of this activity, the books wouldn’t have gotten as large. People were writing uncovered swaps with no natural hedge and no requirement to post margin. In the aftermath, the regulators came in with the uncleared margin rules, which are now being implemented. If you can’t put those types of products in a CCP, then by all means you need to have a robust process of posting margin among one another. The recent uncleared margin rules are a great benefit to the industry as those get implemented. Does the cost of business go up? Of course. But you can’t have trades in the OTC market and not be required to either post margin or receive margin. Where CCPs could add a lot of value is by bringing these esoteric products that generally trade and settle over the counter into a CCP. That’s a challenge, but it brings huge benefits if they can. I would like to see CCPs try to bring products in the uncleared over-the counter space into the CCP.
GARRITT: What is the interconnectedness of the different CCPs? What is the risk that if one experienced problems, there would be a knock-on effect?
MALGIERI: This is where the regulators have to coordinate amongst themselves. A CCP may be regulated by one regulator that doesn’t necessarily regulate, say, the broker-dealer. So there has to be coordination to ensure that you don’t have systemic risk. The industry and regulators have come a long way since the credit crisis to break those walls down. It’s always the responsibility of the industry to make sure that we never have another credit crisis. There should be oversight to try and ensure that there isn’t a knock-on effect. It goes back to the capitalization of the CCPs. If they have a deep default fund and a good capitalization as another buffer to protect themselves, you won’t get that systemic risk if one of them has an issue. When everyone was talking about the advent of CCPs a couple of years ago, there was a bit of pushback by some industry participants who thought that they weren’t well capitalized. There was some truth to that. If they can up their game in that regard, it answers the concern of that knock-on effect, but that also increases the cost of doing business with the CCP and firms could be reluctant to participate.
GARRITT: To what extent can or do regulators try to limit the systemic impact of any one CCP?
MALGIERI: It comes down to the default fund. What are a CCP’s risk management practices as they relate to aspects of the functioning of the CCP? What is their standard for capitalization and creditworthiness? How much initial margin is being asked for trades? What is the concentration risk? That is ultimately where the regulators will assess a CCP’s systemic risk.
GARRITT: Can or should a CCP have concentration limits regarding participants? For example, should it limit an institution to 25% of all the trades being cleared at the CCP?
MALGIERI: This question would make for an interesting debate. My thought about it is, if they breach a certain predetermined volume, their amount of margin goes up exponentially. It goes back to a CCP’s risk management practices around variation margin and initial margin. If they are robust enough and if trades pass a certain concentration level, then there is a disincentive for firms to put more activity into the CCP.
GARRITT: What happens if a CCP blows through all of a party’s various margins and collateral? Are the losses then spread across CCP participants?
MALGIERI: There is a waterfall in terms of the loss. Each CCP has different rules, but they function the same. If a participant goes through the initial margin and variation margin, then for all intents and purposes that participant is in fault. The CCP would have a waterfall as to how the remaining losses are allocated among the participants. Some CCPs do it by counterparty, saying essentially, “You traded the most with that person, so we are coming after you for the higher percentage of the loss.”
GARRITT: In the event of a default that spans CCPs, how coordinated are the CCPs?
MALGIERI: Unfortunately, in my opinion, not very. It comes down to everyone needing to protect their own shareholders, whoever that may be. Coordination would only come into play when the regulators force individual companies to get into a room to do a workout and the CCPs work together to try to find a common ground.
GARRITT: Could CCPs monetize any of the research they do or the data they collect to raise funds and possibly reduce the amount each participant has to kick in, thereby making it an easier decision for firms to join?
MALGIERI: Generally, the answer is no. There is an ongoing debate regarding data aggregation among central clearing parties, brokers, and custodians about whose information it truly is. Is it the person who executed the trade and submitted it to the CCP?Once it is at the CCP, does the CCP say it is their information? This is a slippery slope and brings more complexity into what value a CCP brings to the marketplace. In my opinion, a CCP is not there to monetize the data it gets. It’s there to provide a mechanism whereby parties can submit their transactions, and feel comfortable that their transactions are going to get netted and cleared in an efficient manner. Everything beyond that is ancillary. I would never consider monetizing data; it gets CCPs out of what they are intended to do. It probably depends, though, on the type of CCP. For example, there is a difference between publicly owned CCPs and the CCPs owned by participants; it’s a much different governance structure. So the bottom line is, yes, there is always opportunity to monetize data, but it depends on the individual CCP.