The Cleared Derivatives Ecosystem A Different Approach to Your Management

decade after the financial crisis, the dust has settled in the Frank Perrone Senior Vice President Investor Services derivatives markets. Policy objectives and regulatory reforms [email protected] +1 212 493 7970 Adesigned to strengthen the financial markets and reduce systemic risk have been largely adopted. participants are focusing on fine tuning their responses and considering alternative approaches to managing collateral and funding costs. Understanding how is deployed and used across the ecosystem can inform more efficient and optimized programs.

INVESTOR SERVICES A Brief Overview In this paper, we aim to review and explore core functionalities of the clearing ecosystem and margin infrastructure, including The financial crisis of 2008 shed light on the exposures and how margin collateral is maintained, transferred, and protected structural weaknesses embedded in the over-the-counter (OTC) through the lifecycle. It should serve to assist end derivatives markets. In response, regulators and policy makers users, such as asset managers and insurers, as they consider came together to address the systemic risks associated with derivatives clearing and strategies. OTC transactions. This led to a fundamental review and establishment of regulations designed to mitigate risks inherent in the OTC swaps markets. The successful track Listed Derivatives and Swaps record of the futures clearing system managing and mitigating Clearing counterparty risk provided a foundation for some of the Participants in the listed derivatives and cleared swaps market important OTC swaps market reforms. gain access to the central clearing system through their Two directives that were introduced: relationships with futures commission merchants (FCMs). Clearing houses, or central clearing counterparties (CCPs), • The requirement that standardized OTC swaps be centrally mitigate risk between members of the CCP (also known as cleared. ”clearing members”).

• The mandate that non-centrally cleared OTC swaps be subject to minimum standards for variation and initial Relationships Across the Ecosystem margin requirements.

Introducing Broker Exchange or SEF

FCM acting as agent of FCM acting as agent of end user end user trades as has counterparty relationship Non-clearing FCM exchange member with

End User End User Futures SettlementSettlement CCP Commission Bank Merchant FCM Clearing Member

Trade excecution Margin Proprietary Trading Firm collateral Customer agreement End user to FCM End user margin collateral counterparty delivered to FCM and later relationship transferred to clearing house to satisfy margin requirement

End User FCM Clearing Member

2 Think of the clearing system as a set of concentric circles. Clearing The CCP is at the center, surrounded by clearing members (FCMs and proprietary trading firms). The next ring consists of The clearing process begins when clearing members on both customers of clearing member FCMs which include end users sides of a transaction submit the trade to the CCP. The CCP and non-clearing FCMs. The third ring contains those clients of confirms whether trade details between the buyer and seller non-clearing FCMs. match. Matched trades are accepted for clearing. Through novation the CCP becomes the buyer to each seller, and Direct counterparty risk exists between each circle. CCPs’ the seller to each buyer. The CCP guarantees the financial and FCM clearing members are exposed to each other’s risk. performance of cleared contracts between itself and the End users of FCMs are exposed to FCM . Margin clearing members. The CCPs guaranty does not extend to collateral flows across the system to and from end users the FCMs customers, which is why end users are constantly through the FCM and ultimately to and from the CCP. Around evaluating the credit and risk profile of their FCMs. the periphery are introducing brokers, who support trade flows between end users and FCMs but do not accept or hold customer assets.

Relationships Across the Ecosystem

Introducing Broker

Non-clearing FCM

End User End User

FCM Clearing Member

Proprietary Trading Firm

FCM Clearing Member

INVESTOR SERVICES 3 CCPs FCMs

To support the assurance that cleared transactions will perform FCMs intermediate the relationship between the end-user financially, CCPs have several tools they employ to manage and the CCP. FCMs may provide trade execution and clearing risk, which together form what’s known as a “ waterfall.” separately or together. FCMs are highly regulated financial The default waterfall is structured to cover losses when a entities that have customer protection front and center. To clearing member fails to make good on obligations to the CCP. solicit or accept orders for futures, futures options, or cleared The financial safeguards consists of initial margin, guaranty swaps and to accept or other assets from customers fund deposits, CCP capital and clearing member assessments. a financial entity must be registered as an FCM with the National Futures Association (NFA) and must operate under its CCPs manage credit risk by maintaining a matched book of regulatory authority, as well as that of the Commodity Futures counterparty exposures collateralized by initial margin. Market Trading Commission (CFTC). The NFA and CFTC require FCMs or price risk is mitigated through the variation margin process, to comply with their financial, customer protection, record which transfers marked-to-market gains and losses among keeping, and reporting requirements. FCMs that are clearing winners and losers. members are also subject to the regulatory and financial requirements of the exchanges and CCPs they belong to. CCPs require daily settlement of initial and variation margin from clearing members. FCM clearing members are required A “clearing member FCM” is an FCM that is a member of a to collect initial margin from customers in an amount at CCP and accepts trades on behalf of clients for clearing. To least equal to their CCP requirement and to collect and pay become a clearing member, an FCM must meet the clearing customers variation margin. house’s financial eligibility requirements, maintain a specified amount of capital, and contribute to a guaranty fund to be used in the event of another member’s default. FCMs that clear swap contracts are also required to participate in any auction of a defaulting clearing member’s swaps portfolio.

Trade Date Trade Date +1

CCP CCP calls calls FCM for FCM for VM IM EOD

5:00 AM 3:00 PM EOD 5:00 AM 12:00 PM EOD

FCM pays FCM calls FCM End user FCM End user VM w/ for IM pays IM remits posts trades own and VM w/ FCM margin securities funds

End user FCM sends settles VM in customer securities and cash and IM w/ takes back FCM settles the customer margin IM and VM in advance of receiving securities FCM cash from end user customer

The times shown are meant to be indicative of clearing schedules and are not necessarily accurate.

4 The deadlines and operational flows of margin and collateral Acceptable margin collateral a customer may use to satisfy are not calibrated across the settlement lifecycle. FCMs and initial margin is determined by the FCM. The FCM may set settlement operate to bridge the gaps between a CCP standards that differ from what is allowable under exchange margin action and end user response. Initial and variation and CCP rules. Exchange rules set out the range of initial margin is generally settled twice daily between clearing margin collateral that FCMs may accept from customers. CCP members and CCPs. The previous day’s activity is settled first rules dictate the types of margin collateral acceptable from thing in the morning. Intra-day variation margin is settled within clearing member FCMs. an hour of notification from the CCP. FCMs normally issue customers margin calls, based on the previous days activity Some FCMs strongly encourage customers to cash just once per day. Customer margin payments and collects are instead of securities for initial margin. A consequence of typically completed by the end of the business day on which regulatory reform is the application of Basel III rules the call is made. Because of the timing differences, FCMs on bank-owned FCMs. By holding cash and passing on the often use their own funds to settle CCP margin requirements interest received from deposits, FCMs may be able to lessen and later replace them with client funds. Intraday margin calls the capital charges constraining the amount of business they are subject to similar time lags, with FCMs paying with their are willing to clear. own capital on day one, and conversely holding variation credits until the next day. Settlement Banks

Further complicating the process, CCPs require that early A critical but not well-known role in CCP clearing is played morning end-of-day margin calls are to be settled in cash. by settlement banks. Settlement banks provide the market Clearing members may then substitute securities later in liquidity and collateral servicing necessary to facilitate the the margin cycle. The securities deposited at the CCP may transfer and settlement of margin between clearing members be those of the FCM or those of the FCM’s clients who are and CCPs. FCMs generally hold end user assets at their carrying cleared positions at the CCP. settlement bank to make margin transfers more efficient.

A non-clearing FCM, or “carrying broker,” maintains its Clearing members are required to have a relationship with a customers’ positions with another FCM that is a clearing CCP-approved settlement bank. The settlement bank receives member. This relationship is mainly used to access markets and processes margin settlement instructions from CCPs on outside the FCM or end users home geography, or where behalf of FCM clearing members. These banks operate under having a direct clearing membership isn’t optimal. Many an arrangement that authorizes the CCP to transmit debit or end users maintain multiple FCM clearing relationships. It is credit advices for the accounts of clearing members for margin also typical to have more than one FCM providing execution due from or owed to the CCP. They also confirm margin call services giving trades up to the end users clearing FCM(s). payments to CCPs in advance of initiating the actual transfers.

Client assets and securities deposited with FCMs are subject to certain processes and controls that may affect an end Customer Assets Protection user’s collateral management strategy. Three points of note are; customer assets may be held at CCPs, FCMs may have When an end-user delivers assets to an FCM in support of different acceptable collateral requirements, and FCMs may listed derivatives and cleared swaps accounts, those assets have preferences between cash and securities as margin. become subject to comprehensive customer protection rules under the CFTC’s regulatory authority. Customer funds further Customer margin collateral, including cash and securities, posted by FCMs with CCPs and their depositories continue to deposited with an FCM may be used by the FCM to meet be subject to CFTC customer protection rules. the FCMs customer account margin requirements at the CCP. Margin assets on deposit with an FCM may be held at the FCM’s custodian or at the CCP’s custodian. Assets pledged to a CCP may be subject to processing steps, transfer requirements and timelines that affect returns and substitutions.

INVESTOR SERVICES 5 The CFTC’s segregation rules are a cornerstone of the agency’s Conclusion customer protection regime. Customer funds must be held in a customer segregated account in the name of the FCM and The adoption of central clearing of derivatives is central to the titled to clearly indicate that the assets belong to the FCM’s commitments to reform of the markets, strengthening the clients. These funds must be kept separate from the FCM’s financial system and reducing systemic risk. own funds, must not be used by the FCM for its own account, and are not subject to lien or set-off by the FCM or its creditors. Certain aspects of new regulations have made it more complex and costly for FCMs to provide clearing services. End users are Segregation rules for cleared swaps provide an additional finding access to clearing more difficult and costs are higher. layer of protection. Futures and options customer assets in The number of active FCMs in the US has declined in recent segregated accounts are subject to fellow-customer risk. Fellow years. Business is concentrated at the largest FCMs. The top customer risk is the risk that a large customer default causes a 10 FCMs as measured by customer funds held, as of January shortfall in the FCM’s customer segregated account resulting 2019, $246 billion in customer assets, or 84% of the total $292 in other customers funds being subject to a pro-rata loss billion in the system (CFTC selected financial data report). sharing. Cleared swaps are held under the “legally separated; operationally commingled” (LSOC) model. Under LSOC, one Cleared derivatives collateral management solutions that customer’s funds cannot be used to offset the shortfall caused look beyond posting at the FCM and consider the additional by another customer. influences collateral are more effective than those that do not. Most collateral management solutions address margin Rules mandating the deposit of initial margin for non-cleared challenges from a buy side, sell side, or CCP centric position. swaps are coming into effect for a number of end users over Market participants may do better by thinking about how their the next two years. It is important to note that non-cleared collateral management process can produce benefits across swaps initial margin is required to be held in a segregated the clearing ecosystem, while making them more attractive as account which is not to be confused with a CFTC Segregated clients, resulting in better access and lower costs. Account. Market participants that are in scope will be required to segregate acceptable margin at an independent third-party Solutions lie in bridging the operational, data, timing and custodian. process gaps between market participants. Settlement banks play an essential role in supporting the derivatives settlements FCMs may invest customer funds pursuant to CFTC customer across key market participants. End users, FCMs, and CCPs protection rules only in CFTC approved instruments. FCMs are use these custodial banks as -keepers of margin collateral responsible for any losses on investments of customer funds. and providers of commercial banking services. FCM customer funds investment options are: As markets continue to evolve, the connections between • US government participants will become more linked creating new collateral management options. • Municipal securities

• US agency obligations At BBH, our role as a global custodian, investor services provider, and derivatives settlement bank means we play a part in each • Bank certificates of deposit step in the derivatives settlement lifecycle. This gives us a unique vantage point and positions us work with all the key market • Commercial paper guaranteed by the US participants. • Corporate notes or bonds guaranteed by the US For more information about any of the topics discussed please • mutual funds contact your BBH relationship manager.

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