The Cleared Derivatives Ecosystem A Different Approach to Your Collateral 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. Market participants are focusing on fine tuning their responses and considering alternative approaches to managing collateral and funding costs. Understanding how margin is deployed and used across the clearing 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 settlement 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 collateral management strategies. OTC swap 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 Clearing House End User End User Futures SettlementSettlement Bank 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 credit risk. 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 “default 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 money 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 cash 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 banks 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 deposit 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 leverage 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.