OCCASIONAL PAPER SERIES EUROPEAN CENTRAL BANK ECB EZB EKT BCE EKP September 2002 • No. 5 THE EVOLUTION OF CLEARING AND CENTRAL COUNTERPARTY SERVICES FOR EXCHANGE- TRADED DERIVATIVES IN THE UNITED STATES AND EUROPE: A COMPARISON BY DANIELA RUSSO, TERRY L. HART AND ANDREAS SCHÖNENBERGER September 2002 OCCASIONAL PAPER SERIES No. PAPER OCCASIONAL 5 OCCASIONAL PAPER SERIES ECB EZB EKT BCE EKP No. 5 THE EVOLUTION OF CLEARING AND CENTRAL COUNTERPARTY SERVICES FOR EXCHANGE- TRADED DERIVATIVES IN THE UNITED STATES AND EUROPE: A COMPARISON BY DANIELA RUSSO, TERRY L. HART AND ANDREAS SCHÖNENBERGER September 2002 * Daniela Russo is the Head of the Securities Settlement Policy Division of the European Central Bank (ECB). Andreas Schönenberger is a Policy Expert in the Securities Settlement Policy Division of the ECB. Terry L. Hart is a Project Analyst in the International Organisation of Securities Commissions. The authors wish to thank Victoria Cleland of the Bank of England and Francesco Papadia, Ignacio Terol, and an anonymous referee of the ECB for their comments on this Occasional Paper. Andrea M. Corcoran, Director of the Office of International Affairs of the United States Commodity Futures Trading Commission, also consulted on this document. The views expressed therein are solely those of the authors and do not represent the views of the ECB, the United States Commodity Futures Trading Commission, the International Organisation of Securities Commissions, or any of their respective offices or divisions. ©2002, European Central Bank. All rights reserved. © European Central Bank, 2002 Address Kaiserstrasse 29 D-60311 Frankfurt am Main Germany Postal address Postfach 16 03 19 D-60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d All rights reserved. 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ISSN 1607-1484 Table of contents Executive summary 5 1Introduction 7 2 The organisation of derivatives trading in Europe and the United States 9 2.1 The organisation of derivatives exchanges in Europe 9 2.2 The organisation of derivatives exchanges in the United States 10 2.3 Comparison of the factors influencing the organisation of derivatives markets in the United States and Europe 11 3 The organisation of derivatives clearing in the United States and the European Union 12 3.1 General aspects of clearing houses 12 3.2 Sources of risk and risk management procedures of clearing houses 14 3.2.1 Defaults of clearing members 14 3.2.2 Settlement bank failures 16 3.2.3 Other risks to which the derivatives clearing houses may be exposed 17 3.3 A comparison of the organisation of clearing in the United States and in Europe 18 4 Operational developments in international risk management practices/arrangements 20 4.1 Acceptance of non-domestic currency or non-domestic securities 20 4.2 Acceptance of margin at a non-domestic bank or other intermediary 21 4.3 Clearing in another jurisdiction 23 4.4 Mutual offsetting arrangements 24 4.5 Cross-margining arrangements 25 4.6 Comparative overview of international risk management practices/arrangements in the United States and in Europe 28 5 Consolidation in the financial market infrastructure 29 5.1 Vertical and horizontal structural consolidation in Europe 31 5.1.1 Examples of consolidation in Europe 31 5.1.2 Factors underlying the consolidation process in Europe 32 5.2 Vertical and horizontal structural consolidation in the United States 32 5.2.1 Examples of consolidation in the United States 32 5.2.2 Factors underlying the maintenance of multiple clearing houses in the United States 33 5.3 Comparative overview of structural consolidation in the United States and in Europe 36 ECB • Occasional Paper Series No. 4 • September 2002 3 6 Issues for central banks and regulators 37 6.1 Risks and regulatory challenges relating to cross-border clearing activities 37 6.1.1 Contracts denominated in non-domestic currencies 37 6.1.2 Collateral issued in a non-domestic jurisdiction and held in a non-domestic central securities depository 38 6.1.3 Non-domestic participants 38 6.2 Risks and regulatory challenges relating to structural consolidation 39 6.3 Consequences of the US and EU regulatory schemes for financial services with respect to clearing 41 7 Conclusions 45 Annex 1 – The Eurosystem’s policy line with regard to consolidation in central counterparty clearing 47 Annex 2 – List of US derivatives clearing houses 50 Annex 3 – List of EU derivatives clearing houses 51 Annex 4 – General background information – EU clearing houses 52 Annex 5 – Risk management – EU clearing houses 53 Annex 6 – General background information – US clearing houses 55 Annex 7 – Risk management – US clearing houses 57 Glossary 59 European Central Bank Occasional Paper Series 62 4 ECB • Occasional Paper Series No. 5 • September 2002 Executive summary Practices and procedures regarding clearing current developments. On the one hand, and central counterparty services provided consolidation helps increase the efficiency by derivatives clearing houses in the United of the clearing and settlement process. On States and the European Union are the other hand, the potential systemic currently undergoing a process of evolution. consequences of a central counterparty’s Developments in technology and electronic failure increase with its size. commerce, advances in the design and use of derivative products, progress in financial risk Developments in clearing present numerous management techniques related to derivatives challenges to central banks and derivatives exposures and an increase in the volume of regulators. Central banks have an interest in cross-border trading in securities and clearing houses and the payment and derivatives have prompted some market settlement systems through which derivatives participants to advocate the development contracts are cleared and settled, given the of clearing arrangements and central potential impact a major disruption may have counterparty services on an international, i.e. on two of their key responsibilities, namely the cross-border, basis. The development of these smooth implementation of monetary policy services aims at permitting as efficient a use of and the smooth functioning of payment capital as possible on a global or international systems.1 In addition to these systemic basis, while – at the same time – maintaining implications, derivatives regulators are the financial soundness of existing clearing concerned with the potential non-systemic arrangements. The most significant trends fall impact of a significant failure within the into two categories: on the one hand, clearing and settlement infrastructure on the developments in operational arrangements financial condition of individual regulated firms between clearing houses, in particular at a and on the protection of individual customers cross-border level, and, on the other, using and holding derivatives positions through horizontal and vertical structural consolidation the clearing and settlement infrastructure. in the clearing and settlement infrastructure. When assessing the implications of these In general, trends in the development of recent developments, it is interesting to derivatives clearing reflect efforts to permit compare the existing organisation of domestic direct access to the clearing house clearing arrangements in the United States and electronically, without requiring their physical the European Union, and to analyse both the presence in the clearing house’s jurisdiction similarities and dissimilarities in their or, alternatively, efforts by the clearing house development. The similarities reflect a variety to extend its operations beyond a single of factors. The development of electronic market through cross margining or their technology and electronic communications arrangements. Exchange-traded derivatives capabilities that potentially permit 24-hour markets have always attracted a certain level trading internationally and the development of international participation. From a business and international acceptance of common risk perspective, trends in the development of management models and related computer derivatives clearing reflect innovations in the software for derivatives and cash market manner in which international traders gain products have led to an increase in cross- access to the markets and their associated border trading activity. This, in turn, has led to clearing systems. These innovations are an increased demand by international investors calculated to reduce the costs of trading on for maximum cost efficiency in clearing the markets and to attract an increased level arrangements and for maximum efficiency in of international trading. 1 In a press release of 27 September 2001, the ECB provided a The ongoing consolidation process in the field comprehensive note which explains the Eurosystem’s policy approach with regard to consolidation in central counterparty of clearing and settlement adds an additional clearing within the euro area. Moreover, in August 2001, the element of complexity to the analysis of ECB published an article on this topic in its Monthly Bulletin. ECB • Occasional Paper Series No. 5 • September 2002 5 the use of capital in the acquisition and interest in perpetuating the existing business collateralisation of securities, derivatives, and and regulatory arrangements associated with other financial instruments. However, clearing and settlement. As a result,