Fernando V. Cerezetti and Gerardo Ferrara
Post-crisis regulatory reforms have reshaped and increased the amount of clearing activity in the OTC derivatives market. An emerging issue is so-called “client porting” – i.e. how central counterparties (CCPs) can transfer positions from one clearing member (CM) to another in the aftermath of one member defaulting. In this post, we discuss possible ways to offer clients temporary access to clearing services following a CM default, which we believe could increase the likelihood of successfully porting clients and avoiding further pressure on prices and market stability.
The introduction of central clearing mandates has driven a large volume of derivative contracts that were previously held bilaterally into central counterparties, bringing new clients within the scope of the clearing system. At the same time, CMs and CCPs have been called upon to enhance protections for clients’ derivative positions and the collateral assets supporting them (see EMIR 2012 Art.39 and Art.48 for an example of these rules in the European Union). Record keeping and account structures have therefore been amended to achieve the appropriate level of segregation for positions and assets of CMs and clients. Porting procedures to transfer performing client accounts from a defaulting clearing member to a non-defaulting one have been revised with the aim of supporting the continuation of clearing activities.
In the midst of these changes, however, challenges to successful porting remain. For instance, it has been argued that, because of the new leverage ratio requirements, CMs would be reluctant to accept client accounts during the porting process, as this could trigger additional capital charges. Due to the complexities surrounding this issue, discussions to assuage potential distortions are still in progress. Additionally, a recent Staff Working Paper shows that there might be fewer CMs available for porting, given the new emerging clearing landscape and service offerings. For instance, last year, Deutsche Bank announced the closure of its US swap clearing service, joining Nomura, State Street, BNY Mellon, and Royal Bank of Scotland in retreating from the business. The monthly CFTC survey on Futures Commission Merchants has revealed a tendency towards a concentration of trades in a few clearing members.
CCP porting under stress
Following the declaration of a default, services provided to/by a defaulting CM are disrupted. Usually, trading and trade registration are suspended, collateral withdrawal becomes restricted, and standard settlement functions are impaired. Under these circumstances, clients lose their ability to fulfil financial obligations and are rarely able to continue to clear. At this stage, surviving clients would ideally be ported to non-defaulting members, but if this was impractical, their portfolios would be liquidated by the CCP, together with that of the defaulting CM.
From the operational point of view of a CCP, porting can be considered a regular and straightforward process, where positions and collateral are transferred from one account to another. In reality, however, we believe that a number of difficulties still exist. Ultimately, one of the major challenges lies in finding a CM to accept the client accounts of a defaulting member. Although CCPs may request that clients appoint backup clearing members, the cost of such arrangements and information asymmetry imply that in many contractual provisions there is simply no legal enforcement for the appointed member to compulsorily accept the new client accounts. Indeed, in a default scenario, the backup member may also be under distress, if not in default.
To make things more complex, the nature of these challenges differs according to the particular type of client account to be ported (Figure 1). For instance, if accounts are individually segregated (Figure 1.a) then the positions and collateral of each client can more easily be determined, and porting can occur if the backup clearing member accepts. However, for omnibus accounts, additional margin calls may arise, depending on whether positions are collateralised on a net basis across client accounts (Figure 1.b) or on a gross basis (Figure 1.c).
Figure 1: Account segregation
Conscious of the risks and of the downstream systemic implications to price and market stability, regulators have increasingly sought to ensure that CCPs contemplate the scenario of a failed porting process. In its supplementary guidance on CCP resilience, CPMI-IOSCO (2017, pages 21-22) proposes that CCPs’ stress testing scenarios assume that client portfolios cannot be ported. Similarly, the Bank of England included porting as a test case in the 2017 multi-CCP fire-drill (BOE 2017, page 21). CCPs have also developed their own strategies to address these challenges, typically enhancing testing, internal procedures and understanding of CMs’ on-boarding mechanisms for new clients (CPMI-IOSCO 2016, pages 37-38). Nonetheless, we think that more could still be done.
CCPs’ internal experiences
In some jurisdictions CCPs operate under banking licences (also known as bank-CCPs), while in others CCPs have affiliated banks within the same corporate structure. In either context the ‘banking’ framework typically allows CCPs to perform some types of financial transactions, such as settling in central or commercial bank money. However, these financial services are not always restricted to the cases above and, in other jurisdictions, even non-bank-CCPs may perform some of them – in the UK and Australia, for instance, LCH Ltd, ICE Clear Europe, LME Clear and ASX Clearing Corporation are examples of CCPs in this latter category.
Within the jurisdictions allowing CCP-affiliated banks, one example is [B]3 formerly (BM&FBovespa), a central counterparty based in Brazil. The CCP is supported by a fully owned bank, which offers, among other services, financial settlement, custody, and liquidity. Differently from traditional banks, the CCP’s bank is not allowed to provide credit or to act as an investment counterparty. The objective of the bank, in regard to its clients, is solely to provide alternative means to access the CCP, focusing on cost reduction and, most importantly, risk mitigation for participants not willing to run the credit risk of clearing members.
We believe that although designed to provide financial services under normal conditions, the CCP’s bank can act as an important mechanism for managing a default. When a CM becomes insolvent, it will most likely lose access to the concentration bank, either due to its own limited operational capabilities or because no bank is willing to provide the needed settlement service. Under these circumstances, the CCP’s bank can replace the impaired function, operating settlement accounts on behalf of the defaulting clearing member. These mechanisms would enable the continuation of the settlement process until the defaulter’s portfolio is closed out and clients are ported to other clearing members.
Eurex Clearing AG, LCH SA, and European Commodity Clearing AG are examples of bank-CCPs in the EU. These CCPs could, in theory, also temporarily process financial obligations on behalf of the defaulting member’s clients. Importantly, under the bank-CCP regulation, no impact should be expected in terms of capital requirements, as these mechanisms would neither alter the scope of the CCPs’ activities nor change the fact that counterparty credit risk is mitigated mainly with collateral – i.e., clients of a defaulting member would still be expected to collateralise their risk exposures. Likewise, exemptions from leverage ratio and net stable funding requirements would still hold, as no maturity transformation would be performed (see EBA and ESMA joint publication on the rules for bank-CCPs, ESAS-2017-82).
In summary, the CCPs’ capacity to settle on behalf of a failing clearing member could offer a temporary bridge to allow clients to continue accessing clearing services under adverse market conditions triggered by a default. Not only would this framework enable clients to secure the management of their own risks (e.g., maintaining their hedging strategies), but it would also avoid creating further pressure on the market due to the closeout of client accounts following a failed porting. Once shocks dissipate, clients could then be transferred in an orderly fashion to surviving clearing members or wound down if they (not the CCP) deem appropriate.
In our view, these mechanisms should also alleviate pressure arising from tight porting windows, giving members extra time to perform on-boarding procedures. However, the existence of such settlement arrangements should not be seen as a definitive solution for the challenges faced by client porting. Not only should clients continue designing contingency plans for a CM default, but authorities might also reappraise the value of CCPs providing this form of service.
Gerardo Ferrara works in the Bank’s Capital Markets Division. This post was written whilst Fernando V. Cerezetti was in the Bank’s Risk, Research and CCP Policy Division.
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