Clearing & CCPs
Clearing has many different meanings within the financial markets. In its broadest definition, clearing is a post-trade activity and aims to reduce risk. This often means using a central counterparty (CCP) to eliminate risks associated with the default of a trading counterparty.
In the OTC derivatives markets, ‘bilateral clearing’ means two parties to a trade make their own arrangements to reduce their exposure to each other’s default.
All clearing arrangements are designed to help market participants manage various risks – operational, counterparty, settlement, market, and legal – between trade execution and settlement.
CCP clearing means a CCP becomes the legal counterparty to each trading party, providing a guarantee that it will honour the terms of the original trade even if one of the parties defaults before the discharge of its obligations under the trade. This guarantee removes market risk, i.e. the exposure of the remaining party to adverse price movements if it had to replace the original trade at the prevailing market price.
The term clearing in financial markets has several other meanings, and its use may encompass several arrangements.
In many trading firms, clearing refers to the collective post-trade activities that ensure the firm meets its obligations to trading counterparties.
In organised markets such as stock exchanges, clearing could mean one or more of the following:
- The calculation of obligations between trading firms. Before CCPs were introduced, stock exchanges’ daily clearing process involved the tabulation of all buys and sells, advising trading firms of their obligations to each other so they could reconcile their records and prepare for settlement.
- A central delivery and receipt arrangement in which sellers deliver assets to a clearinghouse which then delivers them to the buyers. When share certificates had to be physically delivered, a clearinghouse was commonly used since it was more efficient and cost effective than each firm managing the process itself.
- Multilateral netting, whereby a party’s purchases and sales in the same asset with multiple trading parties are offset and reduced into one net amount. The net amount is delivered to or received from a clearinghouse (or electronic clearing account).
- CCP clearing, where trades are legally novated to a CCP. Most CCPs perform multilateral netting because it significantly reduces the value and number of obligations that require settlement, reduces operational risks and, combined with legal novation, reduces capital requirements.
A CCP is a corporate entity that provides a guarantee to both parties in a trade that if one party defaulted before the discharge of its obligations, the CCP would fulfil the financial obligations to the remaining party as agreed at the time of the trade. A CCP mitigates replacement cost risk or market risk – that is, the risk that the remaining party has to replace the trade at an unfavorable price.
The traditional description of a CCP as a ‘buyer to every seller and seller to every buyer’ is based on the practice of a single CCP clearing for a trading venue. A number of equities trading venues have appointed several CCPs to clear for them concurrently. The term ‘central’ counterparty remains unchanged but it can acquire a new meaning – if a trading firm is able to concentrate all its equities transactions to be cleared by a CCP of its choice, then that CCP is the firm’s “central” counterparty.
A CCP centralises counterparty risk management and ensures a safe and controlled post-trade process.
A CCP adds value when there is counterparty risk i.e. the possibility that a trading party could become unable to fulfil its obligations, and when there is market risk i.e. the possibility that the price may have moved unfavourably if a trade has to be replaced after a trading party’s default.
A CCP can, through multilateral netting, introduce operational efficiency by reducing the number of transactions to be settled and capital efficiency by reducing the value of obligations to be settled.
The use of a CCP ensures a safe and controlled post-trade process. In markets where an electronic order book matches buyers and sellers, the use of a CCP gives trading firms the assurance that they are protected regardless of which counterparty the electronic trading system matched them with. A CCP also preserves the anonymity of the trading parties vis-à-vis each other.
The CCP ensures that it can meet its obligations by collecting sufficient collateral from each trading party to be used to cover any losses incurred if the collateral-giving party defaulted and the CCP had to replace the trade at the prevailing market price. The CCP calculates collateral requirements based on each member’s exposures and open obligations.
A CCP centralises counterparty risk management. It protects all customers through contract; a CCP’s rulebook defines legally binding obligations and rights over all customers, and the procedures when there is a customer default. The customers of a CCP are usually referred to as participants or members to reflect the rule-based nature of the CCP service. In many jurisdictions, there is specific legislation that ensures a CCP can exercise its rights in order to give legal certainty to the centralised risk management.
A side benefit derived from CCPs is the facilitation of multilateral netting, whereby numerous sales and purchases of the same asset by the same party are netted down into a single obligation to settle against the CCP, instead of many obligations to settle against many different trading parties. CCPs thus help to increase liquidity in a market. In markets where settlement costs are high, market participants could consider the cost and operational benefits of multilateral netting to be one of the main values of a CCP.
Many equity markets introduced CCPs when they went from floor trading to electronic trading, where the system matches orders and each firm lost the ability to choose the party it transacts with. A CCP centrally manages counterparty default risk and gives firms more confidence to trade.
Equity markets that do not have a CCP might have alternative arrangements that deliver many of the same benefits. Markets might also view the benefits of using a CCP as insufficient to justify the cost of implementation, especially markets that are relatively small.
Equity trading venues such as exchanges and multilateral trading facilities are typically required by their regulators to organise orderly post-trade processes for firms to complete their obligations arising from the trade. Trading venues decide whether or not executed trades should go through a CCP, and if so, which CCP.
In general, equities are typical of assets that can be safely cleared: they are standardised and regularly traded, with readily available current prices and liquidity. An equity trading venue may base its decision on whether to use a CCP on factors such as implementation cost, revenue opportunity, and its competitiveness with other trading venues that have a CCP.
An equity market without a CCP can shield trading firms from replacement cost risk in different ways. For example, it may impose a centrally administered levy on trading firms which grows over time into a pool of money that the market can use to cover replacement costs when a counterparty defaults. Another alternative to a CCP may involve each firm giving to the trading venue an amount of collateral that is proportionate to its open obligations on all trades and that would be used to compensate its trading counterparts if it defaulted.
An equity market that does not have a CCP can still centrally organise multilateral netting to reduce the number of settlements, which increases liquidity and reduces operational risk.
Euronext – a shareholder of EuroCCP
EuroCCP is the leading cash equities CCP in Europe, providing safe and efficient clearing services for 16 trading platforms. Euronext was pleased to invest in shared post-trade infrastructure with other exchanges and has become an equal shareholder in EuroCCP. This will allow it to influence the provision of clearing services and EuroCCP’s strategic direction.
Yes, all shareholders have equal rights in the company.
LCH SA will continue to clear for Euronext, for those members that wish to do so.
Euronext envisages a continued extension of “user choice” which will provide access to multiple CCPs in the future.
Euronext is fully supportive of competition in cash equities clearing and, as stated at the Investor Day in May 2016, intends to implement full interoperability when it is technically feasible, meeting all relevant regulatory approvals. In the meantime, Euronext will continue to implement the User Choice model, which is independent to any potential acquisition.
EuroCCP leads by volume of transactions cleared – it cleared 58% of trades on platforms where it competes with other interoperating CCPs and 42% of all CCP-cleared trades in Europe, as at Q1 2016. It has also a successful track record, being the first pan-European CCP and the first equities CCP to be authorised under EMIR. It is the only CCP to have been nominated in equities clearing for the Financial News’ “Clearing House of the Year” award over the last 3 years and won the “Clearing House of the year” award in 2016, for the fourth time.
EuroCCP is the clearer of choice for many firms. It is the market leader by volume of transactions cleared – 58% of trades on those platforms where it competes with other interoperating CCPs. It is at the forefront of advocating for greater competition in equities clearing through extended access and interoperability, for the benefit of all market participants.
In addition, EuroCCP is committed to providing its clients with the most efficient access to local markets, which improves settlement efficiency and reduces costs. EuroCCP settles directly in 15 of the 19 markets it services, including France, Holland, Belgium and Portugal. This unique operations model among equities CCPs, allows EuroCCP’s clients to benefit from the efficiency-enhancing functionalities offered to CCPs by T2S.