The Q&A’s provided here offer an overview of the important issues related to clearing in Europe and how market participants can help shape the future. Together we can make a difference in clearing.
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.
Interoperability provides trading firms with the ability to select a CCP of their choice from a number of valid alternatives. To interoperate, CCPs establish arrangements with one another so that a user of one CCP can execute a trade with a counterparty that has chosen another. There are four equities CCP that interoperate with each other in the European equities markets. Two of these CCPs, EuroCCP and EMCF, have combined and the process of consolidation is expected to finish by 31st March 2014.
Interoperability is a simple concept: it requires competitors to cooperate in order to provide choice to consumers, while still competing on quality and price.
There are many examples of interoperability in everyday life. Everyone who carries an ATM card is a beneficiary of interoperability. Without interoperability among banks, consumers would only be able to withdraw cash at an ATM installed by their own bank. The same with mobile phones – without interoperability among telephone networks, consumers would only be able to call someone using the same network.
Trading venues and CCPs control the reality and speed of implementing interoperability, subject to regulatory approval.
All CCPs need to agree an inter-CCP risk management model that meets regulators’ requirements for interoperability to be safe and scalable. CCPs need access to the trade feeds of the venues they want to clear for. Once the legal agreements among trading venues and CCPs are finalised and approved by regulators, and the data transfer connectivity is built and fully tested between the CCPs, trading venues and users, interoperability can go live. With willing partners, this need not be a lengthy process.
Regulators of CCPs that currently interoperate have made it clear that there is no absolute regulatory barrier to interoperability.
The CCPs need to work together to reach agreement on the details of their interoperable risk management models and obtain approval from their respective regulators, who will jointly review the models and agreements to ensure that they meet regulatory objectives.
Participants will expect transparency on any changes to the CCPs’ risk management models and their impact (e.g. on the exposure of their participants), so it would be desirable if these were clearly communicated by each CCP to its participants, including consultation on rule changes where necessary.
Trading venues that are determined to offer trading firms effective competitive clearing should likewise ensure their incumbent CCPs move quickly to deliver on interoperability.
Users need to ensure trading venues open up their trade feeds to all interoperating CCPs. Without this, free choice is not possible since it would still be the trading venues that decide what choice is available to users.
Interoperability makes possible competition and choice in clearing. Efforts have been made by many firms active in cross-border trading in the European equity markets to encourage interoperability among CCPs. This is mainly because they believe interoperability will combat the high clearing costs which impede their ability to trade, and encourage innovation and improvements in service levels. For these firms, interoperability brings the benefits associated with competition and is therefore worthwhile.
However, the market share and profitability of some entities could erode if competition was allowed to flourish. This is particularly true of CCPs that do not interoperate and that have exclusive rights to clear the trades of a trading venue.
Many market participants believe that if they were given the ability to freely choose which CCP to use, the industry would consolidate. While no one can agree what is the right number of CCPs for Europe, most market participants agree that the current proliferation of CCPs that clear the same securities traded on multiple venues leads to higher costs and risks due to operational complexity and inefficient use of collateral. Interoperability allows competition on a level playing field and many market participants believe it would provide the necessary transitory phase to pave the way for CCP consolidation.
One of the reasons more widespread interoperability seems difficult is that it has to be implemented by trading venues and CCPs, and there is no consensus among them that interoperability is beneficial to their business.
Interoperability among equity CCPs introduces competition in clearing, serves to lower costs to users, encourages innovation, and makes the European equity markets more globally competitive. If firms can reduce the frictional cost of clearing through full interoperability allowing them to choose their CCP, they can be expected to trade more, resulting in a more liquid securities market for the benefit of issuers and investors.
In Europe, trading venues select different CCPs based on their own valid economic interests. Users are obliged to use different CCPs appointed by the venues, adding to costs and risks of post-trade activities.
Full interoperability in Europe will create a virtual single CCP environment with low frictional costs. Full interoperability means firms can choose a preferred CCP, if they wish, to clear all their trades regardless of where they trade, even though there are many CCPs in Europe.
Partial or patchy interoperability will result in firms still being required to connect to multiple CCPs that have been pre-selected by trading venues and their incumbent CCP(s).
Full interoperability allows a firm to choose freely to clear its trades through the CCP of its own choice, rather than be limited to the choice made available by the trading venue and the incumbent CCP(s). Firms desire a choice because their business interests may be different from those of the trading venue and the incumbent CCP(s).
Competition typically delivers lower prices and better services to users. Many market participants believe that there are too many CCPs in Europe and interoperability among CCPs is a necessary phase to arrive at consolidation to fewer CCPs.
Full interoperability which delivers free choice to trading firms means that, if they wish, they could consolidate clearing with a CCP of their choice to achieve economies of scale and efficiency gains. Firms which concentrate with one CCP the clearing of trades executed on multiple venues benefit from:
- Risk management expertise and robustness of their preferred CCP, ensuring that they do have the protection they think they have;
- One CCP relationship to manage, saving time on service monitoring and management;
- One CCP connection to manage, with lower back office costs and operational risks.
- Lower clearing fees, by concentrating business with one provider to qualify for the highest volume discounts;
- Lower settlement costs and operational risks, by reducing to one single settlement per stock per day, regardless of the number of trades or the number of venues on which it has traded;
- Lower funding costs and liquidity needs, both from lower margin requirements through netting and risk offsets within all open obligations, and from one single net settlement per security per day.
For a firm to have free choice, the venues on which it trades need to appoint its preferred CCP, and any other CCP that also clears for those venues needs to interoperate with the firm’s preferred CCP.
Some firms may still want to use multiple CCPs, and interoperability does not prevent that.
Interoperability between CCPs could be cooperative or competitive.
In a cooperative arrangement, one CCP serves as an intermediary for its existing users to access a market serviced by the other CCP, and over time there is little customer defection. Cooperative arrangements were typically put in place by trading venues to accommodate firms who prefer to use a CCP from their own jurisdiction and linguistic area.
The current interoperability arrangements in the equity markets are competitive in nature, whereby each CCP expects to be able to attract customers from the others.
When CCPs interoperate, each has obligations to fulfil towards the other CCPs. Each CCP is exposed to the potential inability of the other CCPs to fulfil their obligations, while being obliged to make good a trade to its own participants. The inter-CCP risks are the additional risks introduced by interoperability.
Regulators have issued risk management requirements that the interoperating CCPs must meet in order to mitigate these new risks.
Risks associated with interoperability arise from several areas:
- Some major components of a CCP's risk management measures are typically not applied to interoperating CCPs, who do not become participants of the other CCP. The measures not applicable may include minimum capital requirements and obligation to participate in loss sharing. Although they do not become participants, the nature of the exposure interoperating CCPs face is similar to that vis-à-vis participants: the inability of the other party to honour its obligations when due. This could happen if, for example, a CCP suffered massive losses from participant defaults and exhausted its available financial resources, which is a possibility in extremely stressful market conditions.
- One CCP’s default could cause financial distress to the other interoperating CCPs, if the remaining CCPs incur significant losses in closing out the obligations of the defaulter.
- Differences in a CCP’s rights and obligations towards its own participants versus interoperating CCPs could create additional exposure to a CCP. Such differences must be identified and appropriately managed.
- Lack of transparency in bilaterally negotiated and confidential inter-CCP risk management arrangements could result in additional but invisible risks. Four CCPs interoperating require six bilateral risk management agreements, only three of which will be visible to each CCP as a signatory.
The regulators of the equities CCPs that interoperate issued a list of requirements that the CCPs must fulfil in order to adequately manage these additional risks. The requirements include additional collateral in the system to cover the additional risks, and assurance that if a CCP defaulted any collateral it has received from the remaining CCPs is not trapped in its estate. Furthermore, the inter-CCP risk management arrangements must be scalable to increased business volumes, additional trading venues and additional CCPs joining the interoperating network.
The regulators’ requirements were very helpful to progress interoperability and have encouraged CCPs to work collectively on a uniform and transparent risk management approach.
When firms are able to choose CCPs, the two parties to a trade might have selected different CCPs. The two CCPs therefore has obligations vis-à-vis each other, and therefore the risk that the other defaults on its obligations. Interoperability between CCPs is a set of legal and operational arrangements that ensure each CCP is protected from the default of the other and remains able to meet its obligations to its own customer. This assurance could be achieved, for example, through exchange of collateral between the two CCPs.
An interoperability arrangement between CCPs is sometimes called a ‘link’. The rights, obligations and recourse of the two CCPs are defined in an interoperability agreement or link agreement.
How the CCPs manage their exposure to each other’s default is at the heart of an interoperability agreement. The agreement typically also includes operational, connectivity, change management, and business continuity provisions, and any other item which requires coordination when CCPs jointly clear for the same trading venue.
A central counterparty relies mainly on having sufficient collateral from a clearing participant to cover any losses it might incur if that clearing participant defaulted under normal market conditions. The CCP needs to have access to additional resources if the collateral of the clearing participant is insufficient to cover losses under stress conditions.
The CCP must therefore ensure that its clearing participants are financially sound and are able to provide the collateral when due, calculate accurately collateral that would be needed if it had to replace the trades of a defaulted user at a loss, and have collected the collateral in time, i.e. before the customer defaults
Banks use their own capital to take credit risk and are remunerated on the amount of exposure they assume through credit extension. They also trade on a proprietary basis and take market risk. CCPs typically do not put their own capital at risk, do not extend credit and do not trade.
A CCP uses the collateral collected from each party to fill any losses it might incur in closing out the collateral-giving party’s obligations if that party defaulted. It follows that if a CCP suffered a loss, it would be due to insufficient collateral calculation and / or collection, which is an operational risk and not a risk resulting from credit extension.
A CCP centralises counterparty credit assessment and collateral management. In the event of a market participant’s default, a CCP reduces uncertainty and eliminates the need for action by multiple parties because it acts centrally via a pre-defined, legally enforceable process and structure to close out open positions and uses the failed party’s collateral.
To accomplish an equivalent level of risk mitigation, a market participant on its own would need to:
- Assess the credit quality of each firm it trades with – difficult to achieve in an electronic execution environment;
- Go through an intermediary (with additional costs and risks) if it desired anonymity to protect its investment strategy;
- Ensure legally enforceable bilateral netting through novation (if used);
- Bilaterally settle with multiple counterparties with the associated operational risks;
- Calculate and exchange sufficient (and significantly more) collateral with each trading party to guard against replacement cost risk;
- Ensure its rights to use the collateral received from the other parties (who may reside in different jurisdictions) are legally enforceable in the event of the other’s bankruptcy;
- Retrieve from the administrators the collateral that it has posted to the bankrupt party.
Moreover, a market participant on its own would not benefit from multilateral netting, which reduces liquidity risk and capital requirements through lower values of net obligations to be settled, and reduces operational costs from fewer bilateral settlements.
How are CCPs different from inter-dealer brokers?
There are some financial institutions which have an operational workflow similar to a CCP, such as inter-dealer brokers. An inter-dealer broker stands in the middle of every trade executed to provide anonymity to the parties that trade. Each party relies on the inter-dealer broker to honour the obligations. But the similarity stops there. An inter-dealer broker typically does not collect collateral from its customers, and takes the risk that a customer might default. If so happens, it is left to honour the trade to the remaining customer and be exposed to market risk if the price has moved adversely in the meantime. Inter-dealer brokers settle trade-by-trade without the risk management and operational efficiency benefit of bilateral or multilateral netting.
How are CCPs different from “clearing banks”?
Certain banks offer a “clearing bank” service to trading firms, which is a form of post-trade, back office outsourcing and is not a central counterparty service. The clearing bank provides value-added services to the trading firm to ensure smooth settlement on the due date, such as lending securities when the customer fails to deliver, or advancing credit to the trading firm for securities purchased. These clearing bank value-added services involve risk taking and are typically not offered by a CCP
The terms margin and collateral are often used interchangeably.
Margin is the difference between the actual price of a trade at execution and guaranteed by the CCP, and the expected price if the CCP had to replace the trade after the default of the clearing participant.
Collateral is the asset provided by the clearing participant to the CCP that represents the margin amount. Forms of collateral commonly accepted by CCPs are cash and liquid securities denominated in major currencies.
While CCPs’ risk management mechanisms generally comprise of three layers - minimum membership requirements, margin, and additional resources - they place different emphasis on specific aspects of their risk management models.
For example, there could be significant differences in the methods CCPs use to calculate the margin they need, similar to people speaking different languages to communicate the same message. There is also wide divergence in the types and amounts of additional resources, and the order in which they are invoked.
A single CCP offers users the ultimate economies of scale and efficiency in settlement, collateral and capital costs. The usual drawbacks associated with a monopoly’s potential abuse of its dominant position could be mitigated through a non-profit business model and effective user governance.
Competition is desirable in a for-profit environment as a means to lower costs and improve services for users, and encourage innovation.
Full interoperability achieves the optimal combination of a virtual single CCP from each user’s perspective and the benefits of competition. Under full interoperability, users can choose to work with a single CCP selected from possible choices within a competitive environment.
Europe’s problem is that today there are multiple CCPs but limited competition, and different stakeholders have different ambitions. Trading venues’ business interests cause them to choose different CCPs, and incumbent CCPs uncertain of their ability to compete are reluctant to interoperate.
A single CCP achieves economies of scale and lowers the unit cost of production, with benefits accruing to shareholders or users, or both. Provided that the CCP’s governance ensures effective constraints to abuse of dominance, a single CCP could also be user-friendly.
From a risk management point of view, each CCP can perform well whether there are one or many CCPs. However, in the event of a default, separate CCPs might collectively suffer a bigger loss than if all the positions of the defaulter were in a single CCP with risks offset within a single portfolio of open positions.
A trading venue might have good reasons to prefer to give its trade feed to a single CCP. It might look to a CCP in which it has an economic interest as a source of revenue, or prefer the simplicity of a single CCP relationship. It could also refuse access to a competitor’s CCP in order to protect its own business.
Alternatively, a trading venue might choose competitive clearing, for example if it anticipates this could increase its trading volumes, more than offsetting any lost revenues or additional costs. A venue could also introduce competitive clearing in order to prevent a loss in market share to venues that have more attractive clearing arrangements.
From a user’s perspective, there are strong reasons why CCP competition is desirable. Some want to be able to choose the CCP that best fits their business model. Others want to be able to consolidate clearing with fewer CCPs (or one CCP) to gain operational efficiencies, to consolidate risk management and reduce capital requirements. Many users believe that competition is necessary to bring and keep costs down, increase responsiveness, and generally improve service quality.
Even though many users favour competition, there are some who believe that Europe needs a single, pan-European CCP that is user-owned, user-governed, and operated at cost. The challenge is how to implement this vision when there are many CCPs in Europe with a wide variety of ownership and governance structures.
All users are exposed to their CCP's ability to manage risks properly. A CCP's track record and competence in risk management should be the most important factor in a user's choice. Cost savings could be illusory if the CCP is not sufficiently robust to provide adequate protection when markets are stressed.
Other factors users should consider are: legal certainty of protection, operational and technical reliability, capacity, service quality, approach to user governance, business reciprocity, pricing and value for money. Different users will give different weightings to each selection factor, and their preference may change over time.
A CCP's primary function is to guarantee that obligations on a trade will be honored regardless of what happens to the original counterparty. A user needs confidence that the CCP has robust risk management practices, a depth of experience and know-how, and a proven track record in successfully handling defaults without recourse to loss sharing.
A CCP's competence in risk management is critical - users do not want suddenly to discover they do not have the protection they thought they had. If insolvent, a CCP could no longer honour its guarantee on trades that have not yet settled. All CCPs have some form of loss sharing among customers (often via a central guarantee or default fund), which is invoked if a default results in losses that exceed the collateral collected from the defaulter plus other available resources. Even though some CCPs may be considered too important to fail, government bail-out is likely to occur only after all users' funds available for loss sharing have been exhausted.
Exposure to loss sharing gives user governance high value. As central risk manager, a CCP should inform and consult with users on matters that substantively affect the risks in the system. As potential loss-sharers, the users need to have influence over how risk mutualisation is achieved and what risk levels are acceptable. Users should pay attention to the level of risk the CCP is taking and what influence they have as paying customers over these decisions.
In addition, as a critical market infrastructure a CCP should have robust systems and processes; a good track record in delivering service implementations and enhancements on time, to specification and without defects; and have scalable capacity to handle surges in volumes. As a service provider it should be flexible and responsive to customer needs, but it should do so without compromising safety.
Value for money and pricing are also key considerations. Some users choose CCPs primarily on visible costs, including the level of clearing fees and the amount of collateral required. Less visible costs include penalty fees on settlement fails and spread retained by the CCP on cash collateral.
Firms that trade on many venues are at present still not able to choose a CCP at all, or not offered the choice of CCP they prefer to use. They are obliged by a venue's rules to use the CCP(s) it has appointed.
Many users are demanding choice beyond the CCPs that are owned and/or pre-selected by the venues. Choice for users requires trading venues to give more CCPs access to their trade feeds, and for the incumbent CCP to interoperate with additional ones.
The governance of the trading venue determines the amount of influence users have in the introduction and appointment of CCPs.
A number of trading venues use CCPs that they own, in a so-called ‘vertical silo’ business model where trading and clearing revenues are captured by the same company.
Some trading venues appoint unaffiliated CCPs guided by their own business interests, such as coverage of the asset class(es) traded on the venue, possibility to participate in the CCP’s governance, time to market, reciprocal business incentives offered by the CCP, the influence of the CCP over their competitiveness with other trading venues, demand from trading firms, and competence of the CCP in risk management.
Governance of the CCPs – where power resides to make decisions and how decisions are made – critically affects their behavior. Governance can be influenced by ownership. There are also other important drivers of a CCP’s behavior and these may change over time, such as the CCP’s competitive position in a market, the perceived opportunities and threats to its business, and its leadership.
The role of CCPs as central risk managers for the financial markets means their governance is not only a commercial matter but is also important from a regulatory and public policy perspective.
CCP ownership falls into broad categories of:
- Under the same ownership as an exchange, in a so-called ‘vertical’ model: CC&G, SIX x-clear, Eurex
- User- and exchange-owned: LCH.Clearnet Ltd., LCH.Clearnet SA, EuroCCP
- Exchange- and central bank-owned: CCP.A.
Ownership and governance, like clearing and settlement, are often said in the same breath but are separate issues. For example, user ownership does not necessarily mean user governance, and vice-versa.
‘User-owned’ infrastructures come in several varieties. User ownership can be proportional to usage, which aligns the financial interests of the users with the CCP. User ownership can mean all shareholders are users but their holdings are not proportional to usage: i.e. there could be users with a keener interest in the profitability of the company. User ownership can also be used by user- and exchange-owned CCPs to describe themselves, counting trading venue owners as well as trading firms as users.
‘User governed’ is a term which in its tightest definition means the management is ultimately accountable to a board of directors comprised of users. Loosely applied, user governed could mean no more than the existence of user advisory committees without real power of decision.
What concerns CCP users most is the extent to which they have the ability to influence CCP decisions that affect their welfare – such as changes in the CCP’s risk profile affecting their potential financial exposure in the event of default of one or more participants.
What concerns trading venues most is the extent to which they have the ability to influence decisions of the CCP that affect their business – such as introduction of new services and changes that could impact the CCP’s ability to continue servicing the venue to the standard required.
Securities transactions in organised equities markets typically involve three sequential and distinct steps: trade execution, clearing and settlement. Clearing and settlement are both ‘post-trade’ activities; they are different although often used in a single phrase.
Clearing is a risk management process. In the most common current usage, it means the use of a CCP to eliminate market risk for trading firms.
Settlement is an obligation fulfillment process. In the securities market, settlement is complete when securities are delivered by the seller and payment is made by the buyer.
Several well-known central securities depositories have the word ’clear’ in their names, although they perform settlement and not central counterparty clearing: for example, Clearstream, Euroclear, and Iberclear. Euroclear was the first international central securities depository (ICSD) established in the 1960s, before the introduction of CCPs, when the term clearing was generally used (as it sometimes is now) by trading firms to describe the collective post-trade activities that ensure they meet their obligations to trading counterparties.
Equity CCPs have three main revenue streams: clearing fees, penalty fees on late settlement, and net interest earnings on collateral supplied by users. The latest publicly available figures show that equity CCPs typically derive about 80% of revenues from fees and 20% from net interest earnings.
CCPs that clear fixed income and derivative instruments have a significantly higher portion of revenues, over 40%, from net interest earnings because of the much higher amount of collateral supplied by users for these asset classes.
Users are particularly keen that penalty fees should not be used as a source of profit, but should be recycled back into service improvements. Most CCPs provide assurances that penalties are not set at levels that will increase profitability, although the figures are generally not available in published financial statements.
At present the pricing of most equity CCPs in Europe is more typical of a transaction processing service with unit fees than a risk-taking service with ad-valorem fees. Generally, equity CCPs charge a fee per trade guaranteed irrespective of the value of the trade.
CCP users incur several costs which could be less visible: funding costs associated with securities collateral provided to a CCP, opportunity costs of cash collateral (for-profit CCPs take a spread on the cash), and penalty fees for late settlement over which users have no effective control but which could be a quite substantial amount.
There is a wide variety of CCP pricing models in Europe, such as:
- ‘Free’, as CCP services are bundled with an exchange’s trading fees;
- Flat fee per trade;
- Flat fee per trade plus a penalty for failed settlement;
- Flat fee per trade plus an ad-valorem fee;
- Flat fee per order;
- Flat fee plus a fee payable to a central depository that carries out part of the clearing function;
- Flat fee per trade plus a fee per security cleared plus an ad-valorem fee on the net open position after netting weighted by the credit rating of the user;
- Ad-valorem fee with floor and cap.
It may seem counter-intuitive that a CCP charges a flat fee per trade regardless of the value of the guarantee extended. A CCP’s pricing model is a business decision and partly determined by competitive practice. A user, on the other hand, does incur costs relative to the value of the guarantee it receives, in the form of funding costs for the amount of collateral required by the CCP which is proportional to the exposure it creates for the CCP.
CCPs’ fee schedules are posted on their websites and some provide fee calculators for different types of users and / or usage levels. Because there is a large variety of pricing, discount and rebate models, fee schedule transparency does not equal fee level comparability.
Financial institutions that must account for SDRT, e.g. market participants such as brokers that undertake transactions which fall within the scope of SDRT and whose transactions are aggregated or netted off before settlement in CREST.
In the first phase, the tax authorities require the assessment and reporting of all gross trades cleared by CCPs. Thereafter, the second phase will include OTC activity.
A CCP which has access to the gross trade information is ideally placed to act as a Stamp Data Provider to EUI on behalf of its participants.
Clearing Participants should flag EuroCCP as Stamp Data Provider via the CREST GUI.
Thereafter, EuroCCP will report the Clearing Participant’s gross trade data to EUI as a Stamp Assessed Trade (SAT) file.
As the Stamp Assessor and Collector on behalf of the UK and Irish Tax Authorities, EUI will reconcile the Gross Trade Data provided by EuroCCP with the net settlement and undertake stamp assessment and collection where applicable.
Should the reconciliation fail at EUI, any breaks will be reported to affected Participants via the CREST GUI. Should the break remain outstanding by the intended settlement date, EUI will report the details to the relevant tax authority.
Clearing Participants wishing to nominate EuroCCP as Stamp Data Provider (SDP) must flag EuroCCP accordingly via the CREST GUI (ID: EMCFNLKE).
Clearing Participants that are NOT using the “Direct Input” functionality in CREST – i.e. sending bilateral matching instructions versus EuroCCP – must include the new CREST stamp status “K - No SDRT liability & Irish exempt, net/aggregate transaction or assessed elsewhere” in the transaction stamp status field of all matching settlement instructions.
There is no additional documentation required to appoint EuroCCP as Stamp Data Provider
EuroCCP will only report a Participant’s gross trade data if they have nominated EuroCCP as an SDP.
“Non Direct Input” Participants that fail to include the correct Stamp flag on their settlement instructions will result in a break.
Reconciliation breaks that remain outstanding by the intended settlement date will be reported to the relevant tax authority by EUI.
EUI has published an online training session for this service which is available in the “Recorded Sessions” section of the its website at https://euroclear.webex.com
Once reconciled by EUI, Stamp duty will be assessed on a Participant’s gross trades. Therefore, a Participant’s netting arrangements is independent from the enhanced stamp assessment process and is not impacted by splitting or shaping.
Any Participant wishing to test the Stamp functionality must ensure that it is using version 201406 of the CREST GUI.
Participants are invited to contact the EuroCCP Testing team to ensure that the correct configurations are in place prior to testing
EuroCCP’s SDP ID in the CREST testing environment is EMCFNLKE
EuroCCP does not currently envisage charging for its SDP Services