A clash over CCP membership

The Commodity Futures Trading Commission has proposed a $50 million cap on minimum capital requirements set by CCPs on clearing members. Major dealers and clearing houses claim regulators risk undermining the strength of CCPs, but smaller firms that want a piece of the clearing pie say this is nonsense. Matt Cameron reports

Christopher Edmonds, Ice Trust

Central counterparties (CCPs) have become the ultimate too-big-to-fail institutions. Already responsible for trillions of dollars worth of risk, new regulations will force an even greater share of the over-the-counter derivatives market through clearing houses – and by doing so, create a small number of institutions that are vitally important to the financial system. Any loosening of CCP risk standards, no matter how small, is therefore bound to raise eyebrows. A recent suggestion by the Commodity Futures Trading Commission (CFTC), however, has created shockwaves.

The December 16 proposal would see minimum capital requirements set by CCPs on clearing members capped at $50 million. Capital requirements should instead be scalable and proportionate to the risk posed by individual members, the CFTC said – which would significantly broaden the membership of clearing firms.

The proposal has caused acute alarm among existing clearing members, which claim a $50 million cap – just 1% of the current minimum capital requirement for SwapClear, the interest rate swaps clearing platform run by London-based LCH.Clearnet – could threaten the stability of clearing houses. They argue poorly capitalised members would be unlikely to meet emergency calls to top up default funds following a sequence of failures, threatening the very concept of risk mutualisation.

“I’m terrified,” says one US dealer, whose firm is a clearing member of four derivatives CCPs. “The proposal to completely overhaul CCP member capital requirements has me running scared. I don’t want to be in an organisation that lowers the bar to the point that my firm is being put at more risk and my capital in jeopardy.”

That opinion is not shared by everyone, though. Smaller banks and broker-dealers say they can play a role as clearing members without having billions in capital. They claim they have been unfairly excluded from CCP membership in the past as a result of these capital requirements – a ploy they say has been formulated by CCPs and their large dealer members to keep the whole of the lucrative clearing pie to themselves.

“Some current capital requirements are exclusionary. Membership needs to be opened up – clearing works when there is a large buffer of intermediaries dispersing the risk. If the risk is spread between too few entities, it is too close to bilateralism. You need to have different groups of clearing members, which lessens the correlation in the clearing house,” says Gary deWaal, group general counsel at Newedge in New York. Newedge is one of a number of firms – including BNY Mellon, MF Global and State Street – that are not currently members of clearing houses Ice Trust and CME Clearing but have clearing ambitions.

Existing clearing members strongly dispute the outsiders’ argument. They say it is purely a risk management issue – and warn the CFTC proposal could spark a dealer exodus from clearing if it passes in its current form. “The chatter about requirements being exclusionary and labelling current members a cabal is just rubbish. This is risk management, and the requirements are set at prudent levels to ensure the safety of the clearing house. Unfortunately, this stuff is really starting to affect clearing members, which have historically been willing and incentivised to provide clearing services to customers. We will re-evaluate membership ourselves. If some of these rules go through, I don’t think I want to be a clearing member anymore,” says the US dealer.

The subject is extremely sensitive. LCH.Clearnet would not comment on the $50 million figure – although chief executive Roger Liddell expressed shock at the level of the cap during a panel discussion in New York on January 25. On the record, the clearing house warned about the need for stringent risk management standards for CCPs.

“It is essential there be appropriate, objective risk-based tests to determine eligibility, otherwise a CCP might increase systemic risk. CCPs are only as strong as their weakest link,” says Michael Davie, London-based chief executive of SwapClear.

In the event of a default, SwapClear would first tap into initial and variation margin, before using the defaulter’s own default fund contribution. Once that is depleted, it would use up to £20 million of its own capital, then turn to the remainder of the default fund. SwapClear members would then need to contribute a further £50 million, as well as make voluntary contributions to top up the default fund. As a result, its membership requirements are meant to ensure firms have sufficient financial resources to meet these obligations.

Other clearing houses make a similar point. “Capital requirements are part of the safety net in a default scenario, together with other factors such as margin and the default fund,” says Christopher Edmonds, president of Ice Trust in New York.

Nonetheless, strong pressure is being exerted to lower member capital requirements. Gary Gensler, chairman of the CFTC, believes the proposed participant eligibility requirements will promote fair and open access to clearing. Meanwhile, a source close to the drafting process of the derivatives section of the Dodd-Frank Wall Street Reform and Consumer Protection Act believes current CCP membership requirements are much too high. “The guys who provide all the flow are using their economic power to prevent competition from participating in central clearing. It is anti-competitive,” he says.

Regulators on the other side of the Atlantic have remained tight-lipped, but one senior European regulatory source believes it is unlikely a similar quantitative cap on minimum capital requirements will be imposed in Europe. He did, however, say high member capital requirements are not the most vital factor to ensure CCP health. “It is unlikely Europe will go down the route of setting quantitative limits, but capital requirements are not the primary functions that protect clearing houses – they rely on liquid and available resources like margin and a guarantee fund. I can understand where the current capital requirements come from, but I’m not sure lowering them would jeopardise the safety of a CCP,” he says.

Some existing clearing members concede there may be room to reduce capital requirements from current levels. Nonetheless, most market participants, including prospective clearing firms, believe the proposed cap is too low and is essentially an initial bargaining chip to get clearing firms to accept lower requirements than those currently in place. Prospective clearers estimate the regulator will settle on a final figure around the $200 million mark – but that is still significantly lower than current requirements. Both Ice Trust and SwapClear have minimum capital requirements of $5 billion, while CME Clearing has a $500 million and $1 billion minimum requirement for credit default swaps (CDSs) and interest rate swaps clearing, respectively.

Those who argue the current caps are too high point to the futures market, where a minimum cap of $5 million is in place. They claim many of the requirements for futures clearing merchants would be similar for OTC swaps – and say the minimum caps should reflect that.

Clearing houses admit there is no scientific formula for setting minimum capital requirements, but insist the figure needs to be significantly higher for OTC products than for futures clearing, reflecting lower liquidity, lack of observable prices and the asymmetric risk profiles of some products.

“Although we set those capital requirements carefully with thoughtful consideration given to the risk profile and market conditions surrounding the product set, it is not as if there is a mathematical formula when coming up with the requirement. Futures are a very simple product set to clear, both in managing the risk and a default scenario. This is because there are generally more observable prices and ample liquidity. However, in the case of some of the OTC swaps, prices are less observable, and liquidity is far from comparable with futures. Therefore, it is legitimate for clearing houses to impose higher capital requirements,” says Kim Taylor, president of the CME Group clearing house division in Chicago.

CME Clearing currently requires members to make an initial $50 million contribution to its default fund for both interest rate swaps and CDSs, but this could be increased depending on the scale and exposure of the clearing member. In the futures clearing model, the default fund contribution is set at 2.25 times the initial margin, but is likely to be higher for OTC products. This is meant to cover the residual default risk of the largest two potential defaulting clearing members, and is calculated by conducting a stress test on member portfolios.

Clearing members are also on the hook for further contributions if needed, which are meant to cover the next two largest defaulting members. In the futures model, this unfunded portion of the default fund is set at 2.75 times the funded portion – in OTC products, the proportion of funded to unfunded has not been set at a fixed percentage. This means a prospective clearer with $50 million of capital would only be able to meet the initial default fund contribution.

Despite the furore surrounding the possible lowering of minimum capital requirements, both CCPs and dealers agree the most vital requirement for clearing members is operational. If a clearing member defaults, the remaining clearing members are required to bid on the defaulting firm’s portfolio and take down that risk. As a result, prospective dealers need to show they have the operational capability to price and manage large derivatives portfolios.

“The most important hurdle is the operational requirements. Prospective clearing members must be able to provide evidence they have the requisite expertise to perform the duties required of a clearing member. If a clearing member had $50 million in capital, but could liquidate without fail the portfolio of a defaulting client and participate in a CCP auction and successfully take down a pro rata share of risk, then the $50 million is not an operative hurdle,” says CME Group’s Taylor.

Typically, CCPs would insist that clearing houses have an internal trading desk to ensure they are able to deal with chunks of risk they take down in the event of an auction. But those firms outside the clearing circle complain this requirement unnecessarily ties execution to clearing.

“Requiring clearing members to have internal trading desks is not required in other cleared markets. It’s just another artificial barrier to keep the largest independent firms out. Clearing houses should allow their members to co-manage the risk and pricing of swaps through joint ventures with independent dealers. Why can a clearing member not have an agreement with a dealer that will share market risk and balance sheet with a participating clearing broker? Dealers routinely offer pricing and execution expertise to third parties. These arrangements can readily satiate CCP demands to provide actionable end-of-day prices and balance sheet with regards to the default management function,” says New York-based James Cawley, founder of industry group Swaps and Derivatives Markets Association, whose members include Jefferies, MF Global and Newedge.

Dealers argue that outsourced third-party pricing and default management services are unreliable in distressed situations and could potentially jeopardise the safety of the clearing house. Despite this, CME Clearing says it is willing to consider granting clearing membership to firms without internal trading desks, allowing members to instead outsource both pricing and default management capabilities to third parties.

The declaration has caused a split between the clearing house and some of its dealer members. One bank claims the rift could push it to weigh-up its membership to the clearing house.

“Our intention continues to be to provide services as a major clearer of all listed and OTC cleared products, but as with any CCP, we will need to understand the risks to our firm and weigh that versus our wanting to participate. This issue is only one of many that contribute to the robustness of the risk management of a new clearing house that both clearing members, as well as their client base, will have concerns over. All these issues collectively will impact whether any clearing house in the US or globally gets take-up from potential clearing members,” says one dealer at the firm.

Many major dealers argue third-party marks and outsourced default management processes are unreliable during times of market stress. If a clearing member’s third-party default arrangements fail, the clearing member would have to absorb the risk with no way of trading out of it, which in a worst-case scenario could cause the member to default.

According to a comment letter sent to the CFTC by JP Morgan on November 17 last year, third-party pricing and outsourced default management services can disappear quickly in a crisis. “For this reason, we recommend a requirement that clearing members or their affiliates be able to participate in the default management process,” states the letter.

But CME’s Taylor says the firm does not have a problem with a clearing member using third-party marks, so long as the CCP conducts additional scrutiny and due diligence on the third party.

“The most natural way for clearing members to provide the CCP with pricing information is from an internal trading desk. However, we are open to the possibility of clearing members procuring their marks from an affiliate – most futures commission merchants are unlikely to have trading desks – or from another entity. We have this type of facilities-management arrangement in the futures business, and we would certainly entertain a proposal from a prospective clearing member if it was able to convince us that the third party would continue to provide marks in stressful market conditions and they have access to the market to liquidate a portfolio,” she says.

Other clearing houses contacted by Risk say they are not planning on following suit. “It’s all very well accepting third-party marks, but it is essential you get marks with teeth. If you provide a mark in the CCP, there is risk behind it, and our policy is when you submit a bid, those bids can get crossed. It is a check and balance so as to ensure we are not getting erroneous marks. But accepting third-party marks is dangerous. First, in a distressed situation, they could disappear – the third party is not on the hook for the risk. And what happens if 10 clearing members decide to use the same third party for their marks – how good is that mark going to be?” asks one clearer.

On this point, the CFTC rules appear unlikely to force other clearing houses to follow CME Group’s lead. The CCP proposals include a clause that requires derivatives clearing organisations to establish participation requirements that ensure clearing members have adequate operational capacity to meet obligations arising from participation in the clearing house. The requirements include the ability to participate in default management activities under the rules of the CCP.

There may be additional room for manoeuvre on the part of clearing houses. Despite the CFTC’s proposed cap on minimum capital requirements, the regulator also suggested a rule that gives CCPs the ability to take further action with respect to particular clearing members when appropriate, based on the application of objective and prudent risk management standards. Such actions include imposing enhanced capital requirements. The CFTC said CCPs would have discretion to determine when to impose additional requirements, based on the objective and prudent risk management standards.

“This is where the debate is going to centre,” says one senior clearing source. “This rule essentially gives CCPs the ability to impose extra capital requirements, if they can prove it contributes to prudent risk management.”