Before looking at clearinghouses in OTC derivatives, it is useful to see how clearinghouses work in other markets, which may have been the intellectual model for the Dodd-Frank requirement. Most observers have started by looking at securities depositories like DTC and Euroclear, but those organizations and functions aren’t really a good basis for comparison.

A much better basis is the true securities clearinghouses, like FICC or OCC. These entities deal primarily with transactions before settlement, as opposed to the depositories, which handle settlements and post-settlement positions.

Why is that distinction important? Because the risk parameters of a securities transaction change when it settles. If I buy a stock or a bond, I am at risk for the security’s performance after I settle, but I am at risk for both the security’s performance and my counterparty’s performance before I settle.

For typical securities trades that settle in three days or less, the counterparty risk is relatively small, but in longer-dated trades, like forward trades in mortgage-backed securities, the counterparty risk can both grow to large proportions and persist for months.

Clearinghouses handle this counterparty risk in two ways: first, they collect margin deposits and contingency funds from all their members to ensure, as much as possible, the members’ financial performance; and second, they net out offsetting positions, so that the only settlements and the only pre-settlement counterparty risk is between net positionholders.

Those two functions of the clearinghouses mandate that their membership be restricted, generally to market makers or their clearing agents. One reason is that any member must be willing to accept any other member as a counterparty at any time, even if no trades were actually done with that counterparty. Public participants in the market are not generally willing to accept that condition, and so aren’t members of these clearinghouses – their positions are carried by the clearinghouse members, and are not netted or margined by the clearinghouse itself. Thus the risk in the market as a whole, sometimes called systemic risk, is not managed by the clearinghouse, it only manages the risk between clearinghouse members.

When we move to first-level derivatives, like futures or options, the clearinghouse role becomes more important and more visible. One reason is that settlement means something different here than it does in the underlying securities. In these instruments settlement, as used in the securities sense, either doesn’t happen or it doesn’t have the same risk impact.

Option trades settle in the same way as trades in the underlying (the buyer pays the seller and receives an asset in return), but a one-directional counterparty risk remains after settlement. Thus the seller of an option has an exposure to the option buyer for as long as the option exists, and that exposure must be collateralized by either the underlying security or cash.

Futures trades don’t settle at all in the securities sense, unless they go to expiration and are replaced by the underlying, so the two-sided counterparty risk remains throughout the life of the instrument.

This persistent counterparty risk means that futures clearinghouses now become true central counterparties (CCPs). In other words, they assume the position of counterparty to every member, no matter whom that member originally traded with. As a result, they collect initial good-faith margin from all members for each new position, and then mark each position to the market daily. Cash variation margin is passed from the owing member through the clearinghouse to the receiving member each morning as a condition of doing business that day. When a position is closed out, the initial margin is returned to the member. In all these events, each party to the trade views the clearinghouse as their true counterparty.

As different as this arrangement looks from the securities world, one aspect remains the same – clearinghouse membership is restricted to market makers and market insiders. The public (including many financial institutions) are not members of the clearinghouse. Their positions, their margin movements, and their counterparty risks are with the clearinghouse members, not the clearinghouse itself. The variation margin movements within the clearinghouse should match margin movements between its members and their customers, but nothing requires that this be true.

One final aspect of first level derivative clearinghouses is that their variation margining function, which is at the crux of their counterparty risk management, relies on the availability of end-of-day trade prices. Every business day these clearinghouses obtain, usually from an exchange, a closing price for each contract, compare that price to the previous day’s closing price, and use the difference to determine variation margin movement for the day. Any dispute about the end-of-day price for a contract or its underlying severely impacts the margining and risk management machinery.

The nature of OTC derivatives

Now we need to look at the nature of OTC derivatives so we can see how the clearinghouse concept would apply to them. There are some fundamental differences between these instruments and any that we have discussed before:

1. Securities and futures contracts are standardized instruments that can be traded on exchanges and listed in security master files. OTC derivatives are bilateral agreements between two parties about future cash flow that are not standardized or listed in security master files.
2. Securities are issued and paid for, and are treated as assets on the books of the owner. OTC derivatives, like futures contracts, are not issued and not paid for, and are not treated as assets or liabilities. They are bilateral agreements.
3. When the owner of a security, or the holder of a futures position, wants out, he/she can close out the position by doing a trade with a party other than the original counterparty. A party to an OTC derivative contract who wants out can only: 1) close the position out with the original counterparty at a price agreeable with the original counterparty; 2) find another party to replace them in the contract, with the consent of the original counterparty; or 3) enter into a matching, offsetting derivative with another counterparty.
4. Since most derivative contracts have some unique parameters (and many more will have them as dealers strive to keep their trades off the SEFs) there won’t be active daily markets in each of the specific instruments. So there may not be end-of-day prices for the clearinghouse to use in margining.

Clearinghouses in OTC derivatives

These fundamental differences have significant impacts on how a clearinghouse would operate in this market. Some of these impacts:

1. As with futures contracts, the clearinghouse will have to manage risk throughout the life of the contract. In many cases, however, these contracts last five years, longer than any futures contract or forward settlement trade, and could last longer.
2. The clearinghouse will have to manage both types of risk we have already mentioned, market risk and counterparty risk, at the same time. Even if the market hasn’t moved against a member’s positions, the clearinghouse may have to take action if the member’s credit quality deteriorates, since that deterioration would impact the member’s ability to support market risk at some point in the future.
3. Because the preferred method of closing out contracts will probably be establishing offsetting contracts with another counterparty, the clearinghouse will have to have a sophisticated algorithm for detecting and netting out offsets. If the offsetting contract is very close to the original, but not identical (slightly different tenor, for example) the algorithm will have to allow for “pseudo-netting” to reduce but not completely eliminate the counterparty risk.
4. With one-off contracts the rule of the day, the clearinghouse will have to establish a pricing methodology that will be acceptable to all members. Because model-based pricing is formulaic, someone will have to guard against algorithmic errors, which could result in large unexpected price movements and uncovered risks. In the past, pricing methodologies have been a widespread sticking point between market participants, sometimes leading to outright rejections of ISDA agreements.
5. If the primary originators of derivatives are the large commercial banks, and the members of any clearinghouse are likely to be the same large commercial banks, one might well ask what we accomplish by moving the transactions to a clearinghouse. If, as with the current clearinghouses, the only clearinghouse control is over its members, and it knows nothing about public positions, will that arrangement be any better than the current one? If the clearinghouse needs more control over public positions, how will membership be determined?

All these implications will need to be worked out before derivatives clearinghouses can function at all, let alone be an improvement over the current situation.

Much of the current discussion has been about the minimum capital requirements for members, which may be the least of the concerns before us.

What we need instead is an enlightened discussion about what clearing derivative transactions really means, and how we can get it done in the foreseeable future. Without that discussion, implementing Dodd-Frank won’t accomplish much, and may make matters worse.

^[1] http://www.skadden.com/newsletters/FSR_A_Regulation_of_Over-the-Counter_Derivatives.pdf

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