2010/11 Assessment of Clearing and Settlement Facilities in Australia Box A: Central Counterparty Account Structures

One factor in determining the ease with which client positions can be transferred in a default event is the account structure utilised by the central counterparty. As noted, facilitating transfer may have financial stability benefits, as this method of extinguishing the central counterparty's exposures is likely to have the least impact on market conditions. Account structure also has broader implications for both client protection and netting and liquidity efficiencies. For these reasons, account structure has become an increasingly important consideration in the move to mandatory clearing of over-the-counter (OTC) derivatives, as well as in the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commission's (IOSCO) proposed Principles for Financial Market Infrastructures (FMIs). However, regulators remain aware that the optimal account structure for any central counterparty will also be influenced by the legal framework within which it operates, and the characteristics and idiosyncrasies of the market that it clears.

There are broadly three types of account structure used by central counterparties: a single-account (i.e. co-mingled house and client transactions); a house account with individually segregated client accounts; and a house account with an omnibus client account.

Of these account structures, the single account offers maximum netting benefits for settlement and margins. Each clearing participant has a single net novated settlement position and, assuming the central counterparty uses net margining, margin requirements are calculated across all client and house positions. This minimises collateral required against positions and can result in a reduced cost of clearing for participants and clients (depending how a clearing participant margins its clients). However, co-mingling of client and house funds raises client protection concerns, as client funds may ultimately be used to offset losses on house positions or another client's positions. Further, the use of a single-account structure with net margining may significantly weaken the ability of the central counterparty to transfer client positions to a surviving clearing participant following a default, as the net margining may mean individual clients' positions may be undercollateralised when transferred, or leave the remaining positions in the account undercollateralised. An alternative is that the central counterparty applies gross margining, in which case margin is calculated and called separately on house and individual clients' positions. Although this facilitates the transfer of positions, clients remain exposed to losses of the house and other clients.

Individually segregated client accounts, on the other hand, provide maximum protection for clients, as clients are not exposed to risks from the positions of the house or any other client. In this structure, margin collected can only be used against that client's positions. This full collateralisation, as well as the easy identification of any client's positions, facilitates transfer of these positions to a surviving clearing participant. However, this account structure is least efficient in terms of netting, and may be administratively complex for the central counterparty, and clearing participants, particularly in markets with a large number of retail clients.

A structure with a house account and an omnibus client account separates house and client positions and funds, offering something of a ‘middle ground’ in terms of client protection benefits and netting efficiencies. Although house and client positions are segregated, netting is retained across client positions, which can result in lower clearing costs for clients relative to an individually segregated structure. Further, although each client remains exposed to any losses arising from the default of any of the clearing participant's other clients, they are protected from exposures to losses on house positions. However, as with the single account structure, if net margining is used, transfer of individual client positions in a default event can be difficult due to possible undercollateralisation. This problem would not arise if the entire omnibus account could be transferred to a single surviving clearing participant; however, identifying a participant willing to accept the account may be difficult, due to the administrative complexities a participant faces in taking on new clients, as well as the potential financial implications of accepting a large account.

Although there is a trade off between netting efficiencies, and client protection and transfer arrangements across the three broad account structures, the exact nature of this trade off (and, therefore, the optimal account structure for a given central counterparty) is also affected by a range of additional factors, including the legal regime in which the central counterparty operates and the characteristics of the market that it clears. Both of these factors influence the ability of a central counterparty to transfer positions: insolvency laws in many jurisdictions significantly restrict the ability of a central counterparty to enact transfers in a default event; and, even where transfer is legally viable, operational complexities in markets with many retail clients (typically cash equities markets) may also be restrictive. Where transfer is not deemed to be viable, the relative benefits of increased segregation may be reduced. The number of clients in any market also determines the operational complexity of providing increased segregation, which has potential flow-on effects to the cost of clearing.^[1] Legacy issues, such as market practice and conventions, can also be important factors in shaping a central counterparty's choice of account structure.

Reflecting some of these considerations, ASX currently uses several account structures across its different markets. In the derivatives markets, ASX Clear offers individually segregated client accounts for options and individually segregated client accounts with an optional omnibus client account for futures, while ASX Clear (Futures) offers omnibus client accounts with net margining. In the cash equities market, cleared through ASX Clear, a single account structure is used. Although this single account combines house and client positions, there is no co-mingling of client and house funds.^[2]

International Developments

The trade off between client protection and netting efficiencies (and, consequently, the cost of client clearing) across different account structures has been recognised in the proposed CPSS–IOSCO Principles for FMIs. The proposed principles also recognise that the ability of a central counterparty to protect client positions and funds, and to transfer client accounts, is also dependent on applicable national law. Nevertheless, the principles, as currently proposed, require that a central counterparty:

• has segregation and portability (i.e. transfer) arrangements that protect customer positions and collateral to the greatest extent possible under applicable law;
• employs an account structure that enables it to readily identify and segregate positions and collateral belonging to clients of a participant, and maintain these positions and collateral in an omnibus client account or individual client accounts; and
• structure its arrangements in a way that facilitates transfer of client positions and collateral in the event of a clearing participant default.

Although the proposed principles stop short of requiring individual client accounts, it is noted that a central counterparty should consider offering this structure, taking into account applicable insolvency regimes, the cost of implementation, and any risk-management challenges.

The potential exposures of clients under various central counterparty account structures has also been recognised in the Basel Committee on Banking Supervision's ongoing consideration of bank exposures to central counterparties. Under the proposed regime, direct clearing participants will face lower capital charges for positions cleared through a central counterparty. However, indirect clearing participants (i.e. clients) will only receive these reduced charges if their positions are fully segregated from those of their clearing member and there is assurance that the positions would be transferred to another clearing participant in the event of the original clearing participant's default. For the reasons outlined above, this last requirement is likely to be met only if the central counterparty uses individually segregated client accounts.

Account segregation has also been addressed in the push to mandate central clearing of standardised OTC derivatives, with regulators in various jurisdictions seeking to enhance client protections in the event of a clearing participant default. In Europe, the proposed European Market Infrastructure Regulation requires ‘appropriate’ segregation of house and client positions and collateral to allow for account transfers – including that a central counterparty must offer individually segregated client accounts. It will be up to the client to determine the level of segregation of their accounts; where individual segregation is chosen, the central counterparty must ensure that it is able to transfer the client's positions and collateral on request to another clearing participant. In the United States, provisions under the Dodd-Frank Wall Street Reform and Consumer Protection Act require segregation of client monies at the clearing participant level. However, given certain conditions (prescribed by the relevant regulator) are met, client monies may be co-mingled with other client monies at the central counterparty, provided that these monies are accounted for separately.

Footnotes

Client protection concerns can also be addressed through means other than account segregation; for example, some markets may utilise client-protection guarantee funds, designed to compensate clients for any losses arising from the default of their clearing participant or other clients. However, although these arrangements provide ex-post compensation, individual segregation offers ex-ante protection against such losses arising. [1]

At present this is because ASX does not collect margin on cash equities. Although ASX is working to introduce cash equities margining, the proposal does not mandate the pass through of margin requirements to clients, and no client funds will be held in the account. [2]