Central Clearing of Repos in Australia: A Consultation Paper March 2015 3. Key Features of Repo CCPs

This section first introduces the role of a CCP and the potential costs and benefits of central clearing. It goes on to consider the particular implications of CCP clearing in the Australian repo market. The main focus is on how counterparty credit risk management might change, and how central clearing could encourage new operational efficiencies. Implications for settlement arrangements are also considered. Finally, the section provides an overview of the design of existing repo CCPs internationally.

3.1 An Introduction to CCPs

Central clearing can be a highly effective way to enhance the efficiency, integrity and stability of financial markets. A CCP uses standardised risk management tools that, provided a product meets the preconditions for clearing, enable it to clear a product safely and reliably. However, there are costs and benefits of central clearing, and the net benefit or cost will be a function of the existing participation structure of the market and prevailing market practices.

3.1.1 The design of a CCP

A CCP stands between the counterparties to a financial market trade and performs the obligations that each has to the other under the terms of that trade. This occurs through a legal process known as novation, where the CCP becomes the buyer to every seller, and the seller to every buyer. Through novation, a market participant's numerous bilateral exposures are substituted for a single exposure to the CCP.

The CCP manages this exposure using three layers of risk controls:

• Participation requirements and position limits. These are ex ante controls that limit the counterparties to which a CCP is willing to have an exposure and the size of those exposures. CCPs' participation requirements typically take the form of minimum capital requirements and evidence of operational capability to meet obligations as a clearing participant.

• Defaulter-pays protections. These are financial resources provided by each participant to manage the risk it brings to the CCP. Typically, these take the form of variation and initial margin, although there can also be a range of additional margins to cover specific risks.

  – Variation margin is usually collected at least daily and is designed to cover exposure arising from observed changes in market prices. It is collected from participants with a decline in portfolio value since the last variation margin call, and passed through to those with an increase in portfolio value. In this way, the CCP's exposure is reset to zero after each call.

  – Initial margin is designed to cover potential future exposures. The Principles for Financial Market Infrastructures (PFMIs) require that initial margin is calibrated to cover at least 99 per cent of potential future price moves over an assumed close-out period.^[9] This close-out period is set based on the time between the last variation margin call and when a CCP can realistically close out or hedge its exposure to a defaulted participant.

• Mutualised financial resources. In the event of a participant default in more extreme market conditions, initial margin provided by the defaulted participant may not be sufficient to fully cover any losses arising. To cover this risk, a CCP maintains a pool of additional financial resources, which usually take the form of a prefunded default fund made up of contributions by the CCP and its participants. The PFMIs require that these resources, combined with initial margin, be calibrated to cover at least the default of the largest (or in some cases the two largest) participants and their affiliates in extreme but plausible scenarios.

3.1.2 The suitability of a product for central clearing

There are a number of preconditions that a product must satisfy in order for a CCP to clear that product safely and reliably. Specifically:

• the product must have a robust valuation methodology so that the CCP can confidently determine margin and default fund requirements
• there must be sufficient liquidity in the market to allow for close out and/or hedging of outstanding positions in a default scenario
• there must be sufficient transaction activity and participation so that the fixed and variable costs of clearing the transaction are covered
• there must be some standardisation of contracts to facilitate the CCP's trade processing arrangements.

Since a number of CCPs overseas currently clear repos (and there used to be such a CCP in Australia), these preconditions are likely to be met for repos against high-quality, liquid collateral (see Section 3.5 for further details of overseas repo CCPs).

3.1.3 The costs and benefits of central clearing

When assessing the relative costs and benefits of central clearing, it is important to consider the market structure (in terms of the number and type of participants), the nature of participants' activity, and existing practices and infrastructure. Australian authorities have previously considered the costs and benefits of central clearing in a number of different markets, including OTC derivatives and the foreign exchange market.^[10] Based on this previous work, CCP clearing may be expected to contribute to reduced systemic risk and increased operational efficiency by:

• lowering counterparty risk exposures through multilateral netting
• enhancing (and standardising) risk management
• coordinating default management
• encouraging operational improvements and efficiencies (e.g. settlement cycles, payment flows, margin and valuation calculations)
• facilitating anonymous trading on exchange
• delivering greater transparency
• providing a focal point for regulation and oversight.

However, there are also costs that need to be considered, such as:

• the set up and ongoing cost of maintaining a CCP
• concentration of risk in the CCP
• operational dependence on the CCP.

Costs associated with risk concentration and operational dependence would be expected to be mitigated by strong regulation and supervision of licensed CCPs against domestic standards that align with the PFMIs.

3.2 Counterparty Credit Risk

The emergence of a CCP in the Australian repo market will change how counterparty credit risk is managed in this market. A CCP's ex ante controls may affect activity in the repo market, and how institutions participate in the repo market. While both non-centrally cleared and centrally cleared repos involve exchanging cash in return for collateral, the arrangements are slightly different and therefore the level of protection and the cost of collateralisation will differ.

3.2.1 Ex ante risk controls

Participation requirements and position limits are a CCP's first layer of risk controls. These requirements condition the terms of access to clearing for repo market participants.

For some participants that are unable to meet a CCP's participation requirements, or for which direct participation would be uneconomical, access to a repo CCP as a client of a clearing participant may be the only option. However, this brings with it other risk considerations associated with the dependence on a clearing agent. Furthermore, even where an institution is willing to accept such risks it may have difficulty securing the services of a clearing participant. As a result of these issues around access to client clearing, some existing CCPs are reportedly in the process of considering alternative participation models to allow non-dealers to access the CCP without using a clearing participant.

Access to the repo market could also be restricted by any position limits imposed by the CCP.

3.2.2 Multilateral netting

Where a trade passes a CCP's ex ante controls, the CCP will novate the trade. As a result, the numerous bilateral exposures are substituted for a single exposure to the CCP. Depending on the profile of participants in a market, multilateral netting has the potential to substantially reduce the size of outstanding obligations relative to bilateral arrangements. Netting occurs at two levels – outstanding exposures and settlement:

• Exposure netting. Novation allows multiple offsetting trades to be reduced to a single net exposure vis-a-vis the CCP. In the extreme, after novation, the net exposure of a participant with exactly offsetting trades with different counterparties nets to zero. However, even if trades are not exactly offsetting – for example, there are different terms, different repo rates, different collateral – the trades are risk managed on a portfolio basis, which recognises the reduction in market/interest rate exposure due to these partial offsets.
• Settlement netting. When calculating settlement obligations, the CCP nets trades by line of security and settlement date, resulting in a single net long or short position for each participant in each line of security and at each settlement date.

3.2.3 Collateralisation

A CCP then collateralises these potentially smaller multilateral net exposures. As in the bilateral market, the exchange of cash for securities in a DvP settlement process protects against principal risk. However, as noted, CCP clearing can enhance arrangements for the management of replacement cost risk.

A CCP standardises the settlement of net gains and losses in the value of the collateral and the repo interest accrued by collecting and passing through variation margin on at least a daily basis. If the repos are auto-collateralised through a centralised collateral management system (e.g. ASX Collateral; see ‘Box A: ASX Collateral’), the exchange of variation margin is replaced by adjustments to collateral to ensure that the value of the collateral remains equal to the value of the cash leg of the repo. If there are significant price moves, a CCP will typically also collect variation margin intraday. This potentially lowers replacement cost risk relative to the non-centrally cleared alternative.

Unlike non-centrally cleared repos, the collateral provided under repo is not subject to a haircut. Instead, the CCP collects initial margin from both the securities provider and the cash provider. This difference is illustrated in the example below (Figure 1). In the top panel, CGS with a value of $105 have been provided to collateralise a $100 non-centrally cleared repo. In the event of the default of the securities provider, this protects the cash provider from the risk that the value of the securities has fallen since the net gain or loss was last settled. In the event that the cash provider defaults, however, the securities provider is not protected against the replacement cost risk associated with an increase in the value of the securities and could incur a loss in re-establishing its repo position. In contrast, in the bottom panel of the example, the CCP collects and retains initial margin from both the securities provider and the cash provider. In the event that one of the counterparties defaulted, the CCP would use the initial margin provided by the defaulted participant to cover any replacement cost loss.

As noted in Section 3.2.2, CCPs generally manage the risk associated with cleared repo trades on a portfolio basis. This is reflected in the calculation of initial margin. Consequently, if a counterparty has partially offsetting trades (e.g. it is a cash provider in one repo and a securities provider in another repo) margin requirements will be lower than if replacement cost risk was calculated on a trade-by-trade basis.

Initial margin is calibrated to manage the replacement cost risk, which reflects the potential future exposure due to changes in prices between the last variation margin call and the time a CCP could realistically close out or hedge its exposure to a defaulted participant. For repo transactions, the potential future replacement cost will be a function of repo rates, bond prices and discount rates.

• If a CCP novates a repo prior to the settlement of the first leg and a counterparty defaults before this settlement occurs, the CCP will need to enter the market to execute a repo contract that offsets its obligation to the surviving counterparty. In such circumstances, the replacement cost risk is entirely a function of repo rates and discount rates.
• If a default occurs after the first leg has settled, the CCP will not only have to execute an offsetting repo, it will also need to cover the security or cash that was provided to the defaulted participant under repo by selling the defaulted participant's collateral. Consequently, the potential exposure from a change in bond prices is relevant to replacement cost risk.

In both cases, the net present value of the obligations at the time of the default will also depend on the current discount rate.

In addition to variation and initial margin, CCPs may levy a range of other additional margin requirements to protect the CCP against specific risks. For example, a CCP may levy margin to cover its exposure to:

• concentrated positions that may be difficult to liquidate in the event of a default
• large positions, typically where the stress-test loss on such a position is large relative to the default fund
• sovereign credit risk, where there are concerns about the creditworthiness of the government issuing the collateral
• wrong-way risk, where the value of collateral posted by a counterparty may be negatively correlated with the probability of the counterparty's default
• a particular counterparty (i.e. a counterparty multiplier)
• repos against bonds trading ‘special’.^[11]

CCPs may also charge margin to cover risks that arise in the settlement process. In particular, centrally cleared repos typically settle on a DvP 1 basis in a securities settlement facility. Since initial margin is usually calculated on a portfolio basis, but settlement occurs on a line-by-line basis, there is potential for ‘un-netting’ if a default occurs during the settlement process. This is due to the fact that the CCP typically does not control the order in which settlement occurs. One way for the CCP to ensure that it is covered against such a situation is to collect additional margin on trades that are settling the next day to cover the worst possible case in terms of the settlement order and the point of default. In simple terms, this would mean that repos due to settle the next day were margined on a trade-by-trade basis for that day, with all other repos continuing to be margined on a portfolio basis.^[12]

3.2.4 Default management

Unlike non-centrally cleared repos, in the event of a participant default, all of the surviving participants' positions are maintained, rather than terminated. However, the CCP must enter offsetting transactions to close out its exposure to the defaulted participant. For repos this is generally achieved through a default auction to surviving participants. Since multilateral netting may have decreased the overall exposure to the defaulted participant, and the CCP can coordinate the close out of exposures to the defaulted participant, the CCP is likely to face a lower replacement cost than participants in aggregate would face in the bilateral market. The CCP also has access to prefunded default resources, in the form of the defaulted participant's initial margin and a mutualised default fund.

Nevertheless, since repos are a deliverable product, the CCP may face liquidity risk in excess of replacement cost risk. For example, if the CCP needs to purchase a security to cover the defaulted participant's obligation it will need to buy the security before it settles with the surviving participants. In such circumstances, the liquidity risk would be the price of the security. The replacement cost risk, on the other hand, is the difference between the cash received in the settlement with the surviving participants and the cash paid to purchase the security.

As a safeguard, Australian-licensed CCPs are eligible to hold an ESA at the Bank, which gives them access to Australian dollar liquidity from the Bank against eligible collateral. There is a close relationship between the collateral held against repos and collateral that is eligible for the Bank's liquidity facilities. Accordingly, a repo CCP would be eligible to access the Bank's liquidity facilities to support its liquidity management in the event that market sources were unavailable.

Liquidity risk can also be reduced, at least in part, through ‘shaping’. Shaping is a process of splitting large settlement obligations into smaller parcels that can then be settled sequentially. When managing a participant default, sequential settlement allows the CCP to use the funds from settling part of the defaulted participant's obligations to settle the remainder of the defaulted participant's obligations.

3.2.5 Capital requirements and counterparty credit limits

To the extent that a participant's positions with different counterparties are offsetting, multilateral netting through novation will result in lower overall exposure. In addition, prudential regulators are expected to treat exposures to ‘qualifying’ CCPs (QCCPs) differently to bilateral exposures.^[13] In April 2014, the BCBS finalised the capital requirements for bank exposures to CCPs, which is intended to create an incentive to centrally clear by imposing lower capital requirements.^[14] Exposures to qualifying CCPs are also currently exempt from the BCBS large exposure limit.

Similarly, the calculation of repo exposures in the BCBS leverage ratio framework is more favourable for exposures to qualifying CCPs; bilateral exposures are measured with no recognition of accounting netting, while repos cleared through QCCPs are recognised as a single contractual exposure to the CCP.

It is also expected that institutions' internal risk management frameworks will treat centrally cleared repo exposures differently. Once a trade is novated to the CCP, participants are no longer directly exposed to their original counterparty. This is why central clearing can facilitate anonymous trading on an electronic platform. Even if trades are not executed on an anonymous basis, it is expected that institutions' internal risk management frameworks will not subject centrally cleared trades to equivalent counterparty credit limits to those that apply for non-centrally cleared exposures. Instead they are expected to consider the lower risk exposure to the CCP, reflecting its status as a highly regulated single-purpose entity.

3.3 Operational Efficiencies

As the discussion of the Swiss Value Chain in Box B reveals, central clearing is not essential to achieve straight-through processing of repo transactions. However, due to its central role a CCP can coordinate such operational improvements and efficiencies where they do not otherwise exist.

Centrally clearing trades may encourage execution on an electronic trading platform, as a CCP needs trades to be matched and confirmed electronically prior to novation. From the point of novation, the CCP manages the trade; it values and margins positions and generates settlement instructions as necessary. In comparison, current operational processes in the Australian repo market tend to be more dispersed and require counterparties to communicate bilaterally and agree on how to manage the trade. These arrangements may also involve considerable manual intervention.

The management of a repo can be further streamlined if the CCP uses a centralised collateral management system to auto-collateralise (i.e. margin) repos (see ‘Box A: ASX Collateral’). Generally, repo CCPs use a centralised collateral management system when clearing repos against a class of general collateral. In these circumstances, the centralised collateral management system can also facilitate the recall and substitution of collateral. Re-use and substitution within a centralised collateral management system makes it easier to ensure that collateral that has been re-used can be returned in a timely manner.

3.4 Settlement Arrangements

As discussed in Section 3.2.2, the CCP calculates a single net long or short settlement position per participant, per line of security and per settlement date. As changes in the value of the collateral and the accrued interest have been settled daily, the cash and securities settled in the second leg generally have a very similar value.^[15] To smooth the settlement process, if a particular participant's net obligation in a line of security exceeds a given amount, the CCP will shape the settlement instruction into smaller parcels.

The CCP then submits these settlement instructions to the securities settlement facility. Settlement instructions will be submitted as a batch, generally once or twice a day. Each of these batches is then settled in separate settlement runs, typically on a trade-by-trade (DvP 1) basis. In the case of an Australian repo CCP, Austraclear would be the relevant securities settlement facility. Since Austraclear settles on a DvP 1 basis, in order to initiate the settlement process the CCP will need to maintain, or have ready access to, a buffer of cash or securities to settle the first transaction. The proceeds of that settlement can then be used to settle further obligations, with the CCP in normal circumstances ending the day with the same assets that it started with. As discussed in Section 3.2.4, in the event of a participant default the CCP would still need to settle the obligations of the defaulted participant to the surviving participants and therefore would have a net open position until it could execute offsetting trades to extinguish its exposure.

3.5 Overview of Repo CCPs Internationally

Repo CCPs already exist in a number of overseas markets, and in some cases have been operational for many years. While these CCPs share a number of common features, there is some variability in the specifics of their design and operation (Table 3). Many of these differences in the design of repo CCPs reflect differences in the operating environment and prevailing market practices in the markets they serve.

The product scope of these CCPs varies – some clear both outright bond transactions and repos; some only clear repos against government debt; while others clear repos against a broader range of debt securities. In the case of FICC, typically only the second leg of a repo is centrally cleared.

Some CCPs only clear repo contracts that specify the line of securities to be provided, while others clear repos that specify a class of general collateral. Where a repo CCP clears repos against a class of general collateral, the service is often linked to a centralised collateral management system. Most repo CCPs send settlement instructions to the relevant securities settlement system no more than twice a day, and therefore are unlikely to be suitable for intraday repos.

Typically, each participant's margin is segregated, and can therefore only be used to cover the default of that participant. Any margin in excess of the actual replacement cost risk is returned to the defaulted participant (or its liquidator). However, FICC is an exception, as initial margin is mutualised. While FICC uses the defaulted participant's margin and other defaulter-pays resources first, followed by a portion of the CCP's own capital, the initial margin of other participants can be used to cover any additional loss faced by the CCP in the same way as a CCP's mutualised default fund.

Unlike other repo CCPs, repos cleared through FICC settle across the books of its two clearing banks rather than the relevant securities settlement system. This is because the net repo settlement obligations are settled outside of the operating hours of the Fedwire Securities Service, which is the securities settlement system for US government and agency debt securities. Further, as FICC does not have direct access to the central-bank owned payment system, the Fedwire Funds Service, it settles the cash leg of repos via its clearing banks.

Footnotes

The Principles for Financial Market Infrastructures developed by the Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) are the international standards for CCPs and other financial market infrastructure. The Australian Securities and Investments Commission and the Bank have implemented these as part of their regulation of CCPs that operate in Australia. In particular, the Bank has determined Financial Stability Standards for CCPs, with which all clearing and settlement facility licensees that operate CCPs must comply. These Financial Stability Standards include requirements around margin and credit risk and are available at <http://www.rba.gov.au/payments-and-infrastructure/financial-market-infrastructure/clearing-and-settlement-facilities/standards/central-counterparties/2012/>. [9]

See for example, CFR (2011), Central Clearing of OTC Derivatives in Australia, June, available at <http://www.rba.gov.au/publications/consultations/201106-otc-derivatives/> and Manning M, A Heath and J Whitelaw (2010), ‘The Foreign Exchange Market and Central Counterparties’, RBA Bulletin, March, pp 49–58. [10]

‘Specials’ are securities that are in high demand by market participants. The difference between the repo rate on general collateral and the rate on a particular bond gives an indication of the level of demand for that bond. [11]

Alternatively, this risk could be addressed if settlement occurred on a portfolio or multilateral net basis. However, under the Bank's Financial Stability Standards, where individual trade values are large a securities settlement facility would be expected to settle linked obligations using trade-by-trade (or line-by-line) settlement on a real-time basis (i.e. DvP 1). This is because a participant default that triggered recalculation of multilateral net obligations within a net settlement batch could, if obligations were sufficiently large, cause survivors to face significant liquidity pressures on a short horizon. Furthermore, even where a participant default did not give rise to sizeable swings in liquidity requirements for participants, the dependencies between participants in a net batch settlement model are such that problems with a single participant could nevertheless cause delays and uncertainty for all participants. [12]

A qualifying CCP is a CCP that is licensed to centrally clear a product, where the relevant home regulator/overseer has established, and publicly indicated, that it applies to the CCP on an ongoing basis – domestic rules and regulations that are consistent with the CPMI-IOSCO Principles for Financial Market Infrastructures. [13]

BCBS (2014), Capital Requirements for Bank Exposures to Central Counterparties, April. Available at <http://www.bis.org/publ/bcbs282.pdf>. [14]

An exception to this is repos cleared through LCH.Clearnet Ltd's RepoClear service. In line with repo and bond market convention in the United Kingdom, repos cleared through LCH.Clearnet Ltd settle the second leg using the collateral price as at the time the repo was transacted rather than at the prevailing market price. [15]