A decade after the financial crisis, the dust has settled in the derivatives markets. Policy objectives and regulatory reforms designed to strengthen the financial markets and reduce systemic risk have been largely adopted. Market participants are focusing on fine tuning their responses and considering alternative approaches to managing collateral and funding costs. Understanding how margin is deployed and used across the clearing ecosystem can inform more efficient and optimized programs.
A Brief Overview
The financial crisis of 2008 shed light on the exposures and structural weaknesses embedded in the over-the-counter (OTC) derivatives markets. In response, regulators and policy makers came together to address the systemic risks associated with OTC swap transactions. This led to a fundamental review and establishment of regulations designed to mitigate risks inherent in the OTC swaps markets. The successful track record of the futures clearing system managing and mitigating counterparty risk provided a foundation for some of the important OTC swaps market reforms.
Two directives that were introduced:
- The requirement that standardized OTC swaps be centrally cleared.
- The mandate that non-centrally cleared OTC swaps be subject to minimum standards for variation and initial margin requirements.
In this paper, we aim to review and explore core functionalities of the clearing ecosystem and margin infrastructure, including how margin collateral is maintained, transferred, and protected through the settlement lifecycle. It should serve to assist end users, such as asset managers and insurers, as they consider derivatives clearing and collateral management strategies.
Listed Derivatives and Swaps Clearing
Participants in the listed derivatives and cleared swaps market gain access to the central clearing system through their relationships with futures commission merchants (FCMs). Clearing houses, or central clearing counterparties (CCPs), mitigate risk between members of the CCP (also known as “clearing members”).
Think of the clearing system as a set of concentric circles. The CCP is at the center, surrounded by clearing members (FCMs and proprietary trading firms). The next ring consists of customers of clearing member FCMs which include end users and non-clearing FCMs. The third ring contains those clients of non-clearing FCMs.
Direct counterparty risk exists between each circle. CCPs’ and FCM clearing members are exposed to each other’s risk. End users of FCMs are exposed to FCM credit risk. Margin collateral flows across the system to and from end users through the FCM and ultimately to and from the CCP. Around the periphery are introducing brokers, who support trade flows between end users and FCMs but do not accept or hold customer assets.
The clearing process begins when clearing members on both sides of a transaction submit the trade to the CCP. The CCP confirms whether trade details between the buyer and seller match. Matched trades are accepted for clearing. Through novation the CCP becomes the buyer to each seller, and the seller to each buyer. The CCP guarantees the financial performance of cleared contracts between itself and the clearing members. The CCPs guaranty does not extend to the FCMs customers, which is why end users are constantly evaluating the credit and risk profile of their FCMs.
To support the assurance that cleared transactions will perform financially, CCPs have several tools they employ to manage risk, which together form what’s known as a “default waterfall.” The default waterfall is structured to cover losses when a clearing member fails to make good on obligations to the CCP. The financial safeguards consists of initial margin, guaranty fund deposits, CCP capital and clearing member assessments.
CCPs manage credit risk by maintaining a matched book of counterparty exposures collateralized by initial margin. Market or price risk is mitigated through the variation margin process, which transfers marked-to-market gains and losses among winners and losers.
CCPs require daily settlement of initial and variation margin from clearing members. FCM clearing members are required to collect initial margin from customers in an amount at least equal to their CCP requirement and to collect and pay customers variation margin.
FCMs intermediate the relationship between the end-user and the CCP. FCMs may provide trade execution and clearing separately or together. FCMs are highly regulated financial entities that have customer protection front and center. To solicit or accept orders for futures, futures options, or cleared swaps and to accept money or other assets from customers a financial entity must be registered as an FCM with the National Futures Association (NFA) and must operate under its regulatory authority, as well as that of the Commodity Futures Trading Commission (CFTC). The NFA and CFTC require FCMs to comply with their financial, customer protection, record keeping, and reporting requirements. FCMs that are clearing members are also subject to the regulatory and financial requirements of the exchanges and CCPs they belong to.
A “clearing member FCM” is an FCM that is a member of a CCP and accepts trades on behalf of clients for clearing. To become a clearing member, an FCM must meet the clearing house’s financial eligibility requirements, maintain a specified amount of capital, and contribute to a guaranty fund to be used in the event of another member’s default. FCMs that clear swap contracts are also required to participate in any auction of a defaulting clearing member’s swaps portfolio.
The deadlines and operational flows of margin and collateral are not calibrated across the settlement lifecycle. FCMs and settlement banks operate to bridge the gaps between a CCP margin action and end user response. Initial and variation margin is generally settled twice daily between clearing members and CCPs. The previous day’s activity is settled first thing in the morning. Intra-day variation margin is settled within an hour of notification from the CCP. FCMs normally issue customers’ margin calls, based on the previous day’s activity just once per day. Customer margin payments and collects are typically completed by the end of the business day on which the call is made. Because of the timing differences, FCMs often use their own funds to settle CCP margin requirements and later replace them with client funds. Intraday margin calls are subject to similar time lags, with FCMs paying with their own capital on day one, and conversely holding variation credits until the next day.
Further complicating the process, CCPs require that early morning end-of-day margin calls are to be settled in cash. Clearing members may then substitute securities later in the margin cycle. The securities deposited at the CCP may be those of the FCM or those of the FCM’s clients who are carrying cleared positions at the CCP.
A non-clearing FCM, or “carrying broker,” maintains its customers’ positions with another FCM that is a clearing member. This relationship is mainly used to access markets outside the FCM or end users home geography, or where having a direct clearing membership isn’t optimal. Many end users maintain multiple FCM clearing relationships. It is also typical to have more than one FCM providing execution services giving trades up to the end users clearing FCM(s).
Client assets and securities deposited with FCMs are subject to certain processes and controls that may affect an end user’s collateral management strategy. Three points of note are; customer assets may be held at CCPs, FCMs may have different acceptable collateral requirements, and FCMs may have preferences between cash and securities as margin.
Customer margin collateral, including cash and securities, deposited with an FCM may be used by the FCM to meet the FCMs customer account margin requirements at the CCP. Margin assets on deposit with an FCM may be held at the FCM’s custodian or at the CCP’s custodian. Assets pledged to a CCP may be subject to processing steps, transfer requirements and timelines that affect returns and substitutions.
Acceptable margin collateral a customer may use to satisfy initial margin is determined by the FCM. The FCM may set standards that differ from what is allowable under exchange and CCP rules. Exchange rules set out the range of initial margin collateral that FCMs may accept from customers. CCP rules dictate the types of margin collateral acceptable from clearing member FCMs.
Some FCMs strongly encourage customers to deposit cash instead of securities for initial margin. A consequence of regulatory reform is the application of Basel III leverage rules on bank-owned FCMs. By holding cash and passing on the interest received from deposits, FCMs may be able to lessen the capital charges constraining the amount of business they are willing to clear.
A critical but not well-known role in CCP clearing is played by settlement banks. Settlement banks provide the market liquidity and collateral servicing necessary to facilitate the transfer and settlement of margin between clearing members and CCPs. FCMs generally hold end user assets at their settlement bank to make margin transfers more efficient.
Clearing members are required to have a relationship with a CCP-approved settlement bank. The settlement bank receives and processes margin settlement instructions from CCPs on behalf of FCM clearing members. These banks operate under an arrangement that authorizes the CCP to transmit debit or credit advices for the accounts of clearing members for margin due from or owed to the CCP. They also confirm margin call payments to CCPs in advance of initiating the actual transfers.
Customer Assets Protection
When an end-user delivers assets to an FCM in support of listed derivatives and cleared swaps accounts, those assets become subject to comprehensive customer protection rules under the CFTC’s regulatory authority. Customer funds further posted by FCMs with CCPs and their depositories continue to be subject to CFTC customer protection rules.
The CFTC’s segregation rules are a cornerstone of the agency’s customer protection regime. Customer funds must be held in a customer segregated account in the name of the FCM andtitled to clearly indicate that the assets belong to the FCM’s clients. These funds must be kept separate from the FCM’s own funds, must not be used by the FCM for its own account, and are not subject to lien or set-off by the FCM or its creditors.
Segregation rules for cleared swaps provide an additional layer of protection. Futures and options customer assets in segregated accounts are subject to fellow-customer risk. Fellow customer risk is the risk that a large customer default causes a shortfall in the FCM’s customer segregated account resulting in other customers funds being subject to a pro-rata loss sharing. Cleared swaps are held under the “legally separated; operationally commingled” (LSOC) model. Under LSOC, one customer’s funds cannot be used to offset the shortfall caused by another customer.
Rules mandating the deposit of initial margin for non-cleared swaps are coming into effect for a number of end users over the next two years. It is important to note that non-cleared swaps initial margin is required to be held in a segregated account which is not to be confused with a CFTC Segregated Account. Market participants that are in scope will be required to segregate acceptable margin at an independent third-party custodian.
FCMs may invest customer funds pursuant to CFTC customer protection rules only in CFTC approved instruments. FCMs are responsible for any losses on investments of customer funds. FCM customer funds investment options are:
- US government securities
- Municipal securities
- US agency obligations
- Bank certificates of deposit
- Commercial paper guaranteed by the US
- Corporate notes or bonds guaranteed by the US
- Money market mutual funds
The adoption of central clearing of derivatives is central to the commitments to reform of the markets, strengthening the financial system and reducing systemic risk. Certain aspects of new regulations have made it more complex and costly for FCMs to provide clearing services. End users are finding access to clearing more difficult and costs are higher. The number of active FCMs in the US has declined in recent years. Business is concentrated at the largest FCMs. The top 10 FCMs as measured by customer funds held, as of January 2019, $246 billion in customer assets, or 84% of the total $292 billion in the system (CFTC selected financial data report).
Cleared derivatives collateral management solutions that look beyond posting at the FCM and consider the additional influences collateral are more effective than those that do not. Most collateral management solutions address margin challenges from a buy side, sell side, or CCP centric position. Market participants may do better by thinking about how their collateral management process can produce benefits across the clearing ecosystem, while making them more attractive as clients, resulting in better access and lower costs.
Solutions lie in bridging the operational, data, timing and process gaps between market participants. Settlement banks play an essential role in supporting the derivatives settlements across key market participants. End users, FCMs, and CCPs use these custodial banks as safe-keepers of margin collateral and providers of commercial banking services.
As markets continue to evolve, the connections between market participants will become more linked creating new collateral management options.
At BBH, our role as a global custodian, investor services provider, and derivatives settlement bank means we play a part in each step in the derivatives settlement lifecycle. This gives us a unique vantage point and positions us work with all the key market participants.
For more information about any of the topics discussed please contact your BBH relationship manager.
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