Clearing without a guarantee fund?

By Peter Fredriksson, Baymarkets

The need to provide a guarantee fund has long been a deal-breaker for frontier and emerging financial markets, given the sizeable investment required to create one. New approaches however, are allowing operators of these markets to implement the necessary clearing functionalities without having to put such a guarantee fund in place.

The “CCP-light” model

Recent developments in clearing applications now provide rich functionality such as real-time risk calculations and cross-asset margining via low-cost delivery models, allowing an entity to act as a settlement facilitator, but without the need to perform the usual guarantee obligations of a Central Counter Party (CCP). In-effect, this is what we call a “CCP-light” model, where the residual risk after the margin is exhausted is not held with a central guarantee fund or CCP but is instead carried by the counterparties.

There are a couple of different ways to implement this model. In an OTC market for example, where the trading participants are known to each other, a bilateral relationship would typically be maintained for each trade, which however loses the netting-effect, and ties up more collateral.

In a more anonymised market, the cost of closing the positions of a default party would more likely be distributed to all counterparties in the market.

With either version of this model, since the CCP does not have a default fund and ‘skin in the game’, the risk of market participants being impacted by a potential default is higher than with a traditional CCP. However, firms can still rely on the CCP-light to be transparent and efficient and to close down those that are not fulfilling their obligations. And we should remember that loss from default seldom happens when proper risk management is in place.

The CCP-light performs all other functions that a regular CCP does, one of the most important being the ability to net down positions. The only difference is that in a default situation the market participants are collectively risking more. But this is a risk that is inherent in any bilateral market.

These models must be aligned with the local regulatory authorities.

Pros & cons of this approach

Removing the need to establish a costly guarantee fund and taking advantage of the speed of agile implementation for the various clearing functions, enables markets to be created and to become operational quickly and efficiently.

This agile approach to clearing technology offers another advantage in that it allows the clearing platform to rapidly evolve with its users. This is because new client requirements can be rolled out continuously, benefiting all stakeholders and thus helping each client to reap the rewards of a fast-developing system.

The main disadvantage for markets that do not have a guarantee fund is that margin requirements tend to be higher and the systemic consequence of one participant going bankrupt is not easy to predict. This is however a natural consequence of operating without a central reserve to protect against trade default. To counter this and to offset the risk of default, counterparties can post the necessary collateral with the CCP prior to trading. And the CCP-light provides more transparency than is available in a traditional bilateral market.

Another benefit of this model is that the CCP-light does not necessarily need to be responsible for onboarding new members, a market group (for example) could take on that responsibility, therefore providing more transparency into the makeup of market participants.

Maturing markets

Until now, many emerging and frontier markets around the world have only been able to manage more straightforward securities - such as commodities or cash equities – because they have been unable to clear more complex financial instruments such as derivatives. As these markets start to mature, they require more advanced clearing models.

Here at Baymarkets, we are in discussion with a number of CCP-light initiatives about our Clara clearing platform, which can oversee complex risk management and calculation functionality across multiple asset classes, ensuring that positions are valued correctly and efficiently. Importantly, to support the CCP-light model, Clara can be rapidly implemented at low cost, without any requirement for a guarantee fund.

And although technology is an essential part of the equation, equally important for nascent market operators is to work with partners such as Baymarkets who understand the changing clearing landscape, and who can bring in the necessary mix of experience, expertise and innovation to ensure that the right model is implemented in the right way.

From Frontier to Emerging Status

There is no universally agreed definition of what constitutes a “frontier market” or an “emerging market”. However, the maturity of a country’s trading and post-trade framework can play a significant part in moving a market from frontier to emerging to developed status, and the clearing aspect of this cannot be understated.

In summary, new clearing platforms essentially allow market operators in developing nations to capitalise on the latest clearing technology without having to make major investments in post-trade infrastructure. This is one of the main reasons why this clearing model is starting to lead the way for frontier and emerging markets. It is uniquely positioned to provide efficient workflows and operational agility, without the need to invest prohibitively large sums.

At Baymarkets, we are excited about being a part of this evolution and working with our clients on the provision of cutting-edge clearing models and will continue to provide insight into this topic.