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27. What does a CCP do? What are the pros and cons?
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CCP is the acronym for central (clearing) counterparty. In some markets, they are known as clearing houses. CCPs perform two so-called clearing functions:
  • Once a transaction has been agreed between two parties and registered with a CCP, the CCP inserts itself into the transaction (so that one contract becomes two --- a process called ‘netting by novation’), or is deemed to be an original party to the transaction (one transaction automatically generates two contracts --- a process called ‘open order’), to become the buyer to every seller and the seller to every buyer.
  • The CCP will net transactions between members on a multilateral basis (netting by a CCP is referred to as “clearing”). This means that a delivery of a security due to the CCP from parties A and B can be netted off against deliveries of the same security due on the same day from the CCP to parties C and D. The same applies to cash payments. This produces much smaller net exposures than bilateral netting, in which each party can only net transactions with the same counterparty.
The benefits offered by CCPs include:
  • The reduction of risk exposure by providing a prime counterparty. CCPs are backed by a series of capital buffers (in the form of initial margins, default fund, reserves and equity) and a risk-sharing arrangement among CCP members. CCPs are also subject to a special regulatory regime. Consequently, CCPs are deemed to be low-risk counterparties, for which reason, they can benefit from reduced regulatory risk capital charges.
  • Multilateral netting of risk exposures.
  • More rigorous risk management practices than many market users.
  • The reduction of balance sheets through netting.
  • Operational efficiencies from the netting of payments and transfers.
  • The potential for enhancing market transparency, given that CCPs collect data on transactions and are therefore in a position to publish aggregated price and volume data (eg the DTCC in the US publishes a repo rate index).
For these reasons, regulators wish to encourage the migration of as much financial activity as possible to CCPs in order to reduce systemic risk.  However, there are a number of drawbacks to the use of CCP, which regulators will need (and are generally attempting) to address:
  • As a higher proportion of trading is cleared across CCPs, more and more credit, liquidity and operational risks will be concentrated in these institutions, which will themselves become potential sources of systemic risk.
  • Banks will have to apply credit limits to CCPs, taking account of the fact that, if they are clearing members, they will also have contingent obligations to help bail out the CCP should a default by another member or several other members exhaust the CCP’s margins and default fund. These limits may constrain market liquidity.
  • Greater use of CCPs means greater collective reliance on a limited range of risk management methodologies, which may synchronise reactions to news (eg changes in haircuts or collateral eligibility) and generate pro-cyclical shocks to the financial system. Strict haircutting by CCPs arguably had such an effect on Greece, Ireland, Italy, Portugal and Spain in 2011.
  • Although CCPs apply more rigorous risk management practices than many market users, their methodologies are often proprietary and therefore opaque, and it is not possible for members to scrutinise these methodologies, despite their critical dependence on them.
  • Most financial assets are not eligible for clearing across CCPs. This includes most credit instruments.
  • CCPs tend to specialise in particular products or asset classes. Use of CCPs therefore reduces the scope for netting across products, which institutions are currently able to do on a bilateral basis.
  • The initial margins or haircuts imposed by CCPs are very high compared to current market practice, and the remuneration of cash margin paid to members is low. Consequently, CCPs are expensive to use. The extra cost of using CCPs will raise the cost of funding to all market-users.
  • CCPs may not be suitable for all types of market user. The access criteria and cost represent barriers to entry for smaller firms. Netting is only cost-effective for institutions with two-way flows of business, ie intermediaries rather than end-investors. Many end-users are unused to margining and may be deterred from trading by the cost and effort of margining.  
  • Netting requires standardisation of financial instruments. Less customisation means that residual risks have to be managed in the uncleared market or left with the end-user. Given that uncleared business will be subject to higher regulatory capital requirements (in order to encourage migration, where possible, to CCPs), the latter outcome may be common. To this extent, financial markets will be constrained from their essential task of managing financial risks and allowing non-bank financial and non-financial institutions to focus on their core business.
  • CCPs accept a limited range of collateral assets, usually only cash in major currencies and top-quality government bonds. This may contribute to a systemic shortage of collateral.
During the crisis that erupted in 2007, CCP clearing helped to preserve access to the repo market for banks from some peripheral Eurozone countries who were being squeezed out of the uncleared market by other banks cutting their risk limits on these countries.

The principal CCPs clearing repos in Europe are LCH-Clearnet Ltd in the UK, LCH-Clearnet SA in France, Eurex Clearing in Germany, CC&G in Italy and MEFF in Spain.

CCPs clear a very significant proportion of the European repo market. The ICMA’s semi-annual survey of the European repo market suggests that about 30% of outstanding repos by value are cleared across a CCP. The proportion of repo turnover cleared across a CCP is likely to be even higher because the repos cleared in CCP tend to be short-term transactions (the ECB’s money market survey suggests in the order of 70%).

Most CCP-cleared repos are negotiated on automatic repo trading systems such as BrokerTec, Eurex Repo and MTS. However, repo negotiated directly between parties or via a voice-broker can also be registered with a CCP post trade.

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