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What is clearing?

In the financial market disruption of 2007–08, the once arcane topic of clearing of financial products took center stage in major policy debates. Generally speaking, clearing has to do with the nuts and bolts of the contractual performance of financial products after they have been traded.

Here, we describe a very simple example involving a trade between a farmer and a baker that illustrates what clearing is and why it is important.

The farmer plants seeds today that will produce wheat tomorrow, and the baker will need wheat tomorrow to bake bread.

Suppose that the price per bushel of wheat tomorrow can take on one of three values, say, $5, $10, or $15, that If the farmer and baker could somehow bind themselves to a $10 per bushel agreement, then they would do so, so long as the cost of binding isn’t too great.

This is where the notion of clearing comes in.

One way the baker and farmer may be able to bind themselves to the contract is for each of them to provide $5 of collateral upfront.

The $5 of collateral is used to cover any losses incurred by a counterparty if another counterparty fails to perform on the contract.

For example, if the price of wheat is $5 and the baker reneges on the contract, then he loses his $5 of collateral, which is given to the farmer. In effect, the baker pays $10 for the wheat.

It would seem that with the introduction of collateral, the parties should not have an incentive to renege on their contract. But this is not the end of the story.

One tricky issue is who or what is to hold the collateral. Notice that the lack of commitment cannot be overcome by simply having each party to the contract holding the other’s collateral.

To see this, suppose that the price of wheat turns out to be $15. In this situation, the farmer does best for himself by selling his wheat on the spot market and keeping the baker’s collateral (while the baker keeps the farmer’s collateral).

Here, one holding of collateral simply offsets the other one and does not guarantee performance.

So, a third party is needed to hold the collateral of the baker and farmer.

With the introduction of a third party, things could work as follows.

If the baker and farmer perform on their contract, then the third party returns the collateral to each of them.

If, however, one party reneges and, as a result, harms the other party, then the third party can use the collateral of the nonperforming party to compensate the other party for his losses.

From the baker’s point of view, he has paid $10 for the wheat and, hence, has no incentive to default on the contract. So, it appears that the introduction of a third party that holds no need to have markets open up in any future period.

For example, if the farmer reneges when the price of wheat is $15, then the third party returns the baker’s own collateral and the farmer’s collateral to the baker.

Regulators may ease entry for derivatives clearing

U.S. regulators seeking to overhaul the $583 trillion market for privately traded derivatives have proposed lowering the bar for membership into clearinghouses, which guarantee swaps.

The move would force big banks to share profits from clearing over-the-counter derivatives with smaller non-incumbent firms under the new regulatory regime—a business opportunity estimated to be several billions of dollars, according to consultants at Booz & Co.

The Commodity Futures Trading Commission last week voted in a proposal that derivatives clearing organizations, or DCOs, wouldn't be permitted to set capital requirements on new members above $50 million—significantly lower than the existing hurdles.

"The proposed participant eligibility requirements will promote fair and open access to clearing," CFTC Chairman Gary Gensler said last Thursday at a hearing. The proposal "promotes more inclusiveness, while allowing the clearinghouses to scale a member's participation and risk, based upon its capital."

The CFTC proposal, which won't be implemented until next year after a 60-day public comment period and subsequent vote, also would prohibit a clearinghouse from requiring members to maintain a swap portfolio of a particular size or from setting transaction volume thresholds.

The Securities and Exchange Commission, which was tasked with implementing the derivatives overhaul along with the CFTC, hasn't yet made a recommendation on clearing member requirements, a spokesman said.

The CFTC will regulate swaps, and the SEC security-based swaps. They will jointly regulate swaps that don't fall cleanly into either category.

All derivatives that are standardized enough to be accepted by a clearinghouse must be cleared under the Dodd-Frank financial-overhaul bill signed over the summer. Early estimates suggest as much as 80% of the swaps market could be cleared.

The U.S. has two big horses in the swaps clearing race: ICE Trust for credit derivatives, which is owned by Intercontinental Exchange Inc., and CME Clearing, owned by the Chicago Mercantile Exchange, or CME Group Inc.

ICE Trust, which says it will comply with whatever the new rules are, now requires members processing trades through clearinghouses on behalf of customers—commonly referred to as futures commission merchants—to maintain a minimum of $1 billion in adjusted net capital. Other participants not acting as those agents, or FCMs, have to have $5 billion in Tier One capital to clear credit derivatives through ICE. Tier One capital is a measure of a firm's financial strength used by regulators.

CME Clearing, which also continues to work with regulators on the proposed rules, requires members that aren't banks to maintain a capital adequacy of $1 billion and members that are banks to have minimum tier-one capital of $5 billion.

CME's minimum contribution to its interest-rate swaps guaranty fund alone is $50 million—over and above its membership requirements. Like ICE, it also clears credit derivatives and its minimum capital requirements for that asset class of swaps are that members have access to at least $500 million.

Aside from capital requirements, clearinghouses also have restrictions that address the potential member's creditworthiness, operational capabilities, and expertise in swaps and potential default scenarios.


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