How Much Is Central Clearing Really Costing You?
By Jennifer Liu, Capco
Originally published on TABB Forum
For banks to preserve their profit margin in the new world order of mandatory central clearing, it is imperative to understand the cost of clearing. But that can be a daunting task.
This Part 1 of a three-part series exploring the cost of central clearing to various market participants and potential ways to reduce the cost. Part 1 focuses on direct clearing members (DCMs).
For the banks to preserve their profit margin in the new world order of mandatory central clearing, it is imperative to understand the cost of clearing. However, this can be a daunting task given that:
- Different CCPs have various cost structures, which may not always be transparent.
- The total cost of central clearing involves more than CCP charges.
- Different cost components are handled by different parts of the bank, exacerbating the lack of a comprehensive view of total costs.
Do you know how much central clearing is really costing your firm?
To illustrate the cost components involved in central clearing, the following diagram depicts a generic scenario for direct clearing members. (Only ongoing cost is included. Implementation costs such as program cost and application fees are not included. Actuals may vary depending on the various industries the members are in, firm specific set-up, and particular CCP cost structure.)
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1.1) Clearing fees– Fees payable to CCPs for clearing centrally. Fee structures may vary. Usually it is transaction volume-based, but minimum fees per month can be charged too. Fees are usually invoiced and paid in cash.
1.2) Margin– CCPs usually call direct clearing members Initial Margin (IM) and Variation Margin (VM) to protect themselves from the fluctuations of market movements in case of member default. Securities and cash collaterals can be used to meet the margin calls, though securities collateral may be subject to haircuts from CCPs. Collateral will be returned at the end of the transaction. Costs to fund and source collateral are usually firm specific.
1.3) Default fund contribution– To mutualize the risk of member default, all the direct clearing members need to make contributions to the Default Fund. Initial minimum deposit can range from $1MM to $15MM. (For example, minimum threshold for a clearing member trading over-the-counter fixed income transactions at CDCC is $1MM, while the LCH.Clearnet SwapClear minimum contribution is £10,000,000 plus a minimum of £3,000,000 in respect of the SwapClear Tolerance Contribution Amount.) Regular review of the fund is conducted and members may be called to make additional contributions to the fund. When a member defaults, surviving members may also need to put in more collateral to cover extra loss. The type of collaterals required for Default Fund varies from CCP to CCP.
1.4) Settlement charges– To settle the transactions going through the clearing house, CCPs incur settlement charges and usually pass them on to members.
1.5) Other charges– Depending on the CCPs, some other charges are also passed on to members. However, more transparency in this space is to be desired since they are usually not publicly available on the clearing house websites.
2. Bank charges–Most CCPs require members to set up bank accounts at approved settlement/payment banks for secured or protected payments. Settlement banks charge clearing members for different banking services involved, including wire transfers, reports, account access, etc. The banking charges can add up quickly given the number of banks and accounts that are required.
3. CSD charges –In the case of transferring securities collateral to meet margin or default fund contribution requirements, members can incur settlement charges at CSD.
4. Service provider charges –Certain technology platforms are required or approved to access the CCPs. Clearing members may rely on service providers for the access.
5. DCM Operating cost –Certainly, the number of functional teams, especially operations staffs, involved to support central clearing cannot be underestimated. Technology used in the banks can also account for a large portion of the operating cost.
Truly understanding the firm’s specific cost structure and ideally translating it into the cost per trade is highly recommended. It is a painstaking but rewarding exercise, which will provide insight into the true cost of running the business and help identify ways to reduce the cost. (One cost analysis conducted by Capco revealed a case of astoundingly high cost per trade.)
In the next instalment, we will look at the cost from the clearing brokers’ (GCMs and FCMs) perspective. And in the last instalment of this series, we will discuss some of the ways to reduce the costs