Is Clearing a Force for Good?
By Bill Hodgson, The OTC Space Limited
Originally published on TABB Forum
If central clearing delivers trust in the post-trade environment and the spread of market knowledge, then it is a force for good and should been seen as a new enabler for the development of emerging economies, more than aid or loans.
Most of us are focused on the large changes being made to the OTC derivatives markets in Europe and the US. However, when you look at the total system required to support market infrastructure from trading down to settlement, recreating that framework in a new country from scratch is an enormous undertaking -- I don’t mean just computers and software, but the legal framework, the settlement infrastructure, risk management and, importantly, the knowledge to bring it all together, much of which isn’t freely available and carries a high price by those that can provide it. If central clearing delivers trust in the post-trade environment and the spread of market knowledge, then I argue that it is a force for good, and should been seen as a new enabler for the development of emerging economies, more than aid or loans.
As countries develop, they have to engage with capital markets technology and import some or the entire capital markets framework into their economies to become competitive and attractive to outside investment. Developing a national capital market firstly relies upon law. This entails a well defined insolvency framework that recognises the rights of users of the capital markets to settle a bankruptcy in an orderly manner and preferably with netting of obligations within asset classes. Law enabling the delivery of securities as collateral must be in place, and of course there needs to be a corresponding securities lending market and a depository, to complete the foundations.
Once this is in place, the infrastructure for the effective movement of securities is needed. Most countries develop a depository to enable an equity or bond market, and if settlement delays are to be avoided, will want to provide a clearing function to enforce predictable settlement and de-risk the post-trade environment. Without clearing, the depository can only use fines to enforce good settlement behaviour, or block firms from participating in the markets at all.
The next step is development of traded products with central clearing. That needs technology for pricing and risk management, something that is harder to import or acquire than legal expertise. Vanilla products with observable prices such as interest rate futures, commodity futures or bond futures can be managed by reference to historical market data. Pricing, though, becomes more complex once options are introduced onto an exchange. Not only must the exchange be able to price options to calculate safe margin levels, but participants must have the ability to quote option prices, and become market makers to kick off the flow of trading activity.
Built on pricing technology is that of portfolio risk management and techniques such as Value at Risk (VaR) or the well used Standard Portfolio Analysis (SPAN). Pricing a single option is something you can do on-line; but pricing a whole portfolio of hundreds or thousands of trades and simulating the behaviour of markets to calculate margin levels is a higher order problem.
Computer hardware is cheap, so acquiring the processing power needed to carry out the calculations isn’t a barrier, but the intellectual problem of making sense of the data cascading out of the calculations is harder. The reality is that portfolio risk management relies upon a deep knowledge of statistics, plus the traded products themselves. Most people left behind statistics at high school, and the number of people who have the expertise to apply this knowledge in the context of central clearing is limited. Without this depth of knowledge and experience, the central clearing structure is unlikely to stand strong against the economic instability it is meant to protect against.
What good is all this for a developing nation? By introducing clearing for bond and equity markets, the margin and strict settlement requirements would (in theory) reduce credit risk in the secondary markets and attract more sources of capital, both on-shore and off-shore. Providing hedging products for risks such as interest and exchange rates would enable firms to transfer risk via a trusted counterparty (the CCP) and manage exposures proactively, rather than suffer from unpredictable and adverse rates making their business more costly and uncompetitive. By adding a CCP and bringing ‘trust’ into the capital markets, firms are enabled to grow and attract inward investment into an organised and safe market.