Role of central counterparties and processing of OTC derivatives

Part II – Best practices framework for CCPs

Best practices

Going by the market experience and practice, we have identified certain critical best practices in our suggested framework for Central Counter Parties.

  • Legal framework
  • Membership criteria
  • Exposure management
  • Default procedures
  • Financial wherewithal
  • Margin requirements
  • Risk management
  • Efficiency and transparency
  • Regulatory oversight

Recommendations for CCP

Therefore, the effectiveness of a CCP’s risk control and the adequacy of its financial resources are critical aspects of the infrastructure of the markets it serves. Committee on Payment and Settlement Systems of the Bank for International Settlements and Technical Committee of the International Organization of Securities Commissions have come out with a set of recommendations for central counterparties in November 2004.

CCP Risk models and alternatives

Ideally a central counterparty is expected to have well defined risk models to manage its operations efficiently and cost effectively. Along with the risk models, it would be better if they also put in place appropriate default protections in place.

The following table brings out one such risk model and default protection followed by LCH Clearnet.

Risk Models

  • Strict membership criteria ensures high quality counterparties
  • Real-time novation / open offer of cash market trades
  • Clearing members become the ‘Principal’ to trades
  • Multilateral netting to reduce value at risk
  • Initial and variation margins
  • Intraday margin calls
  • Clearing fund to cover risk in abnormal market positions
  • Buy in / Sell out capabilities
  • Secure payments systems
  • Default Protection
  • Membership criteria
  • Initial margin
  • Variation margin
  • Intra-day margin
  • Defaulter’s own default fund contribution
  • Ltd’s own capital (capped)
  • Remaining default fund
  • Insurance
  • Reminder of Ltd’s capital

Modelling risk in a central counterparty

Central counterparties form a core part of the financial market infrastructure. CCPs were established originally to protect market participants from counterparty risk in exchange-traded derivatives markets, but they now also have an important presence in cash and over-the-counter derivatives markets. By interposing themselves in transactions, CCPs help to manage counterparty risk for market participants and facilitate the netting of positions. In performing this role, however, CCPs are themselves exposed to various risks. To protect themselves, they have developed various models and procedures, amongst which the margining of members’ positions plays a central role. CCPs need to assess the losses they could face on occasions when margin proves insufficient, and ensure that they can meet these losses from extreme events by other means. Sometimes margins alone, calculated to cover losses from typical price movements over one or more days may not be sufficient to protect CCPs from rare but plausible events.

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