Clearing the Cobwebs of Settlement

                                                             By Rajiv Gada
                                                          Asst Vice President
                                                           Thinksoft Global

Capital markets are witnessing sea changes in the way “Clearing and Settlement” functions are being conducted. Across the globe, major transformations are on the anvil.

Background: The financial crisis of 2008 highlighted the risks associated with the OTC derivatives trade and the necessity of insurance against counterpart risk. The default of Lehman Brothers and bail out of AIG are some glaring examples. The market suffered from certain weaknesses:

• Trades were bilateral between counterparties. They were unregulated in the sense that they were not being traded on exchanges and there was no central counterparty clearing.
• The contracts negotiated between two parties governed the trade events like Netting, Termination and Valuation on termination.
• Contracts included clauses vis-a-visvariation margins but initial margins were not strictly enforced.
• The overall exposure of counterparties in the market could not be ascertained.

This prompted the regulators to monitor the OTC derivatives market, thereby highlighting the importance of the Central Counter Party (CCP) in clearing operations. CCPs were thus supported and mandated by regulators across the globe.

Today, with regulations such as the Dodd Frank Act (US) and European Market Infrastructure Regulation (EMIR) being implemented, many more issues are being addressed:

• Standardization of Over The Counter (OTC) derivatives contracts and its clearance through CCC.
• Reporting of OTC derivatives contracts to trade repositories
• Creating a framework for regulation of CCPs and trade repositories.

Worldwide, stress is also being laid on reducing the settlement cycle time and the settlement risk.

What does this mean for Market Participants?

• Regulated vs. Free Market: Equities, the traditional asset class was always traded on the exchanges and hence cleared and settled by a clearing corporation. Now, OTC derivatives contracts like the Interest Rate Swap (IRS), can be traded OTC but need to be reported to the CCP for clearing. Hence, the positions of the participants can be monitored for regulatory intervention.
   Free market advocates who found it difficult to digest these moves, are slowly coming around.
• Increased Cost of Trades: The cost of trading these contracts has increased since CCP reported trades are margined, which necessitates the deposit of appropriate collaterals that adds to the cost.
• Reduced Volume of Trade: The position taken by banks in the highly traded OTC derivatives market is contracted and is restricted based on the availability of clean collateral that can be parked with the CCP.
• Increase in Safety: The market is becoming much more reliable in honoring commitments against contracts, thus minimizing the counterparty risk.
• Reduced Settlement Cycle: All the markets are implementing systems and procedures to reduce the settlement cycle, so that collaterals can be freed up quickly.
  Being a continent of many small nations with their own clearing and Central Securities Depository (CSD) infrastructure, cross-border settlements are fragmented in Europe. With the Euro being the common payment currency across, there is an increase in the flow of money and investment across these nations. With cross border settlement of securities, it takes time to conclude final settlements, thus locking up securities and collaterals.
  The European Central Bank (ECB) is implementing a major infrastructure project; Target2Securities (T2S) to enable cross border settlement in the “Delivery Versus Payment” (DVP) mode, thereby reducing complexity. The emphasis is on collateralization and their
  optimum utilization to increase the trading activity, which will be managed by T2S.
• Multiple CCPs: Today multiple CCPs clear different types of contracts, geography wise:
  - LCH Clearnet (UK) – IRS
  - LCH Clearnet (France) - CDS
  - Eurex clearing – IRS and CDS
  - CME Clearing – CDS
  - SGX Asia Clear (Singapore) – IRS
  - ASX Clearing (Australia) - IRS
   

Challenges ahead:

• Valuation of Contracts and Quantification of Risk: One of the major challenges faced is the valuation of contracts. Sophisticated mathematical models value them and the corresponding risks over a period of time. However, such valuations would be put to test only under
  extreme market conditions and how they stand up to these would be debated.
• CCP – Too Big to Fail: With the increased use of CCPs and the volumes they handle, they become too big to fail. Nonetheless, if a CCP fails, it would pose an enormous systemic risk. Monitoring mechanisms and norms prescribed by regulators, thus become critical.
• Collateral Management: Participants involved in multi-asset clearing would be associated with multiple CCPs. Collaterals being scarce, their optimum utilization is the key to increasing trading limits and reducing the cost of trades, valuing collaterals correctly and making them
  available for margins against the multi-asset class, is the need of the hour. Hence, CCPs and clearing firms would need to evolve strong collateral management policies. 

Fragmentation of trades across CCPs leads to locking collaterals at different locations. Going forward, a Global CCP concept could evolve that helps reduce the margins across hedged positions, thereby reducing collateral requirements. Also, when the positions are squared off at one CCP and there are larger positions at another, the time lost in movement of collaterals, resulting in a temporary need for more collateral and the additional costs involved, would accentuate the need for a Global CCP.

Opportunities for IT Service Providers: 

All the market participants; CCPs, Investment firms (Buy side and Sell side) and regulators are currently revamping their systems to support functionalities such as:

* Multi-asset
* OTC Derivatives Clearing
* Regulators Reporting
* Collateral Valuations
* Increased level of Straight through Processing
* Connectivity and Interfaces.

 

All systems would have to be revamped to handle the changes to workflow, both at the CCP and the investment firm's end.

Pre-implementation, detailed System Integration Testing (SIT) and post-implementation, detailed User Acceptance Testing (UAT) would be required before “Go Live”. 

Conclusion: Considering the various business aspects and regulatory changes, this industry is set to proactively seek increased efficiencies in the coming years.