Shift to clearing presents CCP system challenges

There is a lot resting on the success of central clearing. Regulators are banking on it to help eradicate one of the major risks exposed by the financial crisis – a systemic failure caused by the collapse of a major, interconnected counterparty. But in mandating greater use of central counterparties (CCPs), many regulators also recognise they have shifted systemic risk from a group of large counterparties to a very small number of clearing houses – and they want to make sure they are rock-solid as a result.

The Committee on Payment and Settlement Systems (CPSS) and International Organization of Securities Commissions (Iosco) jointly proposed a set of principles for all systemically important payment systems, central securities depositories, central clearers and trade repositories in March, which puts a strong onus on appropriate risk management procedures and systems.

That’s easier said than done, though. Many CCPs are either new or have a history of clearing exchange-traded instruments. In a relatively short space of time, the number of over-the-counter instruments expected to be cleared will snowball, while clearing volumes are likely to surge. Given the complexity of the product, and the need to have bullet-proof default management systems in place, clearers have recognised they need specialist OTC technology – and many have been turning to third-party suppliers of derivatives and risk management systems.

From a technology point of view, there are two main aspects to clearing: core transaction processing and risk management. Transaction processing includes eligibility checks, matching, life cycle event management and settlement, while risk management includes valuation, margin calculation, default handling and reporting. For the most part, clearing houses are opting to develop their own transaction processing platforms, in some cases building on the systems already in place for their listed businesses.

Not so with risk management. The majority of CCPs that have launched to date, including CME Group, Eurex Clearing and SwapClear, the derivatives clearing platform run by London-based LCH.Clearnet, have turned to third-party risk technology suppliers. The reason is the complexity of the OTC derivatives market, where each contract is tailored to the needs of individual users.

“The biggest challenge of OTC clearing from a technical point of view is that it is a hugely complex market,” says Michael Davie, chief executive of SwapClear in London. “As each contract is unique, the valuation methodology is many times more complicated than it is for traditional futures markets.”

Ensuring the technology is scalable and can deal with potentially huge volumes is also an issue for some. “Many clearers are looking at the technology they currently have for risk management and asking whether it could cope with the volumes that are potentially moving to these markets,” says Richard Bennett, London-based European president of Sydney-based Razor Risk Technologies. Among the clearers using Razor’s risk technology are International Derivatives Clearing Group (IDCG), the Australian Securities Exchange, the Indonesian Clearing and Guarantee Corporation and LCH.Clearnet for its Repoclear platform, as well as a clearing service it provides for Virginia-based Nodal Exchange.