How long can CCPs afford to wait?

Clearing HouseTwo months ago the Basel Committee decided that banks will have to set aside less capital against trades through central clearing houses in a bid to encourage them to use their services. The aim is to make banks use the central counterparties (CCPs), making it easier for regulators to follow the flow of banks’ trades and exposures to each other.

This followed a joint statement by the European Central Bank and the Bank of England over the City’s clearing houses that finally agreed that Euro denominated transactions could be cleared outside the Eurozone whilst making a point that “CCP liquidity risk management remains first and foremost the responsibility of the CCPs themselves”1.

Increasing trade volume

This will certainly lead to an increase in the volume of OTC trades cleared through CCPs and increase the competition between CCPs that until then tended to care more about their domestic business. In this article we will try to understand how this will further strain CCPs risk systems and force them to consider revisiting their system architecture to improve their risk management.

Clearing Houses have been humming along for almost decades without having to change much to their margining calculations and liquidity risk management when SPAN became the de facto standard for cash and option products. To a large extent, CCPs are still using mainframe applications to clear listed and cash products.

The need to clear OTC swaps and CDSs has turned their IT architecture upside down: the old systems couldn’t cope with the complexity of the new calculations (typically based on VaR). So they had to bring in new systems, in many cases the same systems used for trade processing and risk management by their clearing members. As there was no point, and more importantly, no time to rewrite span margining on the new systems, they are now left with disparate multiple systems – usually one for each asset class.

This sort of stop-gap tactical deployment won’t be sustainable as volumes cleared through CCPs keep increasing. A study from Deutsche Bank recently showed that twice as many CDSs could be cleared through standard CCP contracts for CDS and four times as many for IRS2. Even if the volumes of derivative trades remain fairly stable since 2012, the Basel Committee Capital requirement changes will surely increase the CCP volumes further.

Disparate risk systems don’t fit anymore

OTC do not represent a marginal business line any more for CCPs. Therefore they cannot keep managing those sectors in isolation. The time has come for CCPs to consolidate their risk systems.

But there is more to coping with increasing trade volumes than system consolidation: CCPs also need to produce their risk measures and margin calls faster. Calculations for cash and listed products are pretty straight-forward as exposures can be recomputed intra-day when market prices tick with existing infrastructure. For OTC products, valuation simulations take more time and so do aggregation and margin calculations. Most CCPs do not have the time or appetite to completely overhaul their risk engines and have therefore been using conventional techniques such as data warehouses to consolidate their member exposures coming from separate risk engines across product types.

Interactive “what-if” analysis: a must-have

Risk ManagementThese technologies cannot cope with the increased data volumes and the need for real-time interactivity. Usually processing data by batch, they are not suited for interactive “what-if” analysis which is a growing requirement expressed by the CCPs. Typically, the accrued competition between CCPs which tend to reach out to new members across frontiers, forces them to propose advanced simulation tools to their members. These are interactive and require more reactive technologies to enable these kind of “what-if” simulations on initial margins and variation margins.

Using an in-memory aggregation and analytics platform such as ActivePivot adds flexibility and timeliness to risk control with minimum impact on existing IT infrastructure. A CCP could add “what-if” analysis on new trades (or simulated trades) and immediately see the impact of intra-day changes to market data or collateral rules that can, in the first step, help their internal risk controllers. It can also improve the overall risk management across multiple product types by easily adding more dimensions to their reports for better/more detailed analysis, and by facilitating the deep reconciliation of aggregated risk measures.

At a later stage a CCP could propose a service to their clearing members, offering them a consolidated view of their transactions cleared through several exchanges within the CCP – all at a reasonable incremental cost.

Failing to comprehensively monitor a member’s exposure across their entire trading activity during the day, and instead relying heavily on late end-of-day reporting, will lead to serious mistakes. Financial crises of various magnitude do keep happening, with the next one perhaps just “around the corner of the Acropolis” – so how long can CCPs afford to wait?

1 ECB, Bank of England reach agreement over clearing houses. Jessica Morris 29 March 2015 City AM.

2 Reforming OTC derivatives markets August 7, 2103. Orcun Kaya (DB).

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