Clearing arrangements for exchange-traded derivatives

March 1997

Foreword

The rapid growth of financial derivatives over the last decade has been the subject of numerous studies by central banks and regulatory authorities and by private sector groups. Much of this work has focused on derivative transactions privately negotiated in the over-the-counter markets. Exchange-traded derivatives have received less attention, perhaps because the regulatory framework for such instruments has been in place for some time, and the financial integrity of futures and options markets has withstood some rigorous tests. Nonetheless, stresses that were evident following the October 1987 stock market declines and the February 1995 failure of Barings underscore the need to critically examine the financial safeguards available in the various markets across the world.

The financial integrity of futures and options markets depends on the robustness of their arrangements for clearing and settling trades. The present report, prepared by the Ad Hoc Study Group on Exchange-Traded Derivatives, describes and analyses clearing arrangements for exchange-traded derivatives in the G-10 countries. The focus is on exchanges' clearing houses, which are at the heart of their clearing arrangements and are absolutely critical to their integrity. The Study Group's work is analytical rather than prescriptive - it discusses the sources and types of risks to clearing houses and the risk management safeguards that clearing houses employ to manage those risks. The report identifies several specific sources of potential vulnerability in clearing house risk management systems: (1) inadequate financial resources to meet losses and liquidity pressures from member defaults induced by extreme price movements; (2) a lack of mechanisms to monitor and control intraday risks; and (3) weaknesses in money settlement arrangements, including reliance on payment systems that entail the risk of unwinds of provisional funds transfers late in the day.

For each potential weakness identified, the report points out ways to strengthen clearing arrangements: (1) the use of "stress testing" to identify and limit potential exposures to clearing members from extreme price movements, and to ensure that the clearing house's financial resources are adequate in such circumstances; (2) enhanced intraday risk management through more timely trade matching and more frequent calculation of exposures and through the development of the capacity to reduce intraday exposures by means of more frequent settlements; and (3) strengthening of money settlement arrangements through the use of real-time gross settlement (RTGS) systems for payments and securities transfers and by clarifying settlement agreements with clearing members and settlement banks. As the report suggests, clearing houses should carefully assess whether implementation of these steps would produce benefits, including reductions in systemic risk, that outweigh the costs.

The annexes to the report contain a wealth of information on the risk management procedures and money settlement arrangements at selected clearing houses in the G-10 countries. While the body of the report emphasises the similarities in approaches to risk management across clearing houses, the details often differ, and these differences can be significant to the assessment of the effectiveness of risk management procedures at individual clearing houses. The analytical framework developed in the report should aid both market participants and those responsible for the supervision and regulation of clearing houses in making informed assessments of the robustness of individual clearing arrangements.

The Committee is indebted to Patrick Parkinson for his excellent leadership in chairing the Study Group. Able assistance in editing and publishing the report was provided by the BIS.

William J. McDonough, Chairman  
Committee on Payment and Settlement Systems  
President of the Federal Reserve Bank of New York