Report on Clearing Arrangements for Exchange-Traded Derivatives

The Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries (the CPSS) is today releasing a report on Clearing Arrangements for Exchange-Traded Derivatives. This report describes and analyses the arrangements used to settle trades executed on derivatives exchanges. It focuses, in particular, on the sources and types of risk in such arrangements and the approaches adopted to manage these risks. The report, which is analytical rather than prescriptive, identifies a number of potential weaknesses in clearing arrangements and sets out possible ways to remedy them.

The report is a continuation of the CPSS's earlier work on the payment and settlement infrastructures that underpin financial markets, including netting schemes (on which reports were published in 1989 and 1990), securities settlement systems (reports in 1992, 1995 and 1997), foreign exchange settlement arrangements (reports in 1993 and 1996) and large-value interbank funds transfer systems (a report on real-time gross settlement was published in March 1997).

What is the report about?

The report deals with the clearing arrangements for options and futures traded on organised exchanges. The focus is on exchanges' clearing houses, which are at the heart of their clearing arrangements and are absolutely critical to their integrity. In all but a very few cases the clearing house acts as the central counterparty to all trades on the exchange. The clearing house's counterparties are its clearing members, which are generally a subset of the exchange's members, and which are responsible for performance on their own trades, on trades for the account of their clients, and on those of the other exchange members clearing through them. Both the liquidity of exchange-traded derivatives markets and the timely completion of payments and deliveries associated with these markets are critically dependent on the financial integrity of an exchange's clearing house, in which are concentrated the credit and liquidity risks of exchange trading and the responsibility for managing those risks.

Another key element of the settlement infrastructure for exchange-traded derivatives is the bank or network of banks through which money settlements are effected. This is also described and analysed in the report.

Finally, since the activities of most clearing houses now feature cross-border elements, the report explains how these may make the management of risks faced by clearing houses more complex and potentially more difficult.

What are the potential weaknesses in clearing arrangements identified in the report and what approaches are suggested to remedy them?

The report identifies several specific sources of potential vulnerability in clearing houses' 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.

The report suggests that clearing houses should carefully assess whether implementation of these steps would produce benefits, including reductions in systemic risk, that outweigh the costs.

Who should be interested in the report?

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 exchange-traded derivatives markets around the world. The report should be of interest to all those involved in trading on established exchanges for futures and options, including the owners and operators of exchanges' clearing houses, the clearing and non-clearing members of the exchange and the exchange members' clients. 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. Market analysts and researchers should also find the report useful as relatively little analytical work, particularly on a cross-country comparative basis, is publicly available. The annexes to the report contain detailed information on the risk management procedures and money settlement arrangements at selected clearing houses in the G-10 countries.

Notes to editors:

1. The Committee on Payment and Settlement Systems (the CPSS), based at the Bank for International Settlements (the BIS), serves as a forum for the central banks of the G-10 countries to monitor and analyse developments in payment and settlement arrangements and to consider related policy issues. The Chairman of the CPSS is William J. McDonough, President of the Federal Reserve Bank of New York.
2. The Chairman of the Study Group that prepared the report was Mr. Patrick Parkinson, Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System. A list of the members of the Study Group is contained in the report.
3. The report is available on the BIS World Wide Web site (http://www.bis.org) and copies can be obtained from the individual G-10 central banks and the BIS. The Web site also contains a list of the other publications by the CPSS as well as the full text of a number of recent reports.