Lieven Van den Brande Partner Clearing and risk management for derivatives markets FIA Asia Derivatives Conference 11 August 2005

2 - Clearing and Risk Management for Derivatives Markets - 11-Aug Capco confidential - © 2005 Capco Clearing is the process of determining obligations (cash and delivery) resulting from the buying/selling of a derivatives contract Clearing is generally understood as Central Counterparty clearing, but other services may be offered than merely CCP clearing Traditionally, CCP clearing has been available to exchange-traded contracts only Most exchange-traded contracts are by default subject to CCP clearing CCP clearing in OTC markets was until recently non-existent Credit and counterparty concerns have pushed many OTC participants to embracing OTC clearing Clearing and risk management for derivatives markets Concept

3 - Clearing and Risk Management for Derivatives Markets - 11-Aug Capco confidential - © 2005 Capco Clearing and risk management for derivatives markets Advantages and disadvantages Benefits of CCP clearing “Guaranteed” delivery by central counterparty, reducing counterparty risk Multilateral netting reduces settlement amount and risk exposure Anonymous trading and settlement Clearing facilitates trading with a counterparty, regardless of credit rating Improves liquidity as it brings firms with a lower-credit rating to the market that would otherwise be left out in bi-lateral trading Avoids having to write legal agreements with a host of counterparties and setting individual counterparty credit limits Fosters capital efficiency through freed up credit lines and reduced collateral requirements where otherwise bilateral collateral agreements are in place More transparent valuation through daily margining and daily cash flows (realized P&L) Higher efficiency through single operational process for all contracts Reduced settlement cost through single netted payment with the clearing house Less administrative burden and less risk of operational error Loss sharing and use of guarantee fund in case of default Obstacles to CCP clearing Requires collateral as capital Margining and collateral management process to be put in place (i.e. higher operational costs)

4 - Clearing and Risk Management for Derivatives Markets - 11-Aug Capco confidential - © 2005 Capco Clearing and risk management for derivatives markets Removing the obstacles to CCP clearing Optimizing use of capital and collateral Netting to create a single exposure Cross-margining Product (same product or related) Derivatives and underlying (e.g. future-bond, option-equity, future-swap) Market (e.g. CME-LCH, CME-SGX) Added value through risk reduction and cost savings through netting can generally more than compensate for the increased operational costs. Reducing operational costs Margining calculation facilitation (e.g. PC-SPAN) Outsourced clearing to general clearing member (not common in Asia)

5 - Clearing and Risk Management for Derivatives Markets - 11-Aug Capco confidential - © 2005 Capco Clearing and risk management for derivatives markets Trends and developments Consolidation of clearing houses LCH-Clearnet, DTCC-NSCC Market participants have expressed the interest of “clearing through a single centre, netting down with a single counterparty across as wide a range of products as possible”; provides operating, margin and capital efficiencies Although, the number of consolidations still remains limited Multi-product clearing LCH-Clearnet: equities, fixed-income, interest rate, commodities, energy, freight CME: index, interest rate, FX, commodities, weather Outsourced or multi-market clearing OCC (clears for AMEX, BOX, CBOE, ISE, PCX, PHLX, CFE, OneChicago) CCORP (clears for Eurex US, CCX) CME Clearing (clears for CBOT and CME) LCH-Clearnet (clears for Euronext.Liffe, IPE/ICE, LME, APE, ECX) JCCH

6 - Clearing and Risk Management for Derivatives Markets - 11-Aug Capco confidential - © 2005 Capco Clearing and risk management for derivatives markets Issues related to consolidation Consolidation only brings benefit if there is true integration or interoperability of systems with full cross-margining benefits Cross-border consolidation remains difficult to achieve due to regulatory and operational differences, anti-trust fears and nationalistic interests A single monopolistic CCP may not be preferred from a risk concentration point of view Corporate governance and ownership structure: exchange-owned CCP clearer might have an undue influence A for-profit CCP monopoly raises concerns about fee structure Undercapitalized CCP might not be able to provide guarantee in case of default On the other hand, trading liquidity pools may be fragmented by multiple clearing facilities (e.g. FFA clearing by Nymex, LCH.Clearnet and SGX) Market participants want consolidation to move ahead, even without mergers and acquisitions Possible solution: a few global clearers with interoperability, fungibility of contracts, position transfer and cross-margining agreements

7 - Clearing and Risk Management for Derivatives Markets - 11-Aug Capco confidential - © 2005 Capco Clearing and risk management for derivatives markets Trends and developments Clearing for OTC markets Nymex Clearport: power, gas, freight LCH-Clearnet: swaps, freight ICE (via LCH-Clearnet): power, gas; provides choice of bilateral and cleared trading SGX: FFA + energy clearing Bursa Malaysia: ethylene Possible services for the OTC markets Matching and confirmation (e.g. DTCC/DerivSERV, ICE, NYMEX Clearport, SwapStream) Netting (bi-lateral or multi-lateral) Valuation Tri-party collateral management (e.g. Euroclear, Clearstream) Full Central Counterparty Clearing ICE LCH-Clearnet Nymex Service offering for OTC marketplace

8 - Clearing and Risk Management for Derivatives Markets - 11-Aug Capco confidential - © 2005 Capco Clearing and risk management for derivatives markets Characteristics of Asian vs US/European markets Characteristics of Europe/US markets Separation of trading and clearing with independent clearing house (CCORP, LCH-Clearnet, OCC) Consolidation but not integration (separate entities for trading, clearing and settlement) Outsourced clearing (CME, LCH-Clearnet, OCC) Multi-product clearing (e.g. CME, Eurex, LCH-Clearnet) Integrated clearing of cash and derivatives offering cross-margining offsets (e.g. Eurex, LCH- Clearnet) OTC clearing Clearing membership: general and direct CM Cross-product margining agreements between cash and derivatives (CME and DTCC/GSCC) Cross-market margining offset (e.g. CME-LCH for interest rate contracts, CCORP-Eurex Global Clearing Link) Exchange traded and OTC clearing and resulting cross-margining benefits (e.g. LCH-Clearnet, EEX/Eurex, Nymex)

9 - Clearing and Risk Management for Derivatives Markets - 11-Aug Capco confidential - © 2005 Capco Characteristics of Asia markets Each exchange his own clearing house General clearing membership is not common practice Few OTC clearing services Few consolidation efforts Few cross-margining offset benefits Initiatives in Asia Single independent clearing house offering cross-market CCP services (e.g. JCCH) OTC clearing (SGX, Australia) Areas for development in Asia General clearing membership Cross-market margining Cross-market consolidation: Single mechanism for clearing and netting Collateral optimization through cross-margining Efficiencies due to rationalization of systems, processes and policies Better capitalized central counterparty Consolidated reporting Clearing and risk management for derivatives markets Characteristics of Asian vs US/European markets

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