Central Counterparty is a concept of centrally clearing counterparty trade settlements through an entity called Central Counterparty (CCP) which acts as a buyer to the seller and seller to the buyer.
The primary function of a CCP is to simplify operational process and reduce counterparty risk that exists in bilateral market. It reduces the interconnectedness of trades and of participants and reduces the risk of default or nonpayment by a counterparty improving trade liquidity and transparency.
Key functions of a CCP are;
. Margining
. Novation
. Netting
. Managing Auctions
. Loss Mutualizing
Margining in Central Clearing in CCP Concept is one of the risk mitigation tools used by CCPs to minimize the counterparty and market risk. It involves posting cash or Liquid Security collateral for initial margin and variation margin requirements. Initial margin is cash or liquid asset transferred by a member at trade inception to cover worst case loss in the event of a member default. Variation margin is typically cash posted by a member to cover the daily change of member positions.
Novation is the legal process of interposing the CCP between seller and the buyer. Through novation an Over the Counter (OTC) contract is replaced with another contract with CCP.
Novation transforms bilateral trading to trading with CCP and CCP acts as the insurer of counterparty risk.
Netting reduces the total risk, mitigating the domino effect arising from counterparty default.
The following diagram illustrates the simple netting mechanism of CCP concept where ‘P’, ‘Q’ and ‘R’ are counterparties.
In the above simple netting mechanism, finally CCP has to pay counterparty P, 100, Q, 50 and receive 150 from R and reduced interconnectedness among three counterparties and risk is pooled to manage centrally.
Auction process is a situation when a Counterparty defaults in a trade without closing the trade at market value, and in an adverse eventuality the CCP auctions the trade/s to the surviving members through an auction process. Participating to the auction is the best method for participants to minimize the losses through lower market prices. Even nonmembers in the market who has no enough capacity to join to a CCP network can also participate by combining with a big CCP member like a Bank with specialized arrangements.
Loss mutualizing is a kind of insurance and it involves a contribution by members to a Default Fund to cover future losses from any member defaults.
Loss waterfall model in an event of member default is illustrated in the following flow diagram;
Advantages of CCPs are;
1. Transparency
2. Offsetting
3. Loss mutualizing
4. Legal and Operational Efficiency
5. Liquidity
6. Default Management
Sri Lankan Financial System and CCP Concept
Sri Lanka has relatively small financial market and relatively small number of counterparties consisting Banks, Primary Dealers, Leasing Companies, Finance companies and other Financial Institutions.
Also trades do not take much complex nature in their structures like in other countries in Europe, US and even closer Indian market. In other words we do not have exotic derivatives trading in our market. Therefore CCP concept can easily be applied to Sri Lankan market to protect the financial system stability of the economy if it is used in prudent manner.
However before the application of the CCP concept in Sri Lankan economy many ground works have to be completed such as ensuring the accuracy of transaction records, viability and efficiency of electronic platforms with strong Cyber Security measures, coverage of mechanisms in trade capturing and monitoring in real time, standardization of OTC products etc.
Risk of COVID 19 pandemic has created many challenges to Sri Lankan Financial System to protect the economy and achieve the economic goals of mother land in next few years’ time.
This pandemic risk has created many liquidity management challenges, Profit barriers, difficulties of maintaining sufficient economic and regulatory capital of financial institutions and so on.
However with the expertise knowledge and high commitment of financial community of Sri Lanka, we all should think about more stringent Financial Risk Management tools and mechanisms to protect financial system by protecting borrowers, depositors, counterparties and all other stakeholders while ensuring the stability of the economy as a whole to be ready to pass the future milestones of the country.
By introducing CCP concept into the Sri Lankan Financial System, many financial disasters could be avoided and protect the economy while preserving the wellbeing of public of the country.
However it is prudent to look at the risk of risk management tools when a new concept is implemented and early identification and better knowledge of that tools and practices will pave the way for experts and regulators to implement the concepts smoothly and achieve the expected benefits without getting exited with unforeseen eventualities which may arise in future.
Dark Side of CCP Concept
Morale Hazard problem is that counterparties will take higher risk in doing transactions knowing that this risk is borne by other members and the CCP.
Adverse selection is that participants with better understanding with products and risk will trade products heavily where CCP will underprice and will trade less products where CCP will overprice.
While it is an infrequent event, CCPs do fail. A failure of a large and systematically important CCP could lead a disaster to an economy.
Therefore a CCP must maintain sufficient loss absorption methods and default fund base in advance to absorb the shock of large number of defaults if arise, because such a disaster may not be tolerated by our economy with all these troubles created by COVID 19 pandemic.
Conclusion
Central Counterparty Concept is one of the excellent Risk Management concepts for the management of Financial Risk in Sri Lankan Financial System to protect its stability. But only thing we must remember is how a team of monkeys managed to drink water from a pond in “Story of Nalapana Jathakaya in Buddhist literature” and the famous English idiom “Fire is a Good Servant but Bad Master” in applying Modern Risk Management Practices in our own economy.
By Janaka Wijayawickrama, FRM,ACMA,CGMA,AIB
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