Clearing:

• The process through which derivatives trades are confirmed and registered

Clearing House:

• Central Counterparty (CCP)
• Greatly reduces counterparty risk (credit risk) - BUT NOT ELIMINATES
• Guarantees the performance of a contract - FOR ITS MEMBERS ONLY
• Gives a high degree of confidence in the system
• Clearing house as registrar
• Most derivatives exchanges have their own clearing house

The Structure of the clearing system:

• Novation (Where the Clearing House becomes the seller to the buyer and the buyer to the seller)
• They are principals, not agents

• T.R.S. = Trade Registration System

NCM would need to give up to a GCM for the trade to be novated

Guarantee (Protection given to counterparties should default occur):

• Mutual Guarantee (Default 'waterfall')

1. Take defaulting member's margin
2. Defaulting member's contributions to the default fund
3. Other members' contributions to default fund
4. Clearing house's own funds

• Remember this list and order

• Independent guarantee
• Defaulting member's margin
• Clearing house's own funds (including insurance)

• Default fund (clearing fund)
• Contributions based on proportionate volume and value of average daily trades novated

Margin Account Types and Key Features:

• House Account:
• Used for proprietary trades by the firm
• Trades are for the firm's benefit or loss, excluding client positions
• Margin payments are managed internally, with exposure fully borne by the firm

• Client Segregated Accounts:
• Separate accounts for individual client trades
• Required by most exchanges and regulators
• Client assets are protected from the firm's liabilities
• Initial and variation margin are calculated and collected per client, ensuring their funds are protected

• Client Non-Segregated Accounts:
• Combines multiple client trades into a single account
• Higher risk for clients in case of firm default
• Potential cash flow benefits for clearing firms
• Margin offsets across clients' positions can reduce overall margin requirements, but increase risk exposure for individual clients

Initial Margin: Futures and Options on Futures

• SPAN (Standard Portfolio Analysis of Risk)
• Collects all the derivative positions of a clearing member into portfolios and calculates the risk of each portfolio
• Calculates the most probable ONE DAY LOSS

• SPOT-Month Charge
• Used to reflect increased risk with contracts close to expiry
• An adjustment

Variation Margin: Futures and Options on Futures

• Collected through Protected Payment Systems (PPS)
• An adjustment for any P/L on Position
• Done on a day-to-day basis
• Cash

Maintenance Margin:

• Variation Margin is paid out of the initial margin held at the clearing house
• Margin calls are made when initial margin falls below a pre-determined level
• NOT used in UK by clearing houses, although brokers tend to use this method with their clients

Acceptable Collateral:

• Clearing house margin
• Variation Margin
• Usually Cash

• Initial Margin
• Various collateral accepted
• Collateral must be lodged with depositories and custodians
• Collateral must be marked to market daily and is subject to a published haircut
• Unacceptable as collateral:
• Undated bonds
• Foreign currency bonds (Gilts denominated in Euros)

Credit Lines:

• Clearing house and broker margin
• Broker calls from clients at least what the clearing house calls from them

• Credit extended to clients by brokers and clearing members to cover derivative positions
• Must comply with exchange and regulators rules
• E.g. FCA allows a firm to extend credit for up to five business days without a formal agreement

• Most exchanges don't let credit to cover margin calls (including ICE Futures Europe)

OTC Collateral Management

• Collateral Process
• Threshold amount
• Maximum unsecured credit exposure a counterparty is willing to take

• Minimum Transfer Amount
• Reduces the cost and number of payments by setting a minimum amount ofcollateral that will be transferred
• Delivery Amount
• Return Amount
• Credit Support Annex
• Defines files and conditions under which collateral will be transferred
• Collateral Support Documentation
• Sets out timings and procedure of marking-to-market

Roles of banks: (Custodian)

• Mark to market
• Monitor the value of collateral
• Manage delivery and return amounts
• Pay interest on cash collateral

Uncleared Margin Rules (UMR)

• Purpose
• Regulatory requirements to mitigate (Can't Eliminate) systemic (Not systematic) risk of OTC Derivatives (Not All) not cleared through a CCP
• Reduce counterparty credit and default risk in OTC derivatives post-2007-08 financial crisis
• AANA (Aggregate Average Notional Amount)
• Calculation includes all uncleared derivatives, measured over March - May

UMR Rules and Scope

• Derivatives in Scope: Non-deliverable forwards, FX Options, Equity Swaps, Interest Rate Products, etc
• Standardised Initial Margin Schedule: Grid or SIMM methodologies
• Collateral Thresholds: Initial Margin is collectable above 50 Million EUROS
• Entities with an aggregate average notional amount (AANA) of uncleared contracts exceeded a set figure measured over March - May
• E.g. 8 billion EUR/GBP/USD