Financial institutions can participate in a central counterparty (CCP) in two ways — either as a direct or an indirect clearing member.

To become a direct CCP clearing member, firms need to meet the criteria set by the CCP. Typical requirements include:

• Having sufficient capital (e.g., core capital)
• Making contributions to the default fund (also called guarantee fund or clearing fund)
• Ensuring that appropriate technical and operational systems and controls are in place
• Obtaining all necessary authorizations, licences, permissions and approvals, or their equivalent, with respect to each regulatory authority
• Having the appropriate banking arrangement in place (e.g., fees and margin payment from a certain bank account)

Individual CCPs may also have their own requirements, such as employing staff with sufficient experience and knowledge of the products being cleared (e.g., LCH.Clearnet Ltd) and having appropriate business continuity procedures (e.g., ICE Clear Europe).

When a firm applies for clearing membership, it applies to a certain service and is subject to the criteria set by that particular service. For example, SwapClear and RepoClear in LCH.Clearnet have different capital requirements. The capital requirement for SwapClear members that are going to clear its own business is US$50 million, while the requirement is €100 million for RepoClear members. In addition, SwapClear also requires members to participate in “fire drills,” which involve submitting a bid for a notional portfolio of trades within a specific currency in a specified time frame, in essence simulating another member’s default.

Firms can also participate in the CCP as indirect clearing members by signing a clearing agreement with a direct clearing member that can provide such services. As indirect clearing members, firms do not need to meet all the requirements set forth for direct clearing members. For example, indirect clearing members do not need to contribute to the default funds, which means institutions that are disinclined to participate in risk mutualization (e.g., sharing the default risk) but would like to have transactions cleared through a CCP can still participate through indirect clearing.[1]

Two models exist for indirect clearing: principal and agency model. In the principal model, there is a contractual relationship between the customer and the clearing member and a corresponding contractual relationship exists between the clearing member and the CCP. Typically, the indirect clearing member and direct clearing member have a bilateral transaction, and the direct clearing member then has a cleared mirror transaction with the CCP. The direct clearing member answers the margin calls from the CCP, and places margin calls to the indirect clearing member at a frequency of its own discretion.

In the agency model, the indirect clearing member has a direct relationship with the CCP, with the clearing member acting as an agent/guarantor. For example, the indirect clearing member can submit the transaction to the CCP directly, leveraging a direct clearing member’s account or sub-account with the CCP. The direct clearing member is liable and responsible for collecting margins from the indirect clearing member and passing them along to the CCP. The indirect clearing member can access the reports either directly from the CCP or through the direct clearing member. In the principal model, the indirect clearing member is exposed to the counterparty risk of the direct clearing member, whereas in the agency model, the indirect clearing member is exposed to the risk of CCP default.[2]

Direct clearing members that offer the service to clear for indirect clearing members need to meet additional requirements. For example, while a direct LCH.Clearnet RepoClear clearing member clearing for its own business is required to have €100 million in net capital, those that clear for other indirect clearing members are required to have €400 million in net capital. Since contribution to the default funds are related to the size of the business and volume of clearing activities, clearing members that clear on behalf of their clients are usually required to contribute more to the funds.

To implement direct clearing through CCPs, firms need to ensure that they complete the CCP required activities and internal development.[3] For example, they must:

• Submit the required documentations to the CCP (e.g., membership application, legal agreement, banking arrangement, escalation contacts)
• Complete trainings required by the CCP
• Ensure that connectivity with the CCP is established
• Assess the required development on internal systems and conduct internal testing if necessary
• Ensure that internal operational procedures are updated (e.g., trade booking, margin calls)

Firms looking to choose a CCP that is going to clear their products should carefully evaluate the available options and consider the CCP service’s competitive advantage and cost. Some distinct advantages can include large volume of cleared transactions, experience in risk management, wide range of products offered, robust reporting tools, ease of implementation and large number of participants. Costs associated with clearing through a CCP usually involves upfront costs, such as implementation costs, application fees and the initial deposit of the contribution to the default funds, as well as ongoing costs, such as additional contributions to the default funds as required by the CCP and clearing fees.[4] As the clearing fees are usually based on the volume and size of the transactions, long-term business growth projections should be factored in to understand the ongoing cost.

Has your organization had experience participating in a CCP, either as a direct or indirect member? Join the discussion.

Next week, the final blog of the CCP series will provide an outlook of the CCP market, discussing opportunities and challenges.

[1] However, direct clearing members typically charge their clients a fee for their increased default fund contribution (e.g., via charging some basis points on the IM paid by the client).

[2] There is an ongoing discussion in Canada around segregation and portability of OTC derivatives clearing to protect client collateral. See http://www.osc.gov.on.ca/documents/en/Securities-Category9/csa_20120210_91-404_segregation-portability.pdf

[3] Clearing houses use different terminologies to reference direct clearing members that clear its own business and those clearing for indirect clearing members. For example, LCH.Clearnet calls the former Individual Clearing Member (ICM) and the latter General Clearing Members (GCM).

[4] CCPs use different fee structures. For example, to clear repos, LCH.Clearnet RepoClear and CDCC charge a minimum monthly fee as well as fees based on the size and term of the repo (e.g., different basis points (bps) are applied for different lengths of term), whereas Eurex Clearing does not apply a minimum monthly fee but charges a minimum fee per transaction and the same bps are applied throughout the term.