Central counterparties (CCPs) are financial market infrastructures that interpose themselves between the original counterparties of a financial market transaction in securities, derivatives or goods, etc. In doing so, a CCP substitutes the original transaction between these two counterparties with two separate transactions between the CCP and the respective counterparty. This makes the CCP the buyer to every seller and the seller to every buyer of financial market instruments. The CCP therefore also bears the settlement risk of the given transactions. A distinction is generally made between the concept of open offers, whereby CCPs are automatically interposed between the two counterparties at the time an exchange-based trade is executed, and the concept of novation for over-the-counter (OTC) transactions, whereby the original transaction is placed with the CCP either directly or via a third party and then accepted for clearing by the CCP.
By entering into a transaction, CCPs assume the risk of default between the two counterparties and therefore make a key contribution to the risk management of the financial market participants involved. In addition, the central clearing of all open positions by a CCP increases post-trade efficiency. Multilateral netting can contribute to a substantial reduction in both risk and the number of instructions that need to be processed.
Example of increased post-trading efficiency resulting from multilateral netting.
CCPs need to robustly manage their financial risk if they are to successfully pool and limit default risks for their participants. They hedge potential risks, particularly credit and liquidity risks, in order to be able to reliably contain the negative consequences for the settlement of financial market transactions that a default of individual participants would entail. To do so, they usually employ the following measures:
- CCPs usually set high credit quality standards for their participants and only allow market participants with good credit ratings to access their systems.
- CCPs require their participants to provide collateral, known as margins, to cover the value of potential risk from their participants’ outstanding transactions. This potential risk is calculated on as up-to-date a basis as possible. Eligible collateral usually entails low credit and liquidity risk.
- CCPs maintain ring-fenced provisions to cover some of the losses if the margins provided by the defaulting participant prove insufficient. They also have an institutionalised joint liability arrangement in the form of a default fund which kicks in once the collateral provided by the defaulting participant has been exhausted. When this occurs, the collateral provided to the fund by the remaining participants is used. If these amounts are still insufficient, participants may potentially also be asked to make supplemental default fund contributions.
- As a last resort, the CCP’s own capital may also be drawn upon.
CCPs played a stabilising role during the global financial crisis and were by and large able to carry out their duties successfully. By contrast, bilaterally cleared derivatives contracts were seen to be a major source of uncertainty during the crisis. This is why the G20 countries have since required market participants to settle certain OTC derivatives transactions via CCPs. This G20 provision has been implemented in the EU via the EU Regulation on OTC derivatives, central counterparties and trade repositories (European Market Infrastructure Regulation – EMIR) as well as supplemental legal acts.
Entities subject to oversight
At national level, the Bundesbank is responsible for overseeing the two German CCPs Eurex Clearing AG (ECAG) and European Commodity Clearing AG (ECC).
ECAG acts as the CCP within the Deutsche Börse group. For the cash, repo and derivatives markets of the Deutsche Börse group, ECAG normally performs CCP services using the open offer model. For OTC derivatives contracts, counterparties can use ECAG as a CCP via the novation procedure.
ECAG has been fully owned by the Deutsche Börse group since 2012. Prior to this, it was a joint venture between the Deutsche Börse group and SWX Swiss Exchange (resulting from the merger of the Deutsche Terminbörse and its Swiss equivalent, SOFFEX, in 1998). ECAG nevertheless continues to carry out its CCP activities in Switzerland. In accordance with legal requirements in Germany, ECAG has a banking licence pursuant to the German Banking Act (Kreditwesengesetz). ECAG’s participation requirements stipulate that supervised credit institutions that fulfil minimum capital requirements may take part in the clearing process. ECAG continually monitors the risk positions of its participants and makes same-day and intraday margin calls. If a cash margin is provided, these payments are mainly made in safe central bank money via TARGET2 or the SIC payment system operated on behalf of the Swiss National Bank. In order to cover losses that exceed the collateral provided by a defaulting participant, ECAG also maintains a joint default fund (in addition to its own ring-fenced funds) which all participants contribute to and to which they may be asked to make supplemental contributions.
If financial market transactions such as repo or cash market transactions in equities fall due, the delivery and payment of securities underlying transactions settled via ECAG are made via the central securities depositories Clearstream Banking AG, Frankfurt, Clearstream Banking S.A., Luxembourg, SIX SIS AG, Zurich, Euroclear UK & Ireland or Euroclear Bank, Brussels, depending on the transaction type.
ECC is the CCP of the Leipzig-based European Energy Exchange. Until 2006, CCP services were provided by the exchange itself. Since the outsourcing of CCP services, ECC has been operating as a stand-alone CCP for spot and derivatives transactions in electricity, gas, emission rights, agricultural products and commodities. In addition to transactions on the European Energy Exchange, ECC also offers CCP services to trading venues in Asia and Europe.
In accordance with legal requirements in Germany, ECC has a banking licence pursuant to the German Banking Act. Supervised credit institutions that fulfil minimum capital requirements comprise most of the membership base at ECC.
In order to absorb the default of individual counterparties, ECC requires margins to be provided that cover the respective participant's continually monitored risk positions, which can be adjusted on a same-day basis and for which margin calls can be made. Margins provided in cash are settled in TARGET2. In addition, participants in ECC contribute to a joint default fund.
In addition to overseeing the two German CCPs, the Bundesbank participates in the oversight of foreign CCPs within colleges set up under EMIR and within the framework of global cooperation agreements.
The monitoring of CCPs by central banks reflects the fact that CCPs, as financial market infrastructures, make a major contribution to the stability of the financial system as a whole. Owing to interdependencies with other infrastructures and the magnitude of clearing volumes, this contribution is not limited solely to the securities and derivatives business, but extends to the entire financial system. For example, downtimes in the clearing and settlement business can have negative repercussions on the availability of liquidity for the affected participants and lead to serious disruptions to financial market transactions. Due to their central position in the financial system, CCPs were recognised early on as potential sources of systemic risk. This led to increasingly strict requirements with regard to the robustness of their settlement processes and risk management.
The Principles for Financial Market Infrastructures (PFMIs) form the basis for monitoring CCPs. Drawn up by the Basel Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO), the goal of these principles is to improve the stability and resilience of financial market infrastructures. The 24 principles align, tighten and add new aspects to the international recommendations which were previously applied to financial market infrastructures and form the basis for various European regulatory approaches. These principles are targeted not only at CCPs, but also at systemically important payment systems, central securities depositories (CSDs), securities settlement systems (SSSs), and trade repositories (TRs). For CCPs, this previously non-binding oversight framework was transformed into a legally binding regime at the European level through EMIR, which sets out the substantive requirements for CCPs contained in the PFMIs.
The PFMIs contain five responsibilities for central banks and market regulators (A to E). Responsibility E provides that central banks and authorities charged with supervising and overseeing financial market infrastructures cooperate with each other domestically and internationally in order to promote the safety and efficiency of financial market infrastructures and to provide mutual support in carrying out their respective mandates. Such cooperation is called for in normal circumstances as well as in crisis situations and during any potential recovery, wind-down or resolution of financial market infrastructures.
The Bundesbank performs these tasks through its participation in the cooperative oversight of global CCPs and through its membership of the EMIR colleges for German and other EU CCPs. The authorities responsible for overseeing the CCPs in their respective countries – in Germany, the Federal Financial Supervisory Authority – have set up colleges in accordance with EMIR which incorporate, among other things, the oversight function of central banks, which in Germany is performed by the Bundesbank. This way, central bank oversight is incorporated into decisions concerning the authorisation of CCPs pursuant to EMIR, the extension of a CCP’s activities and services, the risk management models used by CCPs, the authorisation of interoperability arrangements with other CCPs, the outsourcing of certain activities and the assessment of shareholders with qualifying holdings of CCPs. Furthermore, oversight is also exercised with regard to the procedures and contingency plans for emergency situations relating to the supervised CCPs. These procedures and plans are also agreed within the colleges