The mechanics of post trade
"Clearing is a complex task"
Clearing and settlement are going through a period of rapid change and London Stock Exchange Group’s clients are expected to benefit, as David Turner explains.
Clearing and settlement used to be considered the nuts and bolts of financial markets – routine, predictable and a teensy bit dull. No longer. Ever since the financial crisis, regulators have been focused on these activities, anxious to improve the way trades are settled and processed so as to reduce systemic risk.
LCH.Clearnet Group (LCH.Clearnet), part of London Stock Exchange Group (LSEG), is at the forefront of these developments. Its subsidiary clearing house, LCH.Clearnet Ltd and LCH Clearnet SA sit in the middle of trades on their respective platforms. If either party defaults on the trade, the clearing house takes on the defaulter’s risk and becomes accountable for its liabilities. To reduce risk for participants and increase certainty they contribute margin and default fund payments. The pool of assets collected as margin or default fund contributions provide the financial back-stop required to manage the default of a member in an orderly way.
Clearing is a complex task. If clearing houses do not request enough margin, in a crisis market a clearing house may be unable to provide the protection its members expect. If clearing houses request more margin than is necessary, counterparties’ margin is tied up.
For many years a typical model among clearing houses for calculating margin requirements has been the SPAN (Standard Portfolio Analysis of Risk) approach, which calculates the appropriate margin for each transaction. LCH.Clearnet however has recently been moving towards the use of VaR (Value at Risk) for calculating margin, and away from the old SPAN based approach.
“The use of VaR margining creates a consistent risk management methodology across a range of asset classes cleared at LCH.Clearnet, says Alberto Pravettoni, CEO of Repo & Exchanges business at LCH.Clearnet. “It is used for our OTC derivatives clearing services, including our interest rate swap clearing service, SwapClear. We also use it for a number of our exchange-traded services, including equities clearing through EquityClear; NLX, the new London trading venue for interest rate derivatives and Nodal, the North American Power Exchange. In addition, we will be moving to a VaR-based methodology for our fixed-income and repo business.”
“VaR is a more precise and efficient way of calculating risk, which generally means that equivalent risk positions have slightly lower margins, yet it maintains appropriately conservative assumptions”, says Pravetonni.
Cassa di Compensazione e Garanzia (CC&G), LSEG’s Italy-based clearing house, is also well placed to benefit from developments in the post-trade environment, particularly the EU’s European Market Infrastructure Regulation (EMIR) directive. It stipulates that a clearing obligation will apply to a number of over-the-counter (OTC) derivatives (to be determined by ESMA 2014), that would previously have being cleared by agreement between the two parties to the original trade.
“As a CSD, Monte Titoli is the third largest in Europe with over 3.3 trillion Euros of Asset Under Custody offering pre-settlement, settlement and custody services and the strong, existing knowledge and experience within the Group gives us significant appeal to customers”, Paolo Cittadini, Chief Executive of CC&G and Monte Titoli says.
Monte Titoli is responding to new opportunities in the post-trade market too. It is anticipated that from the second quarter of 2014, the CSD will be offering full-fledged collateral management triparty services through its X-Com platform.
“Monte Titoli’s collateral service is part of its strategy to offer a single point of entry for multiple platforms, and allowing our customers to efficiently serve their portfolio through a single provider”, says Alessandro Zignani, Head of Post Trade Sales at LSEG.
The development is needed now. Regulators are determined to improve the stability of the financial system so margin requirements are increasingly stringent. The EU, for example, is considering whether to limit the length of transaction chains, formed when traders who receive collateral in turn use the same securities to back separate trades. In such an environment, banks are under pressure to use their collateral in the most efficient way possible.
“By using their settlement service provider as their collateral manager, customers may be able to maximise the use of their assets, both domestic and foreign, because they can use securities as collateral as soon as a transaction is settled in accordance to their funding needs” he adds.
Besides branching out into new services such as collateral management, Monte Titoli continues to focus on its core function of settling trades. At 98 per cent, its settlement rate is one of the highest in the world, an achievement maintained at least in part through a consistent focus on innovation.
Major US bank JP Morgan announced in 2013 that it was to be one of the first users of a new London Stock Exchange Group’s central securities depository in Luxembourg and giving a vote of confidence to the new settlement capabilities by announcing that its collateral management business, one of the largest in the world, would use the new CSD, expected to be operating by the first half of 2014 for settlement, custody and asset servicing.
Cittadini attributes Monte Titoli’s high success rate for settlement not just to technology, but also to constant monitoring of client and market activity.
“Customers trading through us know that we are looking at their behaviour very carefully, and actively managing the right securities for each trade,” he says.
Proof that this eagle-eyed supervision works well came to the fore during the financial crisis of 2008, when the US investment bank collapsed and defaulted on huge numbers of trades.
“If a big player defaults, you really need to be able to understand all the positions of its counterparties,” says Cittadini. “That was possible because our database included all the transactions that counterparties have made with each other”.
Monte Titoli extracted all the transactions affected by the default from its settlement system and worked the phones to make sure all customers’ remaining positions were closed by substituting other trades. The firm achieved this within two days.
Cittadini believes the advent of Target2-Securities (T2S), the new pan-European securities settlement system scheduled to go live in 2015, will reduce the effect of similar shocks in the future. By shortening the interval between trade and settlement from three days to two, it will minimise the number of trades left in the system by a counterparty after its collapse. T2S is also expected to reduce the cost of cross-border securities settlement in Europe. By making settlement more truly international, it will increase the opportunity for Monte Titoli and CC&G to continue their expansion beyond Italy. The future for both entities looks increasingly bright.