As a result of the global financial crisis, it has become of necessity to consolidate the clearing houses to make it safer and to reduce systematic risks. This creates a platform from which independent clearing houses either merge, or link with each other to deal with major international exchanges. It also become easier to clear the various asset classes, among the exchange traded derivatives, inter-bank interest rate swaps among others (Hull, 67). An example of such a firm is the London Clearing House- Clearnet group limited.
Derivative exchanges as derivative contracts
Derivative exchanges are derivative contracts that are standardized and their transaction is conducted in a regular futures exchange, and they can be futures, call, and put and will normally have the date they expire (Kolb and Overdahl, 62). This essay will discuss the necessity and the advantages that come with consolidating as compared to a single (CCP). IT WILL ALSO DISCUSS the economies of scale benefits that come with consolidation and the technical issues that arise.
Various ways how derivatives are traded
There are various ways that derivatives are traded; there are Over the Counter OTC derivatives contrary to Exchange Traded derivatives (ETDs) or CCP (Central Counter Party) where trading is regulated by Commodity Futures Trading Commission (CFTCs), and is done in a regulated exchange. Derivative exchanges were traditionally only done by Central Counter party (CCP) but recently there is OTC trading for them. The concerns over the credibility of CCPs were raised which pushed many OTC market participants to embrace the OTC Clearing; currently derivative exchanges are offering both the OTC and ETDs.
Role of market participants
Consolidation is preferred by the market participants and it does not necessarily have to be done by merging or through acquisitions, a few CCPs can be linked together. It can be done independently as long as the two clearing houses come into an agreeable contract. The market participants will prefer the presence of several across the borders clearing firms that operate together and with each other. They must have a position transfer and should create cross-margin agreements, by tackling the legal, political and technical hurdles that come with cross-border trading. Cross-margining is done in order to make optimal use of capital and for collateral purposes. It can be can either on the same type or different products. It can be combining of trading in derivatives and other underlying assets such as future bonds, future swaps, or equity option. Cross-margin trading can also be across different markets, e.g. Chicago Mercantile Exchange (CME) and LCH. Different markets trading is meant to enhance inter global trading in derivatives and securities
Consolidation and clearing of derivatives
Consolidation and clearing through a single center is a method being preferred by financial and non-financial firms, as more products become available and the difference in the prices of OTCs and ETDs is narrowed down (Pickup). The marketers have discovered the advantages that go with clearing through a one centre. The single center will net down and cover deals from various products. An example is the London Clearing House (LCH) –clearnet and Depository Trust Clearing Company National Securities Clearing Corporation. (DTCC-NSCC).
The benefits of consolidation are found and fully utilized on condition that the systems are fully integrated and are interoperability with the benefits of full cross margining. Consolidation across the borders has been hindered by different border regulations, lack of trust by the participants and national interests. A Central Counter Party (CCP) may not gather as much benefits in a risk management point of view (European Central Bank). A CCP must have enough capital and strong risk management standards so as to meet and provide a guaranteed in case of default. The marketers may not want to deal with an undercapitalized CCP.
Maximization of economies of scale
Economies of scale can be maximized by creating a single global CCP for OTC. Increase of the number of transactions subsequently reduces the cost of each transaction this is as a result of reduced administration and technology infrastructure expenses. There are no clear rules. Firms that merge have the advantage of gaining a market more easily than their single counterparts. An acquisition and a merge are more beneficial than creating a new branch or company. A big company is more efficient, as there is only a single operational process that is required.
The main advantage of CCPs is that it reduces systematic risk, by enforcing and maintaining quality risk management standards. The single global CCP will also reduce counter party risk. To the trader’s point of view, the number of legal contracts is reduced, by reducing the number of counterparties the trader has to deal with.
There are technicalities that however that arise with consolidation. There are the legal and political issues that come with cross-border integration. These are brought about by different rules and regularities in different countries. These are disadvantages of having a single CCP in that in case it fails, this would have a big impact in the market and it would even paralyze the trading before a solution is found. In this case multi-CCP would be preferred. For a single CCP that trades in the foreign exchange the impact of its failure would affect the currency exchange trade and this may have eve more financial effects. A single CCP would also have challenges in jurisdiction coordination. At a trader’s point of view, they believe that competition is a healthy ingredient in the market, competition is optimal. If consolidation leads to one single trader there is a danger of a monopoly situation arising. A monopoly may lead to increased transaction cost which is a disadvantage to the trader.
Benefits of consolidations
The benefits of consolidation cannot be underestimated, as has been witnessed by the success of (LCH) –clearnet. However to counter the disadvantages mentioned above there should be strong risk management strategies. To reduce counter party risk through netting of multilaterals, there should be interlinking and cross–margining through a statutory and contractual point of view. Thus for consolidation to be at its best several issue need to be addressed, a need for quality risk management standards; improved infrastructure; cooperation from public policy decision makers and at the global level; and defining efficiency market structures. There should be frequent supervision and regulation conducted by an independent body. This can be enhanced by the Committee on Payments and Settlements Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) revising the international standards to accommodate this new trend.
Works cited
European Central Bank. Eurosystems Policy Line with Regard to Consolidation in Central Counterparty Clearing. European Central Bank. 2009. Web.
Hull, John. Options, Futures and Other Derivative Securities. Options, Futures and Other Derivative Securities. 2008. Print.
Kolb, Robert and Overdahl, James. Financial Derivatives: Pricing and Risk. New York: Willy. 2009. Print
Pickup, Paul. Consolidation of Cash and Derivative Markets Technology. World Federation of Exchanges. 2008. Web.