Central Counterparty: Goals and Functions
In this paper, the author describes core functions of a central counterpartyand the tasks performed in connection therewith.The institution of central counterparty is a unique phenomenon not only for the Russian domestic financial market, but for the world's most developed markets as well.Thanks to its unique status, a central counterparty acts, above all, as a hub where the participants' risks are concentrated.Therefore, determining the functions of a central counterparty is extremely important, both in view of enactment of the specialized legislation and for the purpose of further development of this critical infrastructure element.One of the most interesting conclusions derived from this paper is that CCP is a hub where risks are concentrated.
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The institution of central counterparty is a unique phenomenon for the financial market; its formation stems from the need to solve several objectives related to development of the financial market.The preconditions for establishment of a CCP as an institution have determined its primary functions and the list of tasks performed.These functions are risk management and improvement of market efficiency.
Risk management is a primary and key function of a central counterparty.It has to be noted that the first central counterparties were established exactly in the most highly risky markets – markets for financial derivatives.If we view CCP exactly as a risk-concentrating institution, we can make certain conclusion that CCP is needed just at the moment when the risks have actualized, rendering it necessary to do certain decision-making and use a specialized set of instruments in order to minimize their influence on the market situation.In terms of this function, a central counterparty performs certain range of tasks, whereof one has to emphasize establishment of requirements to participants and establishment of margin requirements.More detailed description of these tasks is provided hereafter.
Yet risk management is not the only key goal for CCP.Another major CCP's goal is to improve market efficiency.The term "market efficiency" can imply quite extensive range of factors.The most precise definition of such factors has been provided by one of the classics of economic science, Harry Markovitz[1], whom the author deems to be expedient to adhere to in this paper.In his definition of efficient market, Markovitz focuses on the following aspects:transparency in prices’ data, counterparties and traded instruments, as well as minimal transaction costs.Having mentioned these criteria, one can easily note that CCP renders certain, quite strong influence thereon and, consequently, affects market efficiency.The challenges met by CCP in order to improve market efficiency are provided below.
Before we proceed to describing CCP's goals and tasks, we must make a small comment regarding interpretation thereof.From theoreticalstandpoint, the risk reduction can also be viewed as a task performed in line with the market efficiency improvement function.However, given the CCP's paramount role in risk management, it is advisable that these terms be separated in this paper.
Functions of a central counterparty.
As already noted, CCP's key functions are:
- risk management;
- improvement of market efficiency.
Having determined the major components of CCP's set of functions, it seems to be necessary to disclose the essence of each of the functions and describe the list of tasks performed by CCP in connection therewith.
Riskmanagement.
CCPactsasariskconsolidationcentre. Therefore, in order to realize its risk management role, a central counterparty has to perform an extensive range of tasks.Such tasks can be grouped into several major blocks:
- Establishmentofaccessrequirementsandrequirementsforparticipationofmarketparticipantsinthetradingprocess.
Theaccessrequirementsandrequirementsforparticipationinthetradingprocessarebasedonthe securing of a participant'scompliancewithfinancialandnon-financialperformancetargets.CCPsetsrequirementsintermsoftheparticipant'scapital (capitalquality, adequacyandliquidity)andcompliancewithmandatoryperformancestandardsestablishedbyregulators.Also, CCPmayhavecertainrequirementsintermsofthemarketparticipant'sassetquality.Alongwithindicatorsoftheparticipant'sfinancialcondition, acentralcounterpartymaysetspecificrequirementstotheleveloftheparticipant'soperatingcapacity, aswellastotheriskmanagementsystemusedbysuchparticipant.
Inordertomakepromptdecisionswithregardtocertainindividualparticipants, CCPshallonanongoingbasisanalyzealltotalityofinformationabouttheabovementionedpositions, receivedfromvarioussources.
Toachievehigherefficiencyasregardsanalyzingtheincomingdata, anumberofleadingCCPshavedevelopedtheirowninternalsystemsforassignmentofratingstoparticipants.Essentially, theratingprocessmeanscollectinginformationabouttheparticipantandsubsequentgroupingofsuchinformation, dependingonitsimportance (i.e. byassigningweightratios), followedbycalculatingthefinalratingonthebasisofthedatasogrouped.Theassignedratingenablesthecentralcounterpartytoassigncertainriskgrouptoagivenindividualparticipant.Alongwithbetterefficiency, thissystemenableshigherspeedofanalysis, whichlikewiseplaysacriticalroleinacentralcounterparty'soperation.
ThetaskofestablishingrequirementstoparticipantsandconductinganongoingmonitoringoftheirfinancialconditionhastobeperformedinordertorestrictaccesstotransactionswithaCCPforthoseparticipantswhoseunstablefinancialconditioncanbeidentifiedbeforehand.ThishelpsCCPstodecreasetheircreditrisks.
- Establishmentofmarginrequirementsfortradingparticipants.
Themarginpostingarrangementisoneofthekeyinstrumentsintheriskmanagementsystemusedbyanycentralcounterparty.ThisarrangementisbasedonsettingbyCCPofanumberofmarginratios, whichareusedincalculatingthesizeoffundstobeblockedbythecentralcounterpartyunderthegiventransactionwiththegiveninstrument.MarginratiosaresetseparatelyforeachinstrumenttradedbetweentheparticipantsandCCP.Theabove ratiosaresetperinstrumentduetothefactthatthemarginposting mechanismaimstodecreasethemarketrisk, whichactualizes inunfavorablepricemovementsontradedinstruments.Asregardsoperationofacentralcounterparty, thisriskisactualizedinthesituationwhenoneparticipantcannotperformitsobligations, yettheCCPhastohonoritsownobligationstoanotherparticipant, and, thus, itisobligedtosellthecollateralpostedbythedefaultingparticipantandconsequentlyusetheinstrumentwhereunderithasincurredobligationstotherelevantnon-defaultingparticipant.Therefore, marginratioreflectstheforecastedpricevolatilityofagiveninstrument.
Presently, thelargestspotmarketspractice the calculation of marginratiosusingthemodelswhichtakeaccountofsecuring normsforthetotalityofpositions, insteadoffocusingonanyoneisolatedpositionoftheparticipant - i.e. theportfolioapproachisapplied.Themajorobjective should be achievedbyusingsuchratiocalculationmodelsistolowermarginrequirementsand, thus, toimprovetransactionefficiencyintermsoftheparticipant'scosts.ThismodeliscalledtheStandardPortfolioAnalysisofRisks (SPAN).ItwasdevelopedbytheChicagoFuturesandOptionsExchange.
Thepartialassetpre-postingarrangementwasintroducedtoachievetwoprimarygoalsatonce: minimizingmarginrequirementsfortheparticipants (thusloweringtheircosts) andservingastheCCP'smarketriskmanagementtool.Therefore, foranycentralcounterparty, themarginpre-postingarrangementisthemarketriskmanagementtool.
- CCP'sfinancialresources
Toperformitsobligationstothemarketparticipantsandtocoveritsoperatingrisks, thecentralcounterpartyshallpossessasufficientamountoffinancialresources.Suchresourcesinclude:CCP'scapital, guaranteefunds (whetherformedoutofCCP'sresourcesorattheparticipants' expense), orthecollateralpostedbytheparticipantsunderthetransactionsconcludedbythelatter.Fulfillingitsprotectivefunction, CCP'scapitalisthecornerstoneofthelatter'srobustnessandcapacitytowithstandnegativemarkettrends.
OneofthemajorpreconditionsfortheCCPtomaintainitsbalancesheetliquidityisitsabilitytoaccumulateinthemarkets, withinashorttimeframe, therequiredamountoffundssufficientforfulfillmentofitsobligations.Tothisend, CCPmustkeepcreditfacilitiesopenintheinterbanklendingmarket.
Thestatusofacentralcounterpartyplaysanimportantroleinmaintainingitsliquidityandfinancialrobustness.IntheRussianfinancialmarketenvironment, aCCPhavingastatusofacreditinstitution -as isthecasewithNCC -ispermittedtoaccesstheabovementionedinterbankmoneymarketand – whatiscriticallyimportantinviewofinstabilityofthefinancialsystem – makeuseoffundsandrefinancinginstrumentsofferedbytheCentralBank.
DiscussingthestatusofaCCPsetupasacreditinstitution, onemustmentionthatitsfinancialrobustnessasabankissupportedbystrictregulationandequallystrictnormativerequirementsimposedbytheBankofRussia.Inparticular, intermsofanalyzingCCP'srobustness, mostinterestingarethevaluesofmandatorynormativeindicatorsreflectingcapitaladequacy, aswellasinstantandcurrentliquidity.
TheCCPspossessingsufficientamountofliquidfinancialresourcesareabletomanagetheirownliquidityriskseffectively.
Improvement of market efficiency.
In theory, the notion of efficient market is based on the following basic postulates:
- market participants perform operations with minimal transaction costs;[2]
-all market participants have equal access to information on the prices of traded instruments and on the counterparties under the transactions they enter into.
-legal structure of the concluded transactions is transparent and comprehensible for the market participants (i.e. legal risks are minimal).
Here are some detailed examples clearly demonstrating how the existence of a CCP in any given market may improve market efficiency.
- Lower costs of the market participants.
The existence of a central counterparty makes it possible to conclude transactions using the mechanism for partial asset pre-posting by market participants.By using partial posting, they are able to free up the significant amount of funds, thus lowering their implicit costs.
Along with partial posting, the existence of a CCP enables using the arrangement for netting of the market participants' obligations in a legally correct manner.The essence of netting lies in the offsettingthe counter obligations and requirements of the same kind, thus allowing the participants to makesettlements using the smaller amount of funds.This, in its turn, creates preconditions for their more efficient liquidity management.
Aside from indirect costs reduced through netting, the existence of a CCP enables cutting direct costs stemming from the need to analyze risks under transactions concluded with each individual counterparty.
- Transparency of information about concluded transactions.
If a market is served by a central counterparty, the market participants are able to clearly identify their transactions’ counterparty, since the only counterparty for them is the CCP.This factor enables the market participants to assess their operating risks in a correct and objective manner, develop uniform approach to operating procedures, and optimize operating costs.
When one and the same CCP serves several markets at once, this makespossible the unification of standards and approaches to operating procedures applied to such markets.The aforesaid unification allows decreasing operating risks and achieving higher market efficiency.
When discussing the transparency issues, one cannot but note that the major positionsin the central counterparty's risk management system are open for the market participants.They may obtain information about the collateral calculation procedure, requirements to the participants, and other important information, from the CCP's official documents made publicly available.At the same time, the participants may take part in the development of the risk management system.
- Legal transparency of transaction conclusion process.
Market participants enter into transactions with the only counterparty, by using the open offer arrangement.If a market is not serviced by a CCP, the market participant can not possess information as to which counterparty it had concluded the transaction with (if transactions are concluded otherwise than in the address mode).Such arrangement would be in certain contradiction to the adopted provisions of law and would generate some preconditions for violation thereof.
Along with the aforementioned functions and tasks, the author deems it to be expedient to provide a separate discussion of such important role of a CCP as promoting attractiveness of the national market for foreign investors.
Given the globalization of the today's global financial market, capital is changing its "dislocation" at enormous speed and flows to those national markets, which meet efficiency criteria with minimal, clear and manageable risks.As mentioned above, the central counterparty as an institution operates with the view to developing and maintaining such criteria.In essence, a CCP is the derivative from the above criteria, designed to ensure proper compliance therewith.Therefore, CCP acts as one of the "quality marks" for the national financial market, the assessment whereof enables the participants of the international capital markets to view the given market in terms of its acceptability as the place where investments can be made.
Such role of a CCP in the coordinate system of any national financial market, including the Russian one, attains even more importance due to the need to achieve the goal of establishing in Moscow an international financial centre.
Afterword.Conclusions.
IdentificationoftheCCP'sfunctionsintheprocessofevaluationofitspositionandroleisthemostimportantstageofanyscientificresearchoftheCCPinthefinancialmarketsystem.
Theworld'sexperienceinsettingupandoperatingCCPshasbeenformanyyearsdemonstratinghighreliabilityandefficiencyofthisinstitution, thoughalsogeneratingadiscussionamongfinancialmarketprofessionalsastoformationofanexcessivelycarelessattitudeofmarketparticipantstothevolumeofrisksassumedbythisinstitution, which at the same time provides highly efficient functioning.
Italsohastobenotedthat, atpresent, theprofessionalcommunityisonitswaytodeterminingtheverynotionofacentralcounterparty, whichisalsosubjecttodiscussion.
ThesefactorsgeneratemuchinteresttowardsCCPnotonlyfromtheexpertpractitioners, butfromtheacademiccirclesaswell.
[1] W. Sharp, G. Alexander, D. Bailey, "Investments".
[2]Inthiscase, thenotionofparticipants' costsincludesnotonlydirectcosts (feesfortrading, clearingorsettlementservices), butindirectcostsaswell (opportunitieslostduetotheneedtopostalargeamountoffundsasacollateral).