CH6: Principles of Clearing and Margin

Question 1

Clearing and risk

Answer 1

• CLearing = process of clearing and registering deriv trades. Registering is done with the clearing house which becomes the lgeal counterparty to each trasnaction (novation)
• Every original exchange contract becomes 2 new contracts post novation
• Clearing house members must maintain an account with the clearing house in the CH’s currency to reduce ccurrecny risk
• CCP structure removes almost all counterparty risk and the only outstanding risk is with the CCP itself
• CHs monitor all open positions and action the settlement process as the intermediary if required. Exposed to credit risk for 1 day only if the counterparty deafults due to daily margin payemnts.
• CHs maintain a default fund (with cash paid in by members) in the event that a defaulted counterparty’s margin doesn’t cover the psotiion’s loss.
• CHs are very credit worthy and guarantee execution of a contract. Also makes contracts very easy to trade
  *

Question 2

Clearing and risk 2 - mutual offset, principal to principal

Answer 2

• Brexit - required UK CHs to open EU based units and apply for authorisation to operate in the EU.
• CHs provide netting - reduce settlement risk
• mutual offset system - agreement between 2 exchanges allowing trades exectued on one exchange to be executed and cleared in another happens between CME and SGX
• principal to principal system- CH guarantees performance of trades executed by it’s members (not member’s clients however on ICE Clear Europe
  *

Question 3

Print page 184 and 185 list of major exchanges and their clearing house

Question 4

Brexit impact on clearing

Answer 4

• EMIR (EU regulator for derivs) aims to bring better stability to the deriv mkt
• EU introduced a plan to avoid distruption in the cross boarder deriv mkt post brexit to prevent EU and UK trades from being blocked. Expired in 2020 and UK CHs lost their passporting rights
• As a result, UK CHs had to tell clients to move $billions from London tothe EU.
• The LCH had to get an exception from ESMA to continue operating as it closed 90% of EUR denominated IR swaps

Question 5

CME group’s Mutual Offset global partnership network

Answer 5

PRINT PAGE 186

Question 6

Structure of the clearing system - 4 parts

Answer 6

1. Clearing House
2. Clearing member
3. Individual/general clearing member
4. (under general clearing) Non clearing member

Clearing houses are ususally owned by their members or he exchange that it clears for.

Question 7

Clearing futures example - stages for ICE ftrs and margining

Answer 7

1. The trade - client of member firm (A) trades on ICE futures so the member has to use a member (B) of both ICE futures and ICE Clear EU to register the trade on ICE clear europe
2. Confirmation and matching - B puts the trade details into the conf. and matching system (known as UCP) where it will wait for A’s client’s counterparty to enter the opposing trade details
3. Registration - once matched, B registers the trade with ICE Clear EU. Gives details if the client’s account is segregated, client acc or non segregated house acc.
4. Novation - ICE Clear EU novates the trade and becomes the counterparty to 2 new transactions, one with B and one with A’s client. The old contract is terminated.
   * ICE C EU gives a principal to principal guarantee to B, as the immediate client for performance of the contract
   * ICE C EU will contact B if any margin is required. B will then request the margin payment from A who will then ask their client to pay the margin fee. Each firm in the chain has a principal to principal guarantee.
   * The above is repeated for when A’s client closes out the contract but A won’t have to engage the client as they are the counterparty on the contract following novation

Question 8

Clearing house margining for ICE Clear EUROPE- what must clearing members have to access APS.

Answer 8

• Clearing members must hold an acc with an approved bank for the assured payment system (APS) used to collect margin/collateral
• Cash, accepted securities and other collateral collected as initial margin
• if the member defualts the CH uses margin to close the position
• If margin doesn’t cover the loss, the default fund (members contribute based on the volume of business with the CH and the amount deposited is reviewed quarterly)

Question 9

Clearing houses - sources of funds used to cover defaulted positions - called what

Answer 9

• Default member’s margin
• Default fund contrbutions of the defaulted member
• Default fund contributions of other members
• Insurance policies

Called teh default watefall

Question 10

Prime brokers responsibilites related to derivs

Answer 10

• Efficient and best execution
• Ensuring client confirmations of trades on teh correct docs
• settles trade cash flows - provides cash financing/sec. lending when needed
• Provides custody, asset safekeeping and any required risk mgmt functions.
• update clients on all issuer correspondance like annual meetings or corp actions

Question 11

Services prime brokers provide

Answer 11

• Ckearing and settlement of trades globally
• custodians and consolidated positions for extending leverage
• financing multiple currencies
• SBL
• integrated web reporting of positions, activities and performance
• hedge fund consulting services
• counterparty/broker for OTC derivs
• facilitates comms between sales, trading, research

Question 12

4 additional services provided by some prime brokers

Answer 12

• Capital introduction - PB introduces their hedge fund client to new potential investors
• Office space leasing and services - some PBs lease offices and services for clients who use their space (security etc).
• Risk mgmt and advisory - provide risk analysis tech, sometimes consult senior risk professionals
• Consulting services - provides consulting services usually to new hedge funds to help comply with regulatory requirements

Question 13

Hedgee fund/ prime broker regulators

Answer 13

• UK - FCA
• EU (and UK firms operating in the EU) MiFID II
• US - Federal reserve, SEC and CFTC
• China - CSRC, CBIRC - CHN govt announced they were streamlining regs by introducing new National Fin. Reg. Admin. (NFRA).

Question 14

Exchage-cleared OTC prods - LCH, CME, EUREX

Answer 14

• Exchanges offer clearing facilities and guarantees to a range of OTC derivs
• LCH group (LSE) provides clearing for a range of individual/index equity, commod, FI and F&O prods.
• LCH limits volume and trade size on OTC contracts. Some have min contract sizes etc
• Clearing360 (CME Group) - OTC IR derivs, FX option block trades. Access is restricted to only principle/agents in OTC trades. Clears OTC trades by subsidituting OTC FRAs and IR swaps for futures
• Eurex - bilateral clearing of OTCs by using OTC options and off-exchange trades of futures using EUREXOTC Clear system.

Question 15

Advantages of having OTC derivs cleared/substituted by a CH

Answer 15

• Eliminates counterpartty risk
• Once cleared, the OTC is subject to the same requirements as an ETD and both parties must be exchange and CH members
• CH does not match buyer and sellers for OTC prods.
• CH guarantees delivery of a trade to both counterparties and delivers using the CH.

Question 16

Clearing/ guarantee/ default Funds

Answer 16

• AKA guarantee fund - pool of funds contributed by a CCP’s clearing members or by prroviders of guarantee arrangements that meet the obligations of a deafulting CCP party or cover losses/liquidity problems
• Acts as insurance for irregular price movements not accounted for by the intial margin fee
• Every clearing member must contribute to the clearing fund based on each member’s uncovered risk profile. reviewed on a regular basis. LCH does it monthly, others - quarterly
• Clearing funds accept cash collateral (G7 currencies) and GOVT bonds of a high quality, varying maturity, M-T-M. Haircuts are applied at maturity

Question 17

Price limits (circuit breakers)

Answer 17

• Price limits = circuit breakers imposed by exchanges palcing maximum price movement limits on contracts in a day
• Trading of the security halts for a few mins if the limit is breached to allow participants to lock in and get a more reasoned view of trading conditions and trade positions that will make them money to bring the mkt back in line
• March 2020 - NYSE engaged circuit breaker due to a 7% fall in S&P500 index (due to COVID)
• Some exchanges have price limits on derivs
• CME Group has scaled price limits from 5% to 20% price movement, the higher the % teh longer the breaker
• Price limits also exist to ensure orders are within the allowed price spread of the mkt. if not it gives the exchange time to reject the order

Question 18

Position limits

Answer 18

• Prevent traders from cornering the market by buying loads of derivs in an asset, allowing them to manipulate short term prices
• Exchanges have limits for contracts as they approach their maturity.
• CME group has limits for 10 and 5 days before maturity
• Less liquid exchanges/mkts hhave stricter limits
• CHs or brokers might have position limits on members/members clients to reduce credit risk

Question 19

Margin for CHs - what do they use to protect themselves from default, what is contingent liability

Answer 19

• CH take on contingent liability (a liability that depends on a specific event outcome). so they introduce rules to protect themselves from risks of default etc. As follows
• Qualit of membership - members must meet/continue to meet membership and fin. criteria. first line of defence
• Fin. resource requirements - only deals directly with clearing members who have the highest resource reqs
• Margin system - level orr margin depsoited to cover defaults in the form of initial and variation
• CH’s own fin. resources and default fund - lines of credit with multiple major banks and has insurance policies

Question 20

Standard portfolio analysis of risk (SPAN) - calcs what, includes what, impact on margin, client funds, PPS, FCA requirement

Answer 20

• used to calculate daily margin reqs by using algorithms to measure a portfolio’s risk and calculate margn based on that. been adopted by most major F&O exchanges.
• Includes F&O positions in the calc and can factor in inter-maturity and inter-commod spreads
• SPAN typically offers lower margin reqs as it is very efficient.
• Client’s funds held by the CH in non segregated accs can be used to offset debts if they are in credit
• protected payment system CH pulls required margin straight out of the clearing member’s bank acc. Done by LCH and ICE clear EU
• FCA requires that members charge clients at least the amount they are being charged by the CH to avoid them needing to get additional financing
  *

Question 21

Intial margin - who calcs it, when is it recalculated, where is additional margin taken from, when might IM increase

Answer 21

• Cash/collateral deposited when a position is opened and is returned when it is closed out. protects the CH from the worst case loss a position could incur in 1 day
• Calculated by the CH
• Once the client executes a trade, the CH puts the asset in their desired acc and collects the initial margin. Unless it is an option and then the premium is taken instead
• Recalculated everyday and requested before mkt open. If additional margin is required after market open due to a position losing value, extra margin is taken from the PPS account.
• As contracts near maturity (espcially if the physical product needs physcial delivery) CHs might increase the initial margin to cover for the increased volatility and cover a potential physical settlement. It also reduces short term last minute price speculators
  *

Question 22

SPAN and other methods of calculating intial margin - for what prods

Answer 22

• SPAN, TIMS and STANS all calc F&O intial margin by running worst case scenario test to calculate the risk to the CH

Question 23

Standard Portfolio Analysis (SPAN) - considers what, based on estimate of what, 3 scenarios it measures, how many scenarios does it test and what do they do, calcs the number of what to close out to position

Answer 23

• Scenario based risk programme used to calc daily risk margins by looking at the impact on price if the price and volatility of a UA fluctuate by set amounts.
• Based on an estimation of liquidation value of a position based on changes in mkt conditions
  SPAN Scenarios
  1. Possible changes to UA price
  2. Changes to the UA’s price volatility
  3. impact off time on an option’s value
• Based on simple algorithms for 16 different scenarios, offers an advantage
• Algorithms set a maxiumum scanning range (price fluctutation band) and test price impacts within that band. Considers delivery month charges.
• Selects the largest negative number after running the algorithm and sets that as the intial margin.
• 0uses deltas to calc the number of futures positions that would theoretically be needed to close out options
• Calculates overall inital margin for a member’s total exposure with the CH.

Question 24

Theoretical Intermarket Margining System (TIMS) - what based margining, what prods, best at measuring margin for what, calculates total margin with what, more or less complex than span

Answer 24

• Uses a portfolio based margining methodology that is best suited for measuring risk of mixed portfolios (futures, options, physicals etc)
• Option pricing model to identify risks on specific underlying assets with different strikes and maturities. Also provides offsets for different but highly correlated UAs
• Calculates total margn by adding premium margin (market price movement) and risk margin (uses implied volatility to measure potential change or price mvmt) together
• More complex than SPAN

Question 25

Systems for theoretical analysis and numerical simulations (STANS) - who’s prop risk margin system, more or less advanced than TIMS, how does it make up for TIMS shortfall, how many scenarios and risk factors, more or less accurate than TIMS

Answer 25

• OCC’s propreitary risk marginign system
• Uses more advanced tech and algorithms than TIMS
• Makes up for shortcomings of TIMS as it accounts for extreme events and correlated price movements between different UAs
• Generates 10,000 scenarios based on historical behaviour and the portfolio’s asset’s relationship based on 7000 risk factors
• OCC still uses TIMS but relies on STANS to assess clearing member margin requirements
• More accurate than TIMS
• Measure mkt risk associated with derivs

Question 26

Net liquidation value

Answer 26

• margin is based on the net positions held by a member firm so net liquidation value calculates the profits and losses from liquidating all of a member’s assets which gives 1 netted profit or loss for that member

Question 27

Spreads (calculating margin considering what factors)

Answer 27

• Consider the same UA that the member has exposure to but consdiers the delivery month and type of contract (put/call etc and long/short)
• If the client holds a long in wheat futures and a short wheat future expiring in 2 months the posittions largely offset so show less risk
• Inter commodity spreads - different assets with correlated price mvmt like ICE futures O&G and EU Brent Crude Oil
• Offsetting positions will often lead to reduction in margin requirements

Question 28

Variation margin - what is closing range, what happens each day and when is variation margin paid if required.

Answer 28

• Exchanges provide daily settlement prices for derivs so they can be have mark to market variation margin calculated at the end of each day
• Closing range = range of spread prices at a set time before mkts close
• All positions are marked to market at close of business each day based on settlement price. If the member’s P/L is at a loss at the end of the day, they will have to post variation margin the following day. The CH has to pay the member margin back if they are in profit.

Question 29

LCH group criteria for futures contracts to arrive at daily settlement price - what is done to calculate settlement price, what is the settlement range, what are the first 90secs used for, what kind of average is it in what part of set range, can price be adjusted

Answer 29

Done for each delivery month
* Time is specified for when each daily settlement price is calculated. The 2 mins before the time are called the settlement range
* First 90 seconds of the spread range allow market supervision depts to monitor spread levels
* Daily settlement price is the weighted average traded price in the final 30 seconds of the settlement range
* Mkt supervision deptartment can adjust the daily settlement price if it is deemend inaccurate

Question 30

Variation Margin Calculation - what currency must it be paid in

Answer 30

• VM must be paid in cash in the currency of the contract
  Variation Margin= ticks moved on the day X tick value X no. contracts in the open position

ticks moved on the day=today’s closing price - yesterday’s closing price

Each clearing member has at least 1 bank account for PPS accounts

Question 31

Maintenance margin

Answer 31

• Member and client arrnagement and not driven by the clearing house
• The member firm will expect the client to deposit more than the initial margin to act as a safety cushion so the member can pay any variation margin without having to ask the client for money everyday.
• Once the maintenance margin is all used up, the member will then issue a margin call
• Maitenance margin is usually 25-50% below the intial marggin for any new positions

Question 32

Acceptable types of Collateral and credit

Answer 32

Accpetable collateral - cash, bank guarantees, certificates of deposit and govt bonds

things to note =
* undated bonds aren’t acceptable
* Bonds must be denominated in the currency of the issuing country
* Collateral is subject to a haircut
* collateral is lodged with custodians of the CH

Question 33

Lines of credit with CHs - FCA rules, ICE mkts rules.

Answer 33

• Some exchanges (uncommon) give lines of credit to members to cover margin.
• Any requests for credit above the member’s limit are rejected by the CH
• FCA stipulates that CHs can only extend credit for 5 days max without a formal credit agreement
• ICE markets don’t allow credit lines

Question 34

Collateral management - how can risk be reduced further, similar to what, improves what

Answer 34

• reduces credit exposure that arises from longer dated OTC derivs
• This exposure can further be reduced by one counterparty entering into a credit support annex (CSA) which details collateralisation procedures and conditions
• Similar to daily margining processes
• Collateral mgmt can improve captial usage, increasing transactions numbers and make deal speeds quicker

Question 35

Credit support annex (CSA) - requires what to be in place, what is a CSA, defines what, who doesn’t do CSAs

Answer 35

• ISDA agreement contains a CSA.
• CSAs require an ISDA agreement to be in place
• CSA= legal doc regulating the rules for collateral payments for OTC derivs between counterparties to reduce credit risk if positions are at a loss after being M-T-M.
• Defines how often collateral needs to be paid, min. transfer value and accepted collateral types
• Banks/dealers usually enter into 2 way agreements with counterparties for CSAs. Only exception are soverign wealth funds who don’t do CSAs

Question 36

Key procedural details in the Credit Support Annex - 3

Answer 36

• Threshold amounts - unsecured credit exposure that a counterparty is willing to accpet before requesting collateral. usualy very low threshold
• Min. transferr amounts - min amount of a collateral request. designed to prevent small frequent collateral calls to avoid the transfer costs
• Valuation % or haircut - discount applied to the collateral’s mkt value to proctect the holder from a fall in the collateral’s mkt value. Higher wuality colllateral has lower haircut

Question 37

One way credit support annex

Answer 37

• only 1 counterparty has to post collateral to the other when a position moves in the other firm’s favour (price goes up they pay them the difference).
• When the price goes down, the other party doesn’t have to provide additional collateral
• Soverign wealth funds/central banks usually have these due to their govenrment status and credit rating
• If the bank/dealer hedges the position of their client with another bank, they will have to post collateral with that bank and will not be able to call on the client to maintain that.

Question 38

Uncleared Margin Rules - issued by who for what prods

Answer 38

• BCBS released guidance on the margin requirements for non centrally cleared (uncleared) OTC dderviatives called uncleared margin rules.
• Aim = reduce credit and default risk and improve transparency
  *

Question 39

BCBS 8 uncleared margin rules principles

Answer 39

print page 207
1. UMR apply to all derivs not cleared via a CCP
2. All entities covered by UMR must exchange initial and variation margin
3. initial+variation margin must be calc’d based on a reg. approved method
4. collateral must be high quality
5. Segregation of custodianship and initial margin
6. margining between affiliated firms within the same group isn’t mandatory
7. regulators in seperate jurisdictions must cooperate when dealing with multi-jurisdiction entities
8. daily variation margin required on all UMR deals from 2015 onwards with posting of initial margin to be phased in

Question 40

In Scope derivatives for uncleared margin rules

Answer 40

• Non deliverable fwds
• physical fx fwds and swaps
• swaptions
• fx options
• IR prods (caps, floors)
• Equity swaps and fwds
• hedging trades

OUT OF SCOPE
* Cleared instruments
* exchange traded derivs

Question 41

Aggregate Average Notional amount (AANA) calculation - what is exempt, measured daily for which months, progressive introduction has caused what, initial margin threshold

Answer 41

• AANA=total sum of gross notional value of all outstanding uncleared derivs (with the exception of deliverable fx fwds)
• Must be measured for each day over March, April and May every year
• The progressive introduction of AANA has lead to lower and lower values of uncleareed OTC positions to be required before an entity is subject to AANA.
• Once an entity is in scope for UMR based on their AANA amount, it must monitor uncleared derivs value. Once it passes 50 Mil EUR they must post intitial margin

Question 42

AANA thresholds for the 6th phase - values for each country

Answer 42

• EU and UK = 8 Bn EURO
• US = 8 Bn USD
• Switzerland = 8 Bn CHF
• JPN = 1.1 trillion JPY
• South Korea = 10 Tn KRW
• SGP = 13 Bn SGD
• Hong Kong = 60 Bn HKD

Question 43

Intitial margin calculation methodologies - what was introduced by BCBS, industry uses what,

Answer 43

• BCBS introduced a methodology called ‘Grid’ for calculating initial margin. THis is because initial margin is fundamental to UMR rules
• The industry uses Standard Initial Margin Schedule (SIMM) as it gives a lower IM value
• SIMM is approved by the UMR

Question 44

Done!