Chapter 6: Principles of Clearing and Margin Flashcards
What is clearing?
Clearing is the process by which derivatives trades are confirmed and registered.
What is a default fund?
Cash that is paid in by members to a clearing house to be used in the event of a default
How does novation make contracts easy to trade?
You can take an equal and opposite position in the market, and as clearing house is the CCP on both the position is effectively closed
What is settlement risk?
The risk that expected payment or delivery won’t be made on time or at all
What is a mutual offset system?
An agreement between two exchanges that allow trades to be executed on one exchange to be booked and cleared through another.
What is a principal-to-principal system?
Clearing house guarantees the trades executed by its members on the exchanges that it serves
What is the impact of Brexit on derivatives clearing?
UK clearing houses need to decide whether EU customers need to move positions from London to EU.
What are the two types of clearing member?
General
Individual
What is “passporting”?
Offering EU rights to UK firms post Brexit, ended in 2020
Who is a clearing house typically owned by?
Members, or by the excange
What happens before the clearing process begins?
Trade reported to the universal clearing platform
What happens after a trade is matched on a clearing system?
Registration, where clearing members will give the details of the account which the trade is assigned to to the clearing platform.
What will the clearing platform call on clearing members to do after novation?
Make margin payments as necessary.
What is a default fund?
Contribution by members in case of member default
How are members contributions split up?
Will be done based on it’s clearing activities
e.g. swaps contributions will only be used for swap defaults
Known as mutual guarantee system
What are the four sources of default fund and what order are they drawn on?
- The default member’s margin held by the clearing house.
- The default fund contributions of that member.
- The default fund contributions of other clearing member firms.
- The insurance policy.
Called default “waterfall”
Who regulates prime brokers? UK, EU, US
UK - FCA
EU - MiFID II
US - SEC, FED, CFTC
How can OTC products be centrally cleared? (2)
Selective on counterparties: credit ratings etc
Standardised contracts: major indices, min size
What are the advantages of centralised clearing?
Eliminates CP risk, contract novated
Easier operationally
What is a price limit?
Circuit breakers that limit maximum bounds on absolute price movements on the contract on any day
Who imposes price limits?
The exchange
What is the purpose of price limits?
Gives time for participants to calm down and take a more reasoned view about trading conditions
How do exchanges limit price of orders?
Won’t allow orders outside a certain spread, limits mistakes and volatility.
What are position limits?
Limit the amount of positon one market participant can hold
What kind of actions are taken in the event of a position or price breach?
Cooling off period (time)
Changes to subsequent limit bands
Limiting trading for position breaches
What is contingent liability?
Liability that depends on the outcome of a certain event
E.g. futures or options
How can a clearing house protect itself from taking on risk? (4)
Quality of membership, ensure criteria are met
Financial resource requirements, only deals with clearing members
Margining system, ensure adequate cash is deposited
It’s own financial resources
What is the benefit of placing client positions in the house account?
Any credit positions will offset any debit positons
What is the risk of placing client positions in the house account?
Client could lose out in the event of a default
What is the PPS (Protected Payments System)?
System where LCH/ICE will automatically draw directly from the bank account held by that member for margin payments
What does the FCA require for margin payments in the UK?
That the amount demanded by the clearing member is at least as much as that being demanded by the clearing house
How can a clearing house allow margin for OTC products?
Swap the OTC contract for exchange-based equivalent then apply standard margin requirements
What is initial margin?
Good faith deposit lodged with clearing house against liabilities on an open position.
It is returned when the position is closed out.
What is broker margin?
A higher rate of margin demanded by brokers (clearing members) of their clients
When is initial margin collected?
When the client trade is allocated to an account; seg, non-seg, house
What does initial margin seek to cover?
The worst-case loss a position could incur in one day
How is margin rate determined?
By the clearing house and exchange based on volatility
What happens if initial margin is exhausted intra-day?
Clearing house can call for extra intra-day margin to be taken from clearing members PPS account
What do clearing houses do as physical contracts approach delivery?
They increase the initial margin, to drive out speculators and ensure participants have adequate capital to take on delivery
What is spot month margin or spot month change?
Increase in initial margin due to upcoming delivery date
What are the 3 methods for calculating initial margin?
- SPAN (Standard Portfolio Analysis)
- TIMS (Theoretical Intermarket Margining System)
- STANS (System for Theoretical Analysis and Numerical Simulations)
in order of sophistication
How does SPAN work?
Takes into account
- Changes in underlying asset prices
- Potential changes in asset price volatility
- the impact of time on an options value
- Different deriv nuances, e.g. inter spread, and spot delivery months
It then takes these into account to produce 16 different max loss scenarios, and then the largest number is the initial margin
How does TIMS differ to SPAN?
Calculates two margin components;
Premium - daily change
Risk - potential change in the positions value assuming max volatility
How does SPAN use deltas for options positions?
It uses deltas to calculate the equivalent number of futures to quantify an offset.
What is a spread?
More than one position across different delivery months in the same contract
e.g. long June FTSE & short Sep FTSE
What is the closing range?
Price on which the mark-to-market variation margin is set
How does a spread affect initial margin?
It will reduce as the contracts tend to offset one another
What is maintenance margin?
Arrangement between client and member, not clearing house
Client deposits more than initial margin
Allows for price movements without daily payments
Once it has been breached, member will issue a margin call
How are settlement prices established?
Based on a closing range, a price within a window on the day
Can be set by the market supervisor
Called the daily settlement price, decided MTM price.
What is collateral?
Assets that are used as security for a line of credit or line.
What are credit lines?
Where members extend credit to their clients to cover margin requirements
Subject to regulatory rules on lending to clients
What is collateral management?
Allows participants to reduce counterparty credit exposure from OTC derivative contracts
What is a Credit Support Annex (CSA)
Legal documentation as part of ISDA, that allows counterparties to periodically reduce credit risk on longer term OTC derivatives
What does a Credit Support Annex (CSA) define?
Criteria for collateral payments for OTC derivatives transactions.
Rules and conditions under which collateral is transferred between the counterparties to the derivative contract.
Timing, and minimum transfer amount and type of collateral accepted
What is the threshold amount?
Unsecured credit exposure that one counterparty is prepared to accept before requesting collateral
What is the “haircut”
The discount applied to the collaterals market value, this is to protect receiver from falls in the collaterals value
What is a one-way CSA?
Where only one of the counterparties are required to post collateral
When would a one-way CSA take place and who are the typical CPs?
When the size and credit rating of the counterparties vary greatly.
Sovereign, supranational and agency (SSA) CPs
What does UMR stand for?
Uncleared Margin Rules
What are UMR rules?
Margining requirements for uncleared OTC derivatives
What are uncleared OTC derivatives?
Non standard and niche products that are “non-centrally cleared”
What is the purpose of UMR?
To bring this portion of the market more in line with cleared derivatives, using margining and collateral to reduce credit and default risk
What are UMR phase 6 thresholds?
> 50m EUR inital margin must be collected
EU and UK - 8 billion EUR
US - 8 billion USD
Swiss - 8 billion CHF
These numbers decide whether an entity is subject to UMR rules
What is the Aggregate Average Notional Amount (AANA) calculation?
Sum total of all gross notional value of uncleared derivatives, including FX forwards
Specific period over which it is measured - March, April & May
What derivatives are in scope? (7)
Non-deliverable forwards (NDFs)
Physical FX forwards and swaps
Swaptions
FX options
Interest rate products (inc caps and floors)
Equity swaps and forwards
Hedging trades
What is not in scope of UMR?
Cleared instruments
Exchange traded derivatives
What is the standardised initial margin schedule?
Method for calculating intital margin, compliant with UMR
