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What is a central counterparty in financial markets?

20 August 2009

This is the sixth in a series of articles written by Philip Wood, QC, Allen & Overy's Special Global Counsel, on the financial crisis and the global slowdown from a legal perspective.

Like most things in the financial world and especially macro-economics and financial law, simple things are sometimes made to look as difficult as possible. The motive may be to use arcane jargon and code words in order to show one's authentic membership of the inner circle.

But explaining central counterparties is going to be difficult in any event, however hard one tries to make it easy.

The point arises by reason of the discussion which is going on about the need for central counterparties for credit default swaps and other derivatives. In fact the principles of central counterparties apply in a much wider set of financial markets.

Central counterparties are often described as part of the "plumbing" of the financial system, as if they were a mesh of hidden subterranean pipes carrying water and heaven knows what else, deep down in the bowels of that earth. I prefer other metaphors, e.g. the columns which hold up the spiritual cathedral.  At any rate they share with plumbing the features that they are everywhere and quite crucial.

Participants in financial markets commonly have large numbers of reciprocal outstanding bargains between them at any one time. These bargains or contracts could be for the sale of foreign exchange, or for the sale of investments such as shares or bonds on stock exchanges, or for the sale of commodities, or for derivatives contracts, or for credit default swaps or for short-term deposits or loans of money. So two traders can have 10, 20, 100 or 200 contracts between just the two of them outstanding at any one time.

If one of the participants in one of these markets becomes insolvent, then, if it is possible to set off or net all the multitude of reciprocal contracts with the defaulter, the massive gross exposures can be substantially reduced.  "Exposures" are the risk that a bankrupt cannot pay. As to set-off, if I owe you 100 and you owe me 100 and you become bankrupt, then, if I can set off, my exposure is zero.  If I cannot, my exposure could be up to 100 if you have no assets. 

Set-off and its more complicated cousin netting are topics for another day.  All one needs to know at present is that, if they can take place, the reductions in overall exposures can be dramatic. This is crucial in view of the fact that the total exposures in these various markets are typically a multiple of world GDP and that in some of the markets you can reduce exposures by set-off and netting by more than 90 per cent, depending on who owes what on that day. 

However a problem arises from two elemental propositions of the law. The first proposition is that a person's property cannot be expropriated to pay the debt of a third party. For example, a creditor firm which has not been paid by its debtor cannot seize my assets to pay the debt owed by the debtor to the creditor firm. My assets are my assets. They are not available to satisfy debts owed by some third party. Despite many examples of compulsory redistributions of this kind which are considered lawful, e.g. taxation, the principle is basic to the idea of the ownership of property in free societies.

The same proposition applies to bankruptcy law . Once a bankruptcy has commenced by a judicial order, it is not possible for creditors to remove or take away or snatch back the assets of the bankrupt unless they have a mortgage or charge over them. For example, a creditor of a bankrupt cannot kick open the door and remove the television set and sofa belonging to the bankrupt. The assets of the bankrupt are pooled and sold by the insolvency administrator and the proceeds are distributed to unsecured creditors in their proportions.  Piecemeal seizures by diligent creditors are not allowed. Any grabs of assets after the commencement of the insolvency are stopped.

The above concepts are fundamental to set-off.

Consider Diagram 1. (PDF)

X owes a debt to creditor C. This claim is the property of creditor C. At the same time debtor D owes a claim to X. In this situation debtor D cannot set off creditor C's claim so as to discharge the debt which debtor D owes X. If debtor D could do that, then debtor D would be expropriating creditor C's property in order to satisfy the claim which debtor D owes X. Debtor D would be using creditor C's asset to pay debtor D's debt. 

If creditor C is bankrupt, there is all the more reason to disallow the set-off.  The claim which the bankrupt creditor C has against debtor D would be snatched away from the other creditors of creditor C and cease to be available in the pool of creditor C's assets which in the bankruptcy must be used to pay C's creditors.

To stop this from happening, set-off is allowed only if the claims are "mutual", that is, set-off is allowed only if there are only two debtor-creditors and each owns the debt owed to it as its own property and each is personally liable to the other for the debt it owes. In any other case, as where one debt is owned by C and the other is owed by D, set-off would lead to the result that one person's property is used to pay the debt of another.  This would be contrary to the elemental concepts of property and bankruptcy which are summarised in the meaning of mutuality. 

The result of this is that, if there are 10, 20, 100 or 200 firms dealing with a single firm X which becomes bankrupt, it is not possible for all these numerous firms to combine their claims in a global set-off against the bankrupt.

See Diagram 2. (PDF)

It is not possible for all those debtors to seize the claims owed to all these creditors in order to pay the debts which the debtors owe to X.

Enter the central counterparty. The problem of mutuality is solved by the ingenious device of inserting a company, the central counterparty, between the participants and the bankrupt X. 

The central counterparty is just an ordinary company whose only business is to act as a central counterparty. Its shares can be owned by the participants who are using the company or the shares can be owned by independent shareholders or by an exchange.

Whenever two participants in the market enter into a contract, e.g. for the sale of foreign exchange, they have agreed in advance that all of these eligible contracts will be transferred to the central counterparty and converted into two mirror contracts. Thus, if C sells to X in the market, the parties agree with the central counterparty that their single contract is treated as two contracts. The first is between C and the central counterparty under which C sells to the central counterparty. The second contract is between the central counterparty and X under which the central counterparty sells to X on exactly the same terms. The single contract is turned into two mirror contracts with the central counterparty in the middle. 

The set-up is as shown in Diagram 3. (PDF)

The result of this arrangement is that, if X becomes bankrupt, the central counterparty can set off or net against X since all the trades are mutual as between the central counterparty and X. The manifold non-mutual claims on the left are combined into mutual claims on the right. The effect is that a global set-off by all participants against the bankrupt X becomes possible. The reduction of overall risk in many cases can be simply enormous. 

The use of a central counterparty therefore makes  a lot of sense in terms of making financial markets safer and reducing exposures if one major firm should become bankrupt. There is a lesser risk of cascade or domino or knock-on insolvencies. 

The main problem is that there is a gigantic concentration of risk on the central counterparty. All contracts in the particular market go through the central counterparty and so the central counterparty potentially has huge liabilities. If the central counterparty became insolvent, the result could be catastrophic.  They really are too big to fail.

Hence the participants have to make sure that this does not happen. For example, the participants have to provide collateral to the central counterparty and banks have to agree to provide loans so that the central counterparty can borrow if it is suddenly short of cash. These are not fool-proof. Thus collateral can fall in value and banks providing loans can go bust. Systems can fail. But, because the mutualisation of claims results in such a large reduction in exposures, the overall amounts needed to protect the counterparty are very much less.

The outstanding amounts of credit default swaps are many times world GDP.  The overall reduction in these risks by the use of a central counterparty could reduce the current exposures by trillions.

The amounts involved in foreign exchange and payment systems are so huge that the concentration of risk makes central counterparties less appropriate.  As a result (and for other reasons) the main foreign exchange settlement bank (CLS Bank) and payment systems adopt different strategies.

Apart from enhanced set-off, these central counterparties have a number of other advantages. Thus traders mainly have to assess only the credit of the central counterparty, instead of the credit of all the other counterparties which they contract with in the market. The traders contract only with the central counterparty. The central counterparty can "match" trades, i.e. confirm to the traders that their versions of the contract match each other without inconsistencies. The central counterparty can keep statistics and report on the numbers to regulators who can then know what is going on. 

All reciprocal amounts payable on the same day in the same currency can be netted out in advance so as to reduce the risk that one party pays and the other party goes bust before it pays – "settlement netting". The central counterparty can arrange things so that there is no gap between deliveries and payments.

There are also some ancillary issues, e.g. the best contractual mechanics to get the contracts over to the counterparty quickly after they have been made between two traders, whether it is necessary to standardise contracts for the concept to work properly, and how residual losses after set-off and netting are to be shared amongst the solvent survivors. There are issues as to who owns the central counterparty and who has access to them.

Nevertheless, these are issues aside from the grand idea, albeit complex in their detail and often contested. Central counterparties are so useful that practically every stock exchange in the world of any note has one and they are very common in other markets. It is therefore no surprise that regulators and markets themselves should adopt the idea for credit default swaps.

Objections include the fact that this mutualisation is weakened if some contracts are with the central counterparty but others are not, and that the pressures of standardisation may limit client choice.

The principal weakness is the concentration of risk. To take the plumbing analogy further, a recent letter-writer to the Financial Times remarked that God must have been an engineer because in the human frame he drove a waste management system through a recreational area. So even if central counterparties afford us the prize of dramatic risk reduction, we still do not have the nirvana of no risk at all. They are only mortal after all.

Further information

If you have any queries relating to this article, please email Philip Wood or tel: +44 20 3088 2552.

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