The Bank for International Settlements' Committee on Payment and Settlement Systems has published a report evaluating the range of clearing structures currently in use according to the risks they pose and the advantages they offer.
Clearing is under scrutiny in Europe due to its high costs compared to other markets such as the US. Pan-European central counterparties are currently waiting for regulatory approval to interoperate in equity markets so that they may compete with one another and offer lower costs. Exchange group NYSE Euronext announced on 12 May it would build its own clearing house, creating a vertical model for its users, while the London Stock Exchange is also said to be considering a similar move. Clearing houses EuroCCP and EMCF are reported to have discussed merging to offer a horizontal model.
In the report, which covered the major European and Asian markets along with Canada and the US, the horizontally-integrated model was the most commonly found, followed by the vertical model. Under a horizontal structure, central counterparties (CCPs) provide post-trade services to a range of trading venues or market participants sometimes across jurisdictions and it is often the result of mergers rather than organic growth. The vertical model is one in which trading, clearing and settlement services are provided by one organisation.
Through centralising trades into a single CCP, the horizontal model can offer multilateral netting and cross-margining benefits which may reduce the CCP's own credit exposure. In addition to the reduced costs created by operating a single risk management system and infrastructure, this benefit was seen as likely to increase use of the CCP and therefore increase the possibility of netting. On the downside it would be more reliant on commercial banks for funding than a domestic clearer, which might have access to central bank funding, and that could expose it to liquidity risk. It would also face challenges in calculating the necessary size of its default fund against its aggregated risk exposure.
The vertical clearing model was recognised as potentially reducing operational risk by offering a common IT infrastructure for all the CCP's functions and lowering its operating expenses, although the report warns this may “simply be translated into greater profits, without necessarily leading to improved operational resilience”. The model is noted for potentially increasing systemic risk by creating companies that are ”too big to fail' and also for potentially allowing incumbents to limit access to clearing for alternative venues and restricting the entry of new firms.
The report gave no evidence to suggest that one market structure would be superior to another, either in terms of CCP risk management or in terms of wider systemic risk. For example, it noted that risks related to the size of an infrastructure are relevant in the case of both vertical and horizontal integration. Similarly, interdependencies may arise in both vertical groups and horizontal groups which serve multiple markets.
It did suggest that central banks and regulators should attend to certain risks that are more likely to occur in certain market structures than in others, including incentives to weaken the robustness of CCP risk controls that may in turn result in a reduction in the CCP's ability to manage a member default.