Progress on stress testing methodology by European central counterparties (CCPs) this week will demonstrate their ability to handle an increased range of instruments and strip away the need for domestic exchanges to impose their own criteria for interoperability, market participants have insisted.
An agreement on stress testing across asset classes announced by the European Association of Clearing Houses (EACH) comes as sources have confirmed that the London Stock Exchange (LSE) is devising its own set of criteria for CCPs that want to clear for its market.
Although the LSE was the first exchange to offer interoperability, it – along with a number of major bourses – has fallen behind other venues that are now providing greater choice to trading members. The LSE currently offers two clearers for its UK equity market, Anglo-French CCP LCH.Clearnet and Swiss clearer SIX x-clear. Deutsche Börse only widened its access criteria for third-party access to its Eurex Clearing CCP beyond regulated exchanges after the European Commission rejected its first set of compromises offered in support of its proposed merger with NYSE Euronext. Multilateral trading facility BATS Chi-X Europe introduced four-way interoperability on 6 January and other trading venues have confirmed plans to follow suit.
The current wording of forthcoming European regulations – MiFID II and the European market infrastructure regulation (EMIR) – support full interoperability between exchanges and clearing houses for equities and listed and OTC derivatives. But many across the industry have raised queries about the ability of CCPs to effectively handle the risks arising from clearing a much wider range of financial instruments.
But market participants say exchange-led criteria are superfluous in light of existing regulatory requirements and the stress testing work conducted by the EACH. They fear that, by devising their own criteria, exchanges could use proprietary standards to preclude certain clearers for commercial reasons.
“It is the market participants rather than the exchange that should define the criteria for the central counterparties they want to use,” said Stephane Loiseau, deputy global head of execution services at Société Générale. “Exchanges should not have to apply their own standards if regulators have already considered the operational risks beforehand.”
But the creation of standards for CCPs possibly indicates a willingness by the LSE to further expand its post-trade offering and some consider it to be a prudent move given that many clearers are likely to vie for the opportunity to service the UK market.
The EACH paper, published on 17 January, adds another layer of confidence about the ability of CCPs to serve trading venues safely and efficiently. The initiative complements ongoing work by the Committee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO), which are jointly defining principles for ensuring the safety of financial market infrastructures.
Although CCPs have conducted stress tests on an individual basis for many years, the EACH initiative attempts to create a level of harmonisation among clearers.
“With more OTC activity coming on exchange as a result of EMIR, the increased discussion on the stability of CCPs and stress testing is understandable,” said Fredrik Ekstrom, head of risk management at Nasdaq OMX Nordic. “Each CCP should be able to have their own stress testing model, but defining the assumptions for these tests should be standardised.”
EMIR, which is currently under discussion by European authorities, will standardise OTC derivatives where possible so that they can be traded on-exchange and centrally cleared. Some participants have questioned whether funnelling a large portion of market worth around US$700 trillion will reduce systemic risk as intended, or simply concentrate risk with CCPs.
Ekstrom said the input for CCP stress tests is based on the potential maximum movement for each instrument cleared by a trading venue. Nasdaq OMX did this based on historical market activity going back 15-20 years.
The tests then considered whether CCPs have enough capital to cope with the default of the largest participant default or the second and third largest participants default combined, based on the potential extreme movements on an individual instrument level.