FINANCE FINANCE, COMPETITIVENESS & INNOVATION EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT How to Analyze the Costs and Benefits of Introducing a Central Counterparty February 2022 © 2022 International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org This work is a product of the staff of The World Bank with external contributions. The findings, interpretations, and conclusions expressed in this work do not necessarily reflect the views of The World Bank, its Board of Executive Directors, or the governments they represent. The World Bank does not guarantee the accuracy, completeness, or currency of the data included in this work and does not assume responsibility for any errors, omissions, or discrepancies in the information, or liability with respect to the use of or failure to use the information, methods, processes, or conclusions set forth. 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Cover design and layout: Diego Catto / www.diegocatto.com Prepared by Dorothee Delort, Martijn Lathouwers, Gynedi Srinivas, and Froukelien Wendt1 Authorized for distribution by Harish Natarajan (World Bank) DISCLAIMER: This how-to note offers practical advice from World Bank staff members to policy makers. The views expressed are those of the author(s) and do not necessarily represent the views of the IMF and/or World Bank, their Executive Board, or management. 1 Froukelien Wendt was part of the Monetary Capital Markets department of the International Monetary Fund when this note was prepared. She is now an independent member of the CCP Supervisory Committee and director for central counterparties at the European Securities and Markets Authority (ESMA). Martijn Lathouwers also joined ESMA in November 2021. >>> Abstract Central counterparties (CCPs) require a certain level of market development to operate in a safe and efficient manner. This note presents a practical cost-benefit analysis framework for country authorities to decide whether this specific type of financial market infrastructure will benefit their markets, financial institutions, and investors, or whether the costs of a CCP are higher than its benefits. The note discusses three key questions: (1) Are the necessary preconditions met—for example, is the market sufficiently liquid to enable the CCP to calculate margin?; (2) Will a CCP support a well-functioning market?; and (3) Is there a positive business case? Introducing a CCP is recommended only when all questions can be answered in the affirmative. Otherwise, alternative clearing models should be considered, such as bilateral clearing between financial institutions, multilateral netting with a guarantee, prefunding, or clearing through a CCP abroad. Often, introducing a CCP uncovers a chicken-and-egg problem whereby a CCP will positively impact market liquidity while at the same time a minimum level of market liquidity is a condition to set up a CCP. In such cases, the introduction of a CCP should be part of a comprehensive market development plan. Keywords: central counterparty, financial market development, securities, clearing Authors’ email addresses: ddelort@worldbank.org, martijn.lathouwers@esma. europa.eu, gsrinivas1@worldbank.org, froukelien.wendt@esma.europa.eu The authors are grateful for the input from Ana Carvajal, Alessandro Gullo, Cory Hillier, Peter Katz, John Kiff, Nilima Ramteke, Ryan Rizaldy, Manmohan Singh, and Milton Vega >>> Contents 1. Introduction and Summary 6 2. Typology of Clearing Models 8 3. International Data on Clearing Models for Financial Markets 11 4. Framework for a CCP Cost-Benefit Analysis 15 CCP Preconditions 17 Market Cost-Benefit Analysis 18 Business Cost-Benefit Analysis 22 Final Implementation and PFMI Compliance 24 5. Conclusion 25 References 27 Appendix A. World Bank data on CCPs around the world 29 Appendix B. Practical guide for conducting a CCP cost-benefit analysis 33 Figures Figure 2.1. Typology of clearing models 8 Figure 3.1. Global use of CCPs per income level and region 12 Figure 3.2. CCP management of credit exposures 14 Figure 4.1. Cost-benefit analysis framework for the introduction of a CCP 16 Figure 4.2. Quantitative input factors for the market CBA 20 Figure A.1. CCP governance and ownership 30 Figure A.2. Business continuity arrangements for CCPs 32 Figure B.1. Example of identifying current clearing models for markets in Country A 33 Boxes Box 1.1. What is a CCP? 7 Box 3.1. The introduction of CCIL in India 13 Box 4.1. Ukraine: Example of an alternative clearing model 21 Box 4.2. Example of how the CBA framework supported frontier market development 23 Tables Table 4.1. Market CBA for a CCP compared with a bilateral clearing model 19 Table 4.2. Potential benefits of a CCP and main beneficiaries 22 1. > > > B OX 1 .1 : What is a CCP? >>> Introduction and Summary Central counterparties (CCPs) are financial market infrastructures that interpose themselves between counterparties in a financial market, becoming the buyer to every seller and the seller to every buyer to ensure the performance of open contracts. CCPs can bring important benefits to financial markets, such as reduced counterparty risks, operational efficiencies, central man- agement of a defaulting market participant, and transparency. CCPs also support anonymous electronic trading, where participants cannot always manage their credit risks bilaterally through their choice of counterpart. Box 1.1 elaborates on the functioning of CCPs. In short, CCPs can be tools to strengthen risk management and support market development. However, CCPs also concentrate risks, which makes them systemically important. This – the concentration of risks, strengthening risk management, and supporting market development – is why CCPs are in- creasingly regulated and supervised. A central counterparty (CCP) is the single counterparty in a specific market for trades received from trading counterparties—through exchanges, the trading or matching of platforms, or the clearing of members—thereby guaranteeing the performance of open contracts. The CCP becomes the buyer to the seller and vice versa through novation or open offer. Novation is the legal process in which the original contract between the buyer and seller is replaced by two new contracts, one between the CCP and the buyer and the other between the CCP and the seller. Open offer means that a CCP is automatically the counterpart at the moment that the buyer and seller conclude the transaction, which means that there is never a contractual relationship between the buyer and seller. Following novation, the CCP can perform multilateral netting of positions and trades, which reduces counterparty credit risk of the original trading counterparties and allows for a reduced number of settlement instructions. Having fewer instructions reduces operational complexity and risks. Subsequent benefits for clearing members are improved return- on-capital ratios and creditworthiness. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 6 Because every buyer has a seller, a CCP works as a closed zero-sum system under the condition that all the buyers and sellers meet their obligations. However, in the case of a counterparty default, this closed system is broken and the CCP must act to re-establish a matched book. To ensure that the CCP can continue to meet its obligations, it should have risk management and default management procedures in place to handle the default of a clearing member in an organized manner. Any losses that the CCP faces are allocated through a default waterfall, which consists of several types of financial buffers such as margin, the CCP’s own capital, and a default fund. If properly structured, the default waterfall provides incentives for adequate risk management by the CCP and its participants. For extreme but plausible events, a CCP should have a recovery plan in place that allows the CCP to continue its critical operations. Whether a CCP contributes to the development and safety of If the CBA concludes that for a specific market a CCP would a market depends on several factors. In any case, a CCP re- be a beneficial and viable option, then that CCP should adopt quires a certain level of market development. CCPs have been a solid risk management framework with full collateraliza- shown to be effective infrastructures in developed countries tion of the CCP’s credit exposures in line with international with relatively high and sustainable income and liquid markets standards, notably the CPSS-IOSCO Principles for Financial with, for example, narrow spreads, high trading volumes, and Market Infrastructures (PFMI). If, however, the CBA concludes readily available prices. CCPs especially add value in mar- that a CCP would not be beneficial and viable, then alternative kets in which participants actively buy and sell the same finan- ways should be sought to manage counterparty credit risks in cial instrument (CPSS 2001) and credit exposures are more that market and a strategy should be designed to support the volatile or prolonged (Hills et al. 1999). Conversely, CCPs in development of the market up to the point where the market insufficiently developed markets that lack market liquidity, pro- would benefit from the creation of a local CCP or an interna- ficiency, and effective regulation and supervision may not be tional CCP. able to manage risks prudently and may expose banks and other financial institutions and investors to credit risks, liquidity The CBA framework builds on International Monetary Fund risks, and high operational cost. (IMF) and World Bank technical advice provided in various in- dividual countries, and it takes into account good practices in International standards recommend that before a CCP is other countries and literature. introduced, the benefits and costs of doing so should be eval- uated (CPSS-IOSCO 2012).2 The key objective of this how-to Following this introduction, section 2 provides a typology of note is to support authorities in the development of a posttrade clearing models for contracts traded in financial markets. A strategy and particularly in conducting a cost-benefit analy- snapshot of international data is provided in section 3, and ad- sis (CBA) to evaluate whether potential benefits of a CCP ditional details are provided in appendix A. Section 4 presents outweigh the potential cost, now or within a reasonable time a theoretical framework for conducting a CBA, and section frame. The CBA helps authorities understand whether a CCP 5 presents the conclusion. Appendix B provides a hands-on is superior to other clearing models, whether a CCP will con- methodology to conduct a CBA in practice. tribute to the authorities’ objectives of financial stability and market development, and whether the CCP will be an eco- nomically viable entity. 2 CPSS-IOSCO, Principles for Financial Market Infrastructures, Appendix C, Recommendation 4: “The benefits and costs of a CCP should be evaluated. Where such a mechanism is introduced, the CCP should rigorously control the risks it assumes.” EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 7 2. > > > F I G U R E 2 . 1 . - Typology of clearing models Bilateral clearing without netting and margining >>> Typology of Clearing Models A CCP is only one of the possible clearing models that are used in financial markets around the world. Figure 2.1 provides a typology of clearing models. Its six models form a spectrum from fully unsecured bilateral clearing between the counterparts in the transaction (left) to a fully guaranteed central clearing model (right). In the latter, a CCP takes over counterparty credit risk and protects itself through a comprehensive set of financial resources that are calculated and calibrated using advanced quantitative risk methodologies. Between these two ends of the spec- trum, a variety of models is possible, typically providing different levels of guarantees, centrality, and efficiency. Bilateral netting and margining Central multilateral netting without guarantee Prefunding Limited- performance guarantee Central counterparty No netting Maximum netting No coverage of exposures Sophisticated measures to cover exposures Source: Original figure for this publication. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 8 Unsecured bilateral clearing Multilateral netting The clearing model on the extreme left of the spectrum is the Closer to the middle of the spectrum is the exchange clearing unsecured bilateral clearing model, in which transactions are model, which is characterized by multilateral netting of trans- cleared bilaterally between trading counterparties. This model actions and the absence of settlement guarantee. This model comes without measures to protect counterparties against is often used for exchange-traded securities that settle within each other’s potential default, such as margining. Counterpar- a short time frame (for example, T+2), where a central entity, ties of a defaulting trading participant are just another credi- often the stock exchange, nets the transactions on a multilat- tor with a claim on the defaulter’s assets. This model is often eral basis. Generally, safeguards have been put in place, such used in markets characterized by nonfrequent, standardized as membership requirements and transaction validation, but transactions with relatively low transaction risks, such as over- there are no financial resources to cover the losses in case of the-counter (OTC) equity markets. a counterparty default. This model exposes the counterparts of the transaction to the loss of the (full) transaction value for the duration of the period that the security is not settled. Bilateral margining Prefunding Bilateral clearing can also be combined with bilateral netting and bilateral margining. Bilateral netting of transactions takes place between the two counterparties of the transaction over A clearing model that fully guarantees the settlement of the a certain period, such as one day. Bilateral netting may take transaction is the prefunding clearing model. Prefunding stip- place using a standardized bilateral netting agreement—for ulates that a transaction will be performed only if the gross example, the ISDA or GMRA agreement.3 The provision of value of assets and/or cash is available (so the full size of the margin is intended to cover credit exposures and can be either transaction) and is deposited at an account of a central entity variation margin, to cover current exposures through price (for example, the exchange). This model is typically used in movements, or initial margin, to cover potential future expo- developing markets where counterparties or cleared assets sures. Netting and margining reduce counterparty credit risks (or both) have a high-risk profile. Although this clearing model and protect the counterparties of the defaulter for the size of provides a high certainty that a transaction will settle, it is also the margin and as long as transactions are not reversed. This inefficient because it requires a high funding cost and as such clearing model is often used to clear bespoke transactions be- hampers market development. tween two counterparties for transactions with high-risk expo- sures, such as in OTC derivatives and repo markets. 3 The ISDA Master Agreement is an internationally agreed-upon document of the International Swaps and Derivatives Association, Inc. (ISDA) that provides certain legal and credit protections to counterparties in OTC derivatives transactions. The Global Master Repurchase Agreement (GMRA) is a model legal agreement of the International Capital Market Association (ICMA) for counterparties in repos. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 9 Limited performance model set of financial resources, such as several types of margin, complemented by a default fund, the CCP’s own capital, and recovery tools. (See box 1.1 for more information.) The lit- A more efficient model is the limited performance guarantee erature—for example, Wendt (2015)—outlines how well-func- clearing model, consisting of a central administrator of a guar- tioning CCPs can vastly improve the efficiency, transparency, antee fund, which is used to cover potential default losses with- and safety of the financial system, whereas CCPs that are out having a full set of sophisticated financial buffers in place. not properly managed may severely impact the stability of the The central administrator is typically an exchange or central economy. The failure of a CCP may result in a systemic risk, securities depository (CSD). The coverage of the guarantee potentially spreading losses throughout financial markets. The fund is limited to the available funds, and it may not be suf- PFMI standards aim to ensure that financial market infrastruc- ficient under all circumstances (for example, during stressed tures (FMIs), including CCPs, are sufficiently robust and able market conditions). Non-defaulting participants would be en- to withstand financial shocks, and as such support financial titled to make a claim against the guarantee fund; however, stability. This how-to note considers that a CCP should ob- they face a credit loss to the extent that their aggregate losses serve the PFMI, comply with related regulations within its juris- exceed the size of their pro rata share of the guarantee fund diction, and be subject to effective supervision and oversight. (CPSS 2004). The guarantee fund is a less sophisticated risk measure than margin applied by CCPs, which is calculated to In determining a post-trade clearing strategy, authorities cover losses with a confidence level of, for example, 99 per- may consider whether a domestic CCP should be pursued cent. Another difference between a guarantee fund and a CCP or whether clearing through an international CCP is the bet- is that in a guarantee fund, the administrator does not have a ter option. Both options come with pros and cons (Kiff et al., credit exposure to a defaulting participant and typically does forthcoming). For example, a domestic CCP provides authori- not assume a role in managing a default. ties with the capacity to supervise the CCP and allows local participants to clear in the local jurisdiction and deposit local currency and securities as collateral. Several countries have CCP model built sizable local clearing operations (see box 3.1 on the in- troduction of a CCP for government securities in India). Nev- ertheless, a domestic CCP may not always be a viable option A CCP is the most advanced clearing model that provides a in cases of a limited number of market participants and low full guarantee to trading counterparties (often through clear- liquidity in certain product classes. ing members). The CCP protects itself through a sophisticated EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 10 3. >>> International data on clearing models for financial markets The World Bank Global Payment Systems Survey (GPSS)4 collects information on FMIs on a biennial basis and provides detailed insights into the main characteristics of clearing models (including CCPs) across many countries.5 The data and information provide insight into where and how clearing models are used and how clearinghouses organize their risk management. In 2018, 41 countries6 reported having at least one CCP in operation, and there are about 60 CCPs active worldwide. If a CCP has been reported to exist in a jurisdiction, the CCP does not necessarily clear all products or markets in that country. Rather, the use of CCPs can vary per type of product and market. CCPs can be active in markets for (1) cash-traded products (equities, exchange-traded funds [ETFs], and corporate and government bonds), where the CCP provides a guarantee on the settlement of trades generally executed on regulated exchanges or trading platforms; (2) exchange-traded derivatives, where the CCP clears standardized derivatives products such as single equity options, index futures, and interest rate futures; (3) OTC derivatives, which are less standardized derivatives that are traded outside of regulated exchanges; and (4) repo and classical buy-sell transactions, including lending and borrowing activities secured through (high- quality) securities. Data from the World Bank GPSS (figure 3.1) illustrate the use of CCPs for different types of products for different countries (per income level) and regions. The figure shows that CCPs are active mostly in high-income countries with liquid financial markets, whereas alternative clearing models are in place for smaller jurisdictions and less liquid markets. These distinctions reflect that CCPs need liquid markets, where high liquidity ensures the availability of timely and accu- rate market prices necessary to calculate reliable margins. Liquid markets provide more netting opportunities and thus more operational efficiencies for market participants, while ensuring suf- ficient income for CCPs to thrive. 4 The World Bank Group launched the GPSS in 2007 to collect information on payment systems, payment services, and FMIs worldwide. Since then, the GPSS has been used by authorities and policy makers for meaningful cross-country comparisons and reforms in their national payments system (NPS) and has facilitated dissemination of best practices and international standards. In 2018, the fifth GPSS was expanded to collect information on fintech and innovative payment services, the latter focusing on the underlying innovations that enable enhanced access to and usage of transaction accounts. 5 The World Bank Global Payment Systems Survey does not capture and reflect the level of compliance with the PFMIs. 6 No low-income country provided answers to this part of the GPSS questionnaire, whereas almost 60 percent of all reporting CCPs were in high-income economies. The existence of a CCP has been declared by the relevant local regulator but has not been verified. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 11 > > > F I G U R E 3 . 1 . - Global use of CCPs per income level and region Latin America Middle East & Lower middle Sub-Saharan Upper middle North Africa Central Asia & Caribbean High Income High income Low income East Asia & South Asia Europe & income income Pacific Global Africa OECD The CCP provides multilateral netting 89% 94% 88% 78% 80% 73% 100% 100% 75% 100% facilities - - 50/56 29/31 14/16 7/9 4/5 8/11 1/1 26/26 6/8 5/5 Legally becomes the buyer to every 88% 91% 94% 67% 80% 82% 100% 93% 75% 100% seller and the seller to every buyer - - 52/59 31/31 15/16 6/9 4/5 9/11 1/1 27/29 6/8 5/5 via novation 68% 72% 69% 56% 60% 55% 100% 74% 63% 80% Clears exchange-traded derivatives - - 39/57 23/32 11/16 5/9 3/5 6/11 1/1 20/27 5/8 4/5 Clears cash products—corporate 61% 67% 53% 56% 80% 40% 0% 71% 38% 80% equities - - 35/57 22/33 8/15 5/9 4/5 4/10 0/1 20/28 3/8 4/5 Clears cash products—corporate 54% 50% 57% 63% 80% 30% 52% 63% 75% bonds - - - 28/52 15/30 8/14 5/8 4/5 3/10 13/25 5/8 3/4 Clears cash products—government 49% 52% 33% 67% 80% 40% 0% 46% 38% 80% securities - - 27/55 16/31 5/15 6/9 4/5 4/10 0/1 12/26 3/8 4/5 Clears cash products—repos 49% 46% 46% 63% 80% 33% 50% 14% 100% (classical, buy sell-back, and tri-party) - - - 24/49 13/28 6/13 5/8 4/5 3/9 12/24 1/7 4/4 43% 34% 50% 63% 80% 20% 42% 38% 75% Clears cash products—other - - - 22/51 10/29 7/14 5/8 4/5 2/10 10/24 3/8 3/4 41% 52% 31% 22% 20% 27% 0% 62% 13% 40% Clears OTC-traded derivatives - - 23/56 16/31 5/16 2/9 1/5 3/11 0/1 16/26 1/8 2/5 Legally becomes the buyer to every 27% 26% 25% 33% 40% 55% 0% 15% 25% 20% seller and the seller to every buyer - - 15/56 8/31 4/16 3/9 2/5 6/11 0/1 4/26 2/8 1/5 via open offer Operates in more than one 25% 41% 0% 11% 0% 0% 0% 48% 0% 20% jurisdiction - - 14/57 13/32 0/16 1/9 0/5 0/11 0/1 13/27 0/8 1/5 Guarantees settlement of other 11% 16% 0% 11% 0% 0% 0% 19% 0% 20% financial market infrastructures (FMIs) - - 6/56 5/31 0/16 1/9 0/5 0/11 0/1 5/26 0/8 1/5 0% 20% 40% 60% 80% 100% Each box shows the percentage of answers for the FMIs among the jurisdictions in a group. A jurisdiction may have reported multiple FMIs. The number of responding jurisdictions and reported FMIs may differ across options. A jurisdiction may have chosen multiple options for each reported FMI. Source: World Bank Global Payment Systems Survey. Note: CCP = central counterparty; FMI = financial market infrastructures; OECD = Organisation for Economic Co-operation and Development; OTC = over-the- counter; Interestingly, middle-income countries clear government (box 3.1). Conversely, high-income countries are more likely bonds, repos, and corporate bonds through a CCP more often to have CCPs for equities and derivatives, reflecting the con- than high-income countries do. A possible explanation is that tribution of these infrastructures to the safety and efficiency authorities in some countries actively use CCPs as tools to of these markets. Whether a CCP is a useful infrastructure strengthen the risk management in these markets to promote for government securities depends on several factors, as de- further market development. The introduction of the Clearing scribed in the next section. Corporation of India (CCIL) is an example of this approach EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 12 > > > B OX 3 .1 : The introduction of CCIL in India The Reserve Bank of India (RBI) initiated the decision to set up a clearing corporation to strengthen and improve the risk management framework for the clearing and settlement of debt instruments and foreign exchange (forex) transactions in India. The decision was endorsed by the government when the finance minister indicated in his budget speech (2001–02) that a clearing corporation would be set up to further develop a transparent and active debt market in general, and the government securities market in particular, and to enable settlement of forex transactions.7 A core committee for setting up the clearing corporation was formed at the behest of RBI. Representatives from major banks, all-India financial institutions, industry associations representing primary dealers, foreign exchange dealers, fixed-income, and money markets, and RBI were members of the committee. The committee’s deliberations culminated in finalizing a blueprint for the formation of the Clearing Corporation of India (CCIL). The core committee identified six core promoters for CCIL—namely, State Bank of India, IDBI Bank Ltd. (formerly Industrial Development Bank of India), ICICI Bank Ltd., Life Insurance Corporation of India (LIC), Bank of Baroda, and HDFC Bank Ltd.8 CCIL was incorporated on April 30, 2001. CCIL commenced its operations for clearing and settlement of transactions in government securities (including repos) on February 15, 2002. Acting as a CCP through novation, the CCIL provides guaranteed settlement and has put in place risk management systems and also has access to lines of credit from commercial banks.9 During the course of the same year, CCIL also introduced a guaranteed settlement facility for interbank spot and forward US Dollar-Indian Rupee (USD-INR) trades through novation from November 8, 2002, and has recently moved forward with clearing OTC derivatives transactions. CCIL acting as the CCP novates the trades and guarantees settlement for transactions in the government securities market (outright and market repo and tri-party repos) subject to relevant risk mitigation measures with settlement taking place in a Delivery-versus-Payment model 3 (DVP 3) mode. Foreign exchange USD-INR market (cash, tomorrow-next, spot, and forward trades when these enter the spot window) are also novated and settled on a payment-versus-payment basis. CCIL is also licensed under the Payment and Settlement Systems Act, 2008 (and its amendments) to provide other services.10 To sum up, the RBI had a clear strategic vision to strengthen systemic and financial stability in the Indian financial markets and to mitigate systemic and counterparty credit risk in the government securities and USD-INR foreign exchange market segments. It served as a catalyst by bringing in the relevant stakeholders in a core committee and drove the process to set up a member-owned central clearing corporation. It permitted CCIL to act as a CCP in those market segments and products that had a degree of maturity and that had adequate liquidity. Finally, it exercised its powers as overseer to ensure that CCIL continues to remain compliant with the PFMI. CCPs worldwide have put in place a range of risk management ment practices that have been observed in the past few years measures to manage their credit exposure (figure 3.2). These can be ascribed to the implementation of the PFMI. Generally, measures include capital requirements for participants, mar- margin requirements are applied and mark-to-market valua- gin requirements, mark-to-market valuation, participant de- tion is performed. Also, regular stress testing appears to be a fault procedures, loss sharing mechanisms, and the conduct- well-grounded practice worldwide, and 19 respondents apply ing of regular stress tests of adequacy of resources in case prefunding of trades. More international data are provided in of default. To a certain extent, improvement in risk manage- appendix A. 7 Government of India, ministry of finance, “Debt Market,” https://www.indiabudget.gov.in/budget_archive/ub2001-02/bs/debt.htm. 8 CCIL’s current shareholding is as follows: 63.2% by commercial banks; 14.0% by financial institutions; and 22.8% by primary dealers, insurance companies, nonbank financial companies, and other corporate bodies. https://www.ccilindia.com/AboutUs/Promoters/Pages/default.aspx. 9 Reserve Bank of India, 1. Policy Environment Monetary and Credit Policy. https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/32622.pdf. 10 See CCIL Disclosures on Compliance with Principles for Financial Market Infrastructures, updated February 26, 2020, https://www.ccilindia.com/RiskManagement/Lists/ QualitativeDisclosuresFiles/Attachments/10/PFMI%20Qualitative%20Disclosures%20Mar%202019_Final.pdf. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 13 > > > F I G U R E 3 . 2 . - CCP management of credit exposures Applies margin requirements to limit its credit exposures 50 Marks to market participants’ outstanding contracts at least 49 once a day The CCP’s default procedures define an event of default and 49 the method for identifying that default Conducts regular stress tests to check the adequacy of resources in the event of a default in extreme market 48 conditions (IF CCP applies margin req’s), the CCP applies initial margin 47 There is a guarantee fund, consisting of contributions of the 46 participants of the CCP Maintains additional liquid resources, including own funds 46 Sets a minimum capital requirement to its participants 45 (If CCP applies margin req’s), the CCP applies variation margin 44 Maintains sufficient liquid resources to be able to withstand the default of the participant and its affiliates that would generate 42 the largest aggregate payment obligation Has rules and procedures that support segregation 42 and portability of positions and collateral Has a loss-sharing arrangement in place (other than the 40 guarantee fund) Has access to a deposit account at one or more central banks of issue 29 0 5 10 15 20 25 30 35 40 45 50 Central counterparties Source: World Bank Global Payment Systems Survey. Section 4 presents the CBA framework that can be used to determine whether a CCP is the optimal clearing model for a specific market, or whether other clearing models are superior. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 14 4. >>> Framework for a CCP cost-benefit analysis The choice for a specific clearing model is part of the overall development of a financial market. The framework presented in this section aims to support authorities, financial institutions, and other relevant stakeholders in determining whether one or more markets have the profile for ensuring a safe and efficient CCP and, therefore, whether the introduction of a CCP is the right step in the development of the market. The framework was developed by the IMF and World Bank as part of their bilateral techni- cal advice in several countries. The CBA framework consists of three components (figure 4.1): (1) a set of preconditions that should be met before the market is ready to set up a CCP (for example, a sound legal and regulatory framework and the availability of good-quality market prices); (2) a market CBA to determine whether the introduction of a CCP will have a positive impact on the efficiency, safety, and fairness of the market; and (3) a business CBA to determine whether the CCP would generate sufficient revenues to conclude that there is a business case for a CCP. If an analysis of each component concludes positively, then the CCP should ensure that it is PFMI compliant. The last step is not part of the CBA but rather a verification that the CCP adopts governance and risk management rules, procedures, and practices that are in line with international standards. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 15 > > > F I G U R E 4 . 1 . - Cost-benefit analysis framework for the introduction of a CCP + If all preconditions are met and Investment CCP NPV (revenues – Positive there are positive Business CBA + software, capital operational costs) NPV business and market CBAs, a Market benefits CCP can be built are the basis for in compliance Impact Pros Cons CCP revenues. with PFMI Market recommendations. Efficiency Operational > > Capital Market PFMI- Potential benefit > compliant Market CBA Credit risk for CCP costs CCP Resilience Legal risk Systemic risk + Market Fairness Entry criteria Several preconditions should be met to build a resilient CCP. Sufficient quantity Market Product and quality of sophistication suitability pricing Preconditions CCP are mete preconditions Sound legal Effective Coordination and regulatory supervision and and cooperation framework oversight Source: Original figure for this publication. Note: CBA = cost-benefit analysis; CCP = central counterparty; NPV = net present value. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 16 CCP Preconditions A first set of preconditions for a safe and efficient CCP com- In addition, there are specific preconditions that relate to a prise the availability of a sound legal and regulatory frame- CCP’s ability to perform proper risk management in relation work, effective supervision and oversight, and coordina- to cleared positions. These are timely and reliable market tion and cooperation among all relevant stakeholders. prices, a minimum level of market sophistication, and product suitability. The development of capital markets requires a robust legal and regulatory environment (Carvajal and Bebczuk 2019). A market should be able to provide the CCP with timely and Critical to the safe and efficient functioning of a CCP is that reliable price data. Access to daily valuation prices of products the legal and regulatory framework governs CCP activities. is a minimum to perform a mark-to-market valuation of partici- This is the foundation for relevant parties to define the rights pants’ portfolios, which is the starting point for appropriate risk and obligations under contractual agreements. The legal and management. A historical range of reliable end-of-day prices regulatory framework should cover, among other things, col- is needed to set initial margin rates and define stress-testing lateral arrangement for collateral posting, protection and le- scenarios, which are critical to establish sufficient buffers that gal enforceability of (local and international) netting arrange- protect the CCP against the potential failure of one or more ments, the potential default management procedures, and participants. The availability of intraday prices is highly pref- CCP loss allocation. If the legal basis for a CCP’s activities erable, as it provides for the possibility to adjust the margin and operations is inadequate, uncertain, or lacks clarity, then coverage during the day. the CCP, its participants, and its participants’ customers may face unintended, uncertain, or unmanageable credit, liquidity, Market participants should have the sophistication to perform or operational risks. active risk management toward the CCP. Participants should have the capacity, both in numbers and in knowledge, to con- Effective regulation and supervision of a CCP are critical to tribute to the safety of the CCP, and they should understand ensure that the CCP addresses public interests. It is important the balance between safety and costs of a CCP. They benefit that the relevant international standards, the PFMI, are ap- from a safe CCP that operates properly and does not have propriately reflected in the legal and regulatory framework.11 to call for capital to cover unexpected losses. These benefits Supervision should be strong, with a focus on the adequacy of should be balanced against the daily ongoing cost of transac- the CCP’s governance structure and financial buffers to man- tion fees and the opportunity costs of collateral. Participants age credit, liquidity, and operational risks. Operational resil- may actively engage with the CCP as board members, as par- iency of the CCP is of critical importance, as is an understand- ticipants in a CCP risk management committee, or otherwise ing of the CCP’s interdependencies and interconnections to through CCP working groups. If the risk governance of a CCP manage potential spillover risks to banks and other financial is not appropriate, the CCP could guarantee inappropriate institutions and markets. Supervisors should have appropri- products or could calculate margins that are too low compared ate powers, staffing, and supervisory and enforcement tools. with the risk exposures, implicitly exposing the overall market Where multiple authorities are involved, cooperation is es- or taxpayers (or both) to the residual exposure. sential to avoid gaps and inconsistencies in the regulatory and supervisory approach. Authorities should also have crisis Finally, assets to be cleared by the CCP should be sufficiently management arrangements in place to facilitate effective and standardized and fungible in order to be suitable for a CCP timely communication among authorities and market partici- guarantee. Only then can the CCP perform netting, thereby pants, which may help to avoid or reduce the size of financial offsetting positions in identical contracts and allowing for a losses during crisis events. reasonable amount of margin to be called. Also, the charac- teristics of the product should allow the CCP to define appro- The successful implementation of a CCP also requires the priate risk measures to cover the underlying exposures (for involvement of all relevant players (CSDs, stock exchanges, example, too-complex products are difficult to value, making banks, brokers, dealers, central banks, securities regulators, undercollateralization or overcollateralization more likely) (Pir- and others) in all phases of the development and decision- rong 2011). making process. 11 The legal and regulatory framework and supervision/oversight can be developed over time. It is recommended that at the time of the CBA, draft regulations and an imple- mentation plan are available to determine whether the preconditions are likely to be met. The final implementation of the regulations and supervision/oversight can take place during the last step (that is, the PFMI assessment before the introduction of the CCP). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 17 Market Cost-Benefit Analysis The second component of the CBA framework—the mar- ket transparency and a reduction in credit and liquidity risks, ket CBA—analyzes whether a CCP would contribute to the whereas a poorly operated CCP can be a source of systemic smooth-functioning of the market for which the CCP would be risk propagation (for example, through procyclicality of margin introduced. A well-functioning market is defined as a market or through the use of non-prefunded clearing member contri- that effectively meets the financial needs of its users, ensures butions in times of stress). investor confidence, and supports sustainable economic growth. To that purpose, the market CBA evaluates how the Fair treatment occurs where participants act with integrity, introduction of a CCP would impact the efficiency, safety, honesty, transparency, and nondiscrimination. A market econ- and fairness of the market, which are key objectives of secu- omy operates more effectively when participants enter into rities regulators (IOSCO 2017). transactions with the confidence that they will be treated fairly. In a fair financial system, clearing models have fair and open An efficient financial system allocates scarce financial and access criteria and provide incentives to market participants to other resources to the greatest possible benefit of market pursue safe operations, protect customer assets, adequately participants, supporting growth, productivity, and prosperity. manage their risks, and more generally reduce negative exter- Clearing models impact the use of capital through position and nalities related to clearing. exposure netting, as well as the allocation of default losses, and as such may increase or decrease market efficiency. The purpose of the market CBA is to assess whether the ef- ficiency, safety, and fairness of the market indeed improve A safe financial system should be able to adjust to changing through the introduction of a CCP. Comparing multiple clear- circumstances while continuing to provide its core economic ing models—for example, the CCP model and a bilateral functions, even during severe shocks. Institutions in distress clearing model with netting and margining—allows for assess- should be resolvable with minimal costs to investors, deposi- ing whether a CCP is the best model for a specific market, or tors, shareholders, taxpayers, and the real economy. Different whether other models create a better-functioning market. In clearing models have different consequences for the safety case there is a choice between an international CCP and a and soundness of a market. Bilateral clearing models without local one, the aforementioned criteria could also be applied. netting and collateral do not mitigate risks, whereas a bilateral Table 4.1 outlines the cost and benefits of a CCP compared model with netting and collateral can mitigate credit risks to with a bilateral clearing model. a high degree. A sound CCP can strongly contribute to mar- EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 18 > > > T A B L E 4 . 1 . - Market CBA for a CCP compared with a bilateral clearing model Impact on Benefits Cost Additional clearing fees and collateral costs CCP supports an anonymous market, which related to clearing (although netting may improves market liquidity. reduce collateral cost) Efficiency Market Reallocation of losses and capital through netting and the CCP guarantee, which improves market efficiency A CCP may attract foreign investors. Multilateral netting reduces the number Additional operational cost related to CCP Operational of settled transactions, which reduces systems, such as IT systems and cost of cost settlement cost. reconciliation with the CCP Multilateral netting reduces balance sheet Margin and default fund deposits create Capital costs exposures, lowering capital cost. opportunity costs Netting and one creditworthy counterparty (the CCP) reduces overall credit risk, Credit risk Subsidization of lower-rated CCP participants that covers exposures through a set of Safety sophistically calculated financial resources. Continuation of critical operations in case CCP may call for large amounts of (intraday) Liquidity risk of a default event supports market trust and margin during periods of increased market market liquidity. volatility. CCP is single point of failure. If CCP manages Systemic risk manager resolving defaulter’s risk insufficiently/ not in line with PFMI, it Systemic risk portfolios could be a propagator of systemic risk through failures and procyclical margin calls Generally, only high-rated and sophisticated Entry criteria to market participants can participate directly; Fairness Transparent entry criteria for CCP the CCP other market participants join indirectly through the direct participants. Source: Original table for this publication. Note: CCP = central counterparty; IT = information technology; PFMI = Principles for Financial Market Infrastructures. The market CBA requires that the impact of a CCP on the A market CBA consist of both qualitative and quantitative el- efficiency, safety, and fairness of the market is analyzed and ements. Table 4.1 gives an example of a quantitative analysis. compared with the impact of alternative clearing models. Ap- The quantitative analysis is useful to calculate the potential pendix B provides a practical guide for such an analysis. The collateral cost that would come with a specific clearing model. market CBA should be conducted for every type of product It involves assumptions on the netting factor, potential market (cash, bonds, derivatives, and so forth), since important fea- volatility, and liquidity (figure 4.2) using data such as transac- tures may differ per market, such as netting opportunities and tion flows, market prices, number of clearing members, trad- availability of prices. Also, the risk appetite of market partici- ing practices, and capital adequacy rules. The translation of pants may differ per market. quantitative input data to actual positions and netting ratios is not straightforward and depends on the trading practices and activity of members. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 19 > > > F I G U R E 4 . 2 . - Quantitative input factors for the market CBA Notional Trading and value of clearing member transactions population Trading Volumes practices CCP Benefits Pricing Capital and Cost data rules Source: Original figure for this publication. Note: CCP = central counterparty. In many developing markets, a quantitative assessment is dif- Conversely, the introduction of a CCP may positively contrib- ficult because the quantity and quality of market prices are ute to market liquidity and thus to the quality and quantity of insufficient to calculate the size of financial buffers that the market prices, creating a chicken-and-egg problem that needs CCP should keep. For example, trading platforms often do not to be addressed through a comprehensive market develop- function as central platforms where supply and demand meet ment program. As an example, the central bank and securi- but rather collect OTC prices throughout the day. The lack of ties market regulator in Ukraine have been actively developing market prices provides an insufficient basis for a CCP’s risk their post-trade strategy and policies for the capital market in management and can lead to additional losses in cases where Ukraine to address this problem through development of alter- the CCP needs to wind down a defaulter’s position. native clearing models and general market reforms (box 4.1). EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 20 > > > B OX 4 .1 : Ukraine: Example of an alternative clearing model Within the Ukrainian financial market, the settlement center (SC) provides clearing services for several securities exchanges, using a prefunding clearing model in which the SC becomes the counterparty to all trades. The model allows for novation and ensures continuous market access, even under stressed market conditions, which are crucial features for market participants in Ukraine. The Ukrainian post-trade infrastructure is a closed system, in which each investor has to sign a contract with a broker, who is a participant of the SC. Before the execution of the trade, the investor has to deposit the cash (if he or she is a buyer) to the account of his or her broker, who notifies the SC clearing system and exchanges. If the investor is the seller, the broker gives an instruction to the selling investor’s custodian to block the securities on the securities account in the central securities depository. Following the prefunding of the buyer’s and seller’s accounts, the trade is executed on one of the exchanges and the SC becomes the counterparty to the trade. On the same day, the SC sends the settlement instructions to the central securities depository for final settlement. Although this model is very safe, it comes with a high funding cost. Therefore, the relevant public and private stakeholders have investigated the possibilities of introducing a central counterparty (CCP) for the securities or derivatives market (or both) in Ukraine. A CBA has been performed to verify whether the benefits of a potential CCP would outweigh the costs and potential downsides. The main conclusion of the analysis is that a CCP is currently not a viable solution for the Ukrainian markets. Some of the preconditions for a CCP are not in place (for example, the legal framework needs further reforms). Also, market volumes do not support netting efficiencies to materialize, and they are too low to provide reliable prices for the CCP’s risk management function. However, there is a possibility of improving the current model, and alleviating some of its drawbacks, by introducing a limited-performance guarantee clearing model for a limited number of securities with higher liquidity. This model supplements the prefunding model that still exists for the less liquid securities. The limited-performance guarantee model would require a relatively low level of information technology and business investments, while reducing the funding requirements for market participants. A market-wide road map has been initiated to support these reforms. The road map is endorsed by the relevant regulatory authorities, the National Securities and Stock Market Commission, and the National Bank of Ukraine. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 21 Business Cost-Benefit Analysis The third component of the CBA framework is the business risks. The costs of running a CCP are generally fixed costs, CBA, which aims to analyze whether the CCP can generate whereas the revenues are variable and dependent on the sufficient revenues over time to cover its business-related clearing activity. A CCP cannot be a stable company without costs and ensure a positive return on capital. The business sufficient income to cover the relevant costs plus a profit mar- CBA reflects that the introduction of a CCP is also a new busi- gin for the shareholders of the CCP. ness initiative, which requires sustainable long-term revenues. A generally accepted method, in corporate finance literature, The discount rate that is used to determine the NPV of the in- to assess the business viability of an investment is the net vestment should reflect the opportunity costs and can vary de- present value (NPV), which evaluates whether expected fu- pending on the type of investor. A private investor in the CCP’s ture cash flows discounted at an appropriate rate are sufficient capital may use a weighted cost of capital or a required rate of to offset the relevant investments. The positive cash flows are return to satisfy equity and debt investors. For a public inves- the (additional) revenues generated by (new) products and tor, the best approach for a financial discount rate is to con- the outflows related to investments in information technol- sider the return lost from the best alternative investment. For ogy (IT) systems and other operational costs. Furthermore, example, within the European Union, a proxy discount rate of a new CCP requires capital to meet regulatory requirements, 4 percent (in real terms) is used for infrastructure investments although capital costs are relatively low. (European Commission 2014). This proxy should be adapted to the specifics of the relevant market.   A positive outcome of the business CBA indicates that there is a basis for the CCP to generate revenues. CCP revenues are A key success factor in introducing a viable CCP is to align the typically generated through several types of fees—for exam- parties that use the CCP’s services with those parties willing ple, membership fees and transaction fees. Also, fees may be to invest in the CCP as a company. An exchange or trading levied on deposited collateral, or a spread may be added on platform that invests in a CCP may generate additional trad- top of an interbank rate as remuneration for cash deposits. If ing revenues because the introduction of the CCP makes the a CCP requests more fees than there are benefits available to market safer and more efficient. Clearing members may invest clearing members, either the clearing members will not clear in the CCP and simultaneously profit from the efficiency gains. at the CCP or—in a case of mandatory clearing and/or insuf- A public investor in a CCP (for example, the government or ficient alternatives—the CCP will not contribute to an efficient central bank) could value some of the social benefits of a CCP market. In some cases, and if legally allowed, CCP income that are not reflected in the relevant cash flows, such as the may benefit from the bundling of services (for example, by CCP’s contribution to the development of the market, and also offering trade repository services). could include these externalities by requiring a lower rate of return. Table 4.2 illustrates the benefits of the CCP to different The business CBA should include a realistic estimation of types of stakeholders. potential revenues and related costs to ensure low business > > > T A B L E 4 . 2 . - Potential benefits of a CCP and main beneficiaries Impact on Potential benefits Who? • Lower bid/ask • Investors Market • Higher transaction volumes • Exchanges and brokers Efficiency • Easier to raise capital • Issuers Operational • Lower settlement costs • Banks and financial intermediaries Capital costs • Lower capital costs • Banks and financial intermediaries Credit risk • Credit enhancement • Lower-rated banks and financial intermediaries Legal and liquidity risk • Certainty of transactions • Investors, banks, and financial intermediaries Safety • Improved crisis management • Whole marketplace Systemic risk • < probability bailout • Government and regulators Market entry criteria • More fair access to markets • Investors Fairness Entry criteria • Membership criteria • Higher-rated banks and financial intermediaries Source: Original table for this publication. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 22 Finally, the establishment of a CCP for one product may cre- relatively small derivatives market. However, such an invest- ate opportunities to clear additional products within the same ment should not harm financial stability. There should be guar- entity, which could strengthen the CCP’s business case. As antees to cover the long-term business risks (for example, the illustrated in box 4.2, the potential to clear additional products CCP should comply with the PFMI).12 could be an incentive to make the investment in a CCP for a > > > BOX 4.2: Example of how the CBA framework supported frontier market development A developing country13 with a relatively developed banking sector, market infrastructure, and regulatory framework initiated a program to further develop its domestic capital markets in order to strengthen its role as a financial hub in the region. As part of the program, the ministry of finance, together with the stock exchange, Financial Market Infrastructures, and other market players set plans in motion, such as the establishment of a regulated derivatives exchange and a local central counterparty (CCP) to support anonymous derivatives trading. The local central bank used the cost-benefit analysis (CBA) framework presented in this note to review whether the introduction of the derivatives CCP was consistent with its mandate to preserve financial stability. The framework facilitated the discussions with relevant stakeholders on whether the preconditions for setting up the future CCP were met. In addition, the framework helped to identify areas of reform, assess the impact of a potential CCP on systemic risk and market efficiency, and determine the economic viability of the future CCP. The following areas for reform were identified: (1) the oversight activities in relation to the CCP project should be intensified, (2) gaps in the legal and regulatory framework need to be addressed, and (3) market developments would need to be initiated to improve the liquidity of underlying and over-the-counter derivatives markets. The conclusion of the exercise was that there are only limited economic and market benefits of a CCP for derivatives markets. However, it became also clear that several other markets would benefit from CCP clearing, and that a multiasset CCP (potentially covering cash-traded equities and bonds) might meet more prerequisites and conditions for safety, efficiency, and viability. A follow-up CBA is needed to determine what combination of asset classes should optimally be included in the scope of the future CCP. 12 There are interactions between the three elements of the CBA framework. First, if not all preconditions are in place or the CCP cannot become PFMI compliant, this will also negatively impact the safety of a CCP. In this case, it is likely that the market CBA for a CCP will be negative as well because of systemic and credit risk concerns. Also, the benefits recognized through the market CBA will be the input for the business CBA. However, if the CCP is a (quasi) monopolist and there is mandatory clearing, the CCP has the possibility of charging fees to ensure a positive NPV without market benefits. In this case, the fees of the CCP will negatively impact the market CBA through a negative assessment of the impact of a CCP on market efficiency. 13 The country requested to be included in this paper on an anonymous basis. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 23 Final Implementation and PFMI Compliance In principle, the benefits of a CCP outweigh the cost (1) if there the CCP operates in such a manner that operational and in- is a positive business CBA, (2) if there is a positive market vestment loses are minimized and that potential losses are CBA, and (3) when preconditions are met. However, to en- adequately covered by capital or other resources. sure that the CCP is a sustainable solution and delivers on its promises, a final element of the CBA framework entails com- Typically, the operator of a CCP performs a PFMI self-assess- pliance with the PFMI. Also, investors may use compliance ment and assesses its design against the relevant principles with the PFMI as a condition before investing in a CCP. for CCPs. The assessment may identify weaknesses or risks in the legal framework, governance, risk management frame- Compliance with the PFMI ensures that the governance, work, or operational procedures and result in measures taken rules, procedures, and practices are in line with international to mitigate these risks. The self-assessment then serves as a standards. This provides investors, including foreign inves- basis for a PFMI assessment by the supervisory and oversight tors, with comfort that risks are properly identified, mitigated, authorities of the CCP based on the most up-to-date informa- and managed. It requires the CCP and its supervisors to ad- tion.14 It also helps ensure that the CCP complies with local dress questions related to, among other things, (1) credit risk regulations. and how margin and other financial resources are calculated and collected; (2) liquidity risk—that is, whether the CCP gen- CCP supervisors and overseers may condition the introduc- erates sufficient liquidity to manage the largest operational tion of a CCP on a positive CBA in combination with a PFMI and default liquidity exposures; (3) default management; (4) assessment that concludes that the CCP is generally in com- recovery measures and how the CCP manages in the event pliance with the principles. Box 4.2 presents an example of a that its regular resources are insufficient; (5) governance and combined CBA and PFMI assessment in which the financial whether proper checks and balances are in place to control stability risks relating to a planned CCP in a frontier country the risk exposures of the CCP toward the clearing members were assessed. Once a CCP is launched, the actual function- and other stakeholders; and (6) operational risk to ensure that ing of the CCP can be assessed using the PFMI. 14 This information may include implemented risk measures, regulations, and any market developments resulting from the CBA. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 24 5. >>> Conclusion The CBA framework proposed in this paper can assist authorities in defining their posttrade strategy and policies, in particular with regard to the introduction of a CCP. A CCP is often seen as a panacea to solve specific market issues and attract foreign investors. However, a CCP may not be the appropriate solution for each market, particularly if the market is insufficiently liquid or has a low level of sophistication. The CBA framework provides a comprehensive approach to answer the following questions: • • • Are preconditions met for the introduction of a CCP? (For example, is the market sufficiently liquid to allow for reliable margin calculations, and are market activities governed by a sound legal and regulatory framework?) Will a CCP improve the smooth functioning of the market compared with the current clearing model? Does a CCP contribute to the safety, efficiency, and fairness of the market it ser- vices, or are alternative clearing models a better clearing solution for the market? Is there a positive business case for the CCP to ensure that it is a viable company in the medium to long term? Application of the framework results in answers to these questions. Positive answers to all three questions means a green light for the introduction of a CCP for a specific market. A negative answer to one of more questions indicates that a market is not (yet) sufficiently mature to support a safe and efficient CCP. In the latter case, the CBA provides clues to further develop the market to a level where the overall benefits of a CCP outweigh the costs and potential downsides. Generally, a first step is to prepare a market development road map to ensure that the preconditions of the CBA framework are in place. Those preconditions—for example, a sound legal and regulatory framework—will contribute to a sound CCP that contributes to a well-functioning market, which in turn positively contributes to a solid business case. The framework can also be used in cases in which a CCP has already been established. In that context, the framework is a tool to assess the CCP’s setup, including its risk framework. It is a tool to check whether the preconditions for a CCP are in place. (If they are not, plans should be made to address any deficiencies.) EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 25 The development of a CCP is often a classic chicken-and-egg ties share information under a memorandum of understanding problem, where improvements in market liquidity are required (Kiff et al, forthcoming). before a CCP can be pursued, whereas an improvement in market liquidity would follow the introduction of a CCP. This So far, the IMF and World Bank have used the CBA framework dilemma can be addressed by developing financial markets in their technical assistance to developing markets. The frame- gradually and, in each stage, implementing a clearing model work can also be applied to developed markets. A developed that fits the level of development of the market. For each new market probably meets many or all of the preconditions as clearing model, with ultimately the implementation of a CCP, required in the CBA framework. However, for the implementa- an analysis should confirm that the impact of the new clear- tion of a central clearing mandate (for example, for standard- ing model on the safety, efficiency and fairness of markets ized OTC derivatives), the liquidity of the cleared products is is positive compared with the current status. Another option relevant, as is product suitability, which refers to fungibility and is to allow domestic financial institutions to use an interna- the CCP’s capacity to calculate appropriate margins to ensure tional CCP under certain conditions—for example, that this financial stability. CCP complies with international standards and that authori- EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 26 >>> References Bliss, Robert, and Robert Steigerwald. 2006. “Derivatives Clearing and Settlement: A Compari- son of Central Counterparties and Alternative Structures.” Economic Perspectives 30 (4): 22–29. Carvajal, Ana Fiorella, and Ricardo Bebczuk. 2019. Capital Markets Development: Causes, Ef- fects, and Sequencing, A Literature Review. Washington, DC: World Bank. Cox, Robert, and Robert Steigerwald. 2018. “A CCP Is a CCP Is a CCP.” Journal of Financial Market Infrastructures 6 (4), 1–18. CPSS-IOSCO. 2012. Principles for Financial Market Infrastructures. https://www.bis.org/cpmi/ publ/d101a.pdf CPSS-IOSCO (Committee on Payment and Settlement Systems). 2001. Recommendations for Securities Settlement Systems. Basel: Bank for International Settlements. CPSS-IOSCO (Committee on Payment and Settlement Systems). 2004. Recommendations for Central Counterparties. Basel: Bank for International Settlements. Domanski, Dietrich, Leonardo Gambac, and Cristina Picillo. 2015. “Central Clearing: Trends and Current Issues.” BIS Quarterly Review, December 2015: 59–76 Duffie, Darryl, and Haoxiang Zhu. 2011. “Does a Central Clearing Counterparty Reduce Coun- terparty Risk?” Review of Asset Pricing Studies 1 (1): 74–95. European Commission. 2014. Guide to Cost-Benefit Analysis of Investment Projects: Economic Appraisal Tool for Cohesion Policy 2014–2020. Brussels: European Commission. Hills, Bob, David Rule, Sarah Parkinson, and Chris Young. 1999. “Central Counterparty Clearing Houses and Financial Stability.” Financial Stability Review, June 1999: 122–34. IOSCO (International Organization of Securities Commissions). 2017. “Objectives and Princi- ples of Securities Regulation.” https://www.iosco.org/library/pubdocs/pdf/IOSCOPD561.pdf. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 27 Kiff, John, Alessandro Gullo, Cory Hillier, Panagiotis Papapaschalis, and Froukelien Wendt. Forthcoming. “Applying the Central Clearing Mandate in Advanced and Emerging Markets.” IMF Working Paper, International Monetary Fund, Washington, DC. Pirrong, Craig. 2011. “The Economics of Central Clearing: Theory and Practice.” ISDA Discus- sion Paper Series, Number One. https://www.isda.org/a/yiEDE/isdadiscussion-ccp-pirrong.pdf. Ripatti, Kirsi. 2004. “Central Counterparty Clearing: Constructing a Framework for Evaluation of Risks and Benefits.” Bank of Finland Research Discussion Paper 30/2004, Bank of Finland, Helsinki. Wendt, Froukelien. 2015. “Central Counterparties: Addressing Their Too Important to Fail Na- ture.” IMF Working Paper 15/21, International Monetary Fund, Washington, DC. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 28 A. >>> Appendix A. World Bank data on CCPs around the world On a biennial basis, the World Bank Global Payment Systems Survey collects information on financial market infrastructures (FMI), including CCPs, and provides detailed insights on the main characteristics of CCPs across many countries but does not capture and reflect the level of compliance with the PFMI. In 2018, 41 countries15 reported having at least one CCP in operation. Answers were received by 55 to 60 CCPs as identified by the local respondents (depending on the question), some of those CCPs serving markets in several jurisdictions. The CCPs operating in more than one jurisdiction were mainly found in high-income OECD economies. The majority of CCPs clear exchange-traded derivatives, using novation, and provide multilat- eral netting facilities (figure 3.1). Regarding types of assets cleared, 68 percent of CCPs clear exchange-traded derivatives whereas 41 percent clear OTC-traded derivatives, the latter being significantly more common in high-income economies than in upper-middle-income and lower- middle-income economies. The majority of CCPs also clear cash products such as corporate equities (61 percent) and corporate bonds (54 percent). It is worth noting that the various asset classes are not mutually exclusive, which in practice means that the same CCP can clear both types of derivatives, and/or certain derivatives and cash products, and/or several types of cash products. The process of novation is followed by 88 percent of CCPs, whereas open offer is followed by 27 percent of CCPs. Novation is adopted across all regions and all income levels of economies. Netting benefit is one of the outcomes of participating in a CCP arrangement. Accordingly, 89 percent of the CCPs globally provide multilateral netting facilities. Five CCPs in high-income OECD economies and one in the South Asia region guarantee the settlement of other FMIs. In terms of ownership and governance, it appears that the majority of CCPs are owned by the private sector and that PFMI recommendations regarding governance are, to a large extent, im- plemented (figure A1.1). Globally, 75 percent of the CCPs are fully owned by the private sector, this being more evident in high-income OECD economies (92 percent) and in the Latin America and the Caribbean (LAC) region (82 percent). In comparison, only 10 percent of CCPs globally are fully owned by the public sector. The remainder are jointly owned by the private and public sectors. Almost all CCPs (53 out of 54, or 98 percent) indicated that they have documented gov- ernance arrangements, with 91 percent indicating that these governance arrangements include 15 No low-income country provided answers to this part of the GPSS questionnaire, whereas almost 60 percent of all reporting CCPs were in high-income economies. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 29 policies on the responsibilities and functioning of the board the CCPs’ business units. Eighty-nine percent of the CCPs and its committees. Further, 91 percent of the reporting CCPs have established a mechanism for involving stakeholders in have one or more independent board members. The regional the decision-making process. The PFMI Disclosure Frame- analysis indicates that, with the exception of 4 CCPs in the work has been completed and published by 87 percent of the LAC region, the CCPs in all other regions have a risk manage- CCPs, with most exceptions being in CCPs in the LAC region. ment function and an audit function that are independent from > > > F I G U R E A . 1 . - CCP governance and ownership Has documented governance arrangements 53 The roles and responsibilities of management are clearly 53 specified The board (or equivalent) has established a documented risk 52 management framework Has a risk management function and an audit function that 50 are independent from the organization’s business units Governance arrangements include policies on board’s (or equivalent) and board committees’ responsibilities and 49 functioning The board (or equivalent) includes one or more independent 49 board members Has established a mechanism for involving stakeholders in 48 decision-making Has completed and published the disclosure framework 47 Is fully owned by the private sector (that is, banks, privately 39 owned stock exchanges, and other private entities) The private sector has a majority stake in the CCP 36 The public sector has a majority stake (that is, the central 8 bank, ministry of finance, or other public entities) Is fully owned by the public sector 5 0 5 10 15 20 25 30 35 40 45 50 Central counterparties Source: World Bank Global Payment Systems Survey. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 30 The membership of CCPs is formed mainly by commercial observed across all regions with slight variations, ranging from banks, broker-dealers, and other financial institutions. Glob- 90 percent in high-income OECD countries (28 of 31 CCPs) to ally, 80 percent of CCPs provide membership to commercial 73 percent of CCPs in LAC (8 of 11 CCPs). Regarding cash, banks, 83 percent to brokers-dealers, and 72 percent to other 72 percent of CCPs hold their own funds and those pledged financial institutions. The membership type could vary depend- as collateral by their participants with commercial banks, and ing on whether the member can: (1) enter transactions directly only 28 percent do so with the central bank. Regarding settle- with the CCP (type “a”); (2) act as a direct settlement mem- ment of final positions, 64 percent of CCPs settle their cash ber, settling transactions on its own account (type “b”); (3) act positions in central bank money, a percentage that rises to as a direct settlement member and settle transactions on its 78 percent in high-income economies and only 33 percent own account and also on behalf of other participants (type “c”); in lower-middle-income economies, mainly those in the East and (4) settle transactions indirectly through another member Asia and Pacific (EAP), Europe and Central Asia (ECA), and (type “d”). In this regard, about 50 percent of the commercial SA regions. banks and broker-dealers globally have type “c” membership. Another 16 percent of commercial banks and 11 percent of Forty-five of the 61 reporting CCPs do not have any link with broker-dealers have type “b” membership. In the case of other other CCPs. The phenomenon of links between CCPs is pre- financial institutions, 38 percent can enter transactions directly dominantly observed in CCPs in high-income OECD econo- with the CCP (that is, type “a” membership), but only 32 per- mies, as out of the 16 CCPs that do have links with other cent have type “c” membership. CCPs globally, 15 are located in those countries. Further, only 3 CCPs reported having links with other domestic CCPs, and A key measure of liquidity risk management is capacity to all of them are in high-income OECD economies. All but one of maintain sufficient liquid resources to be able to withstand the the CCPs that have links with foreign CCPs are also located in default of the participant and its affiliates that would generate high-income OECD economies. the largest aggregate payment obligation. This is observed in 42 reporting CCPs (out of 51 that answered this specific item, CCP operators and regulators across all country income cat- or 82 percent). The stress testing of resources in case of de- egories and regions demonstrate a very high commitment in fault is performed by the vast majority. Further, the existence implementing robust business continuity and operational re- of a guarantee fund made up with participant contributions silience measures (figure A1.2). Almost all CCPs (96 percent) was reported by 46 (85 percent). Only 29 percent of CCPs already have formally documented their business continuity in lower-middle-income economies have this guarantee fund, arrangements, including procedures for crisis management compared with 96 percent (25 out of 26) in high-income OECD and information dissemination. Further, business continuity economies. Rules and procedures that support segregation arrangements are regularly tested by almost 90 percent of and portability of collateral were reported by 42 CCPs. CCPs, the main exceptions being 4 CCPs in the LAC region Another facet of CCP risk management involves safe custo- and one each in the EAP and SA regions. Testing involves dy of the CCP’s own assets and collaterals pledged by par- settlement banks, liquidity providers, CSDs and in almost all ticipants, and whether settlement occurs in commercial bank cases CCPs (that is, in 45 out of 47 CCPs that perform these money or central bank money. In the case of securities, glob- tests regularly). A fully equipped processing site exists in 90 ally, 51 CCPs (representing 84 percent of the sample size) percent of CCPs, and tapes and other storage media are kept hold their own securities and those pledged as collateral by in sites other than the main processing site in 96 percent of their participants at a supervised and regulated CSD. This is the CCPs. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 31 > > > F I G U R E A . 2 . - Business continuity arrangements for CCPs Latin America Middle East & Lower middle Sub-Saharan Upper middle High-income North Africa Central Asia & Caribbean High Income Low income East Asia & South Asia Europe & income income Pacific Global Africa OECD The CCP has documented a formal 96% 100% 94% 83% 100% 91% 100% 100% 86% 100% business continuity plan - - 51/53 31/31 15/16 5/6 3/3 10/11 1/1 26/26 6/7 5/5 Business continuity arrangements 96% 100% 94% 83% 100% 91% 100% 100% 86% 100% include procedures for crisis manage- - - 51/53 31/31 15/16 5/6 3/3 10/11 1/1 26/26 6/7 5/5 ment and information dissemination Tapes and other storage media are 96% 100% 94% 83% 100% 91% 100% 100% 100% 80% kept in sites other than the main - - 50/52 30/30 15/16 5/6 3/3 10/11 1/1 25/25 7/7 4/5 processing site A fully equipped alternate processing 90% 93% 94% 67% 100% 73% 100% 100% 86% 80% site exists - - 47/52 28/30 15/16 4/6 3/3 8/11 1/1 25/25 6/7 4/5 Business continuity arrangements 89% 90% 94% 67% 100% 64% 100% 100% 86% 80% are regularly tested at the level of the - - 47/53 28/31 15/16 4/6 3/3 7/11 1/1 26/26 6/7 4/5 CCP Backup servers have been deployed 88% 90% 88% 83% 100% 82% 100% 92% 71% 100% at the main processing site - - 46/52 27/30 14/16 5/6 3/3 9/11 1/1 23/25 5/7 5/5 Business continuity arrangements test- 85% 84% 88% 83% 100% 64% 0% 92% 86% 100% ing includes involvement of settlement - - 45/53 26/31 14/16 5/6 3/3 7/11 0/1 24/26 6/7 5/5 banks, liquidity providers, and CSDs 0% 20% 40% 60% 80% 100% Each box shows the percentage of answers for the FMIs among the jurisdictions in a group. A jurisdiction may have reported multiple FMIs. The number of responding jurisdictions and reported FMIs may differ across options. A jurisdiction may have chosen multiple options for each reported FMI. Source: World Bank Global Payment Systems Survey. Note: CCP = central counterparty; CSDs = central securities depositories; FMIs = financial market infrastructures; OECD = Organisation for Economic Co-opera- tion and Development. Finally, it should be noted that for CCPs, the central bank is the primary overseer in slightly less than half of the economies (48 percent), and another financial sector authority is the primary regulator and supervisor for almost two-thirds of CCPs globally. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 32 B. > > > Bilateral >>> Appendix B. Practical guide for conducting a CCP cost-benefit analysis The following questions are intended to be a useful tool to conduct a CCP cost-benefit analysis in practice. Current clearing model(S) Identify the current clearing model(s) 1.1. What is, for every financial market (for example, derivatives 1.2. What are the benefits and drawbacks of these clearing models? F I G U R E B . 1 . - Example of identifying current clearing models for markets in Country A Central and securities markets), the current clearing model, using the categorization of figure 2.1 in section 2? clearing Bilateral multilateral Limited- Central without netting and netting Prefunding performance counterparty netting and margining without guarantee margining guarantee Country A OTC derivatives market Country A Securities market Source: Original figure for this publication. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 33 Availability of preconditions for a CCP 2.1. Does the legal framework recognize the activity of clearing and does it require a CCP operator to obtain a license or other type of authorization? 2.2. Does the legal framework provide a high degree of legal certainty for each material aspect of the CCP’s Sound activities (in particular novation, open offer, netting, settlement finality, rights and interests in financial legal and instruments, collateral, segregation, and default procedures)? regulatory 2.3. Does the legal framework support enforceability of rights and obligations resulting from cleared framework contracts, or more generally, the enforceability of (potential) CCP’s rules? 2.4. Are other regulations aligned with regulations for CCPs—for example, (1) bankruptcy law, (2) market and investors’ regulations, (3) bank regulatory capital, (4) banking recovery and resolution, and (5) accounting and tax? 2.5 Does the legal framework provide the central bank and/or market regulator with powers to oversee and/ or supervise the CCP? 2.6 Do authorities have sufficient resources, including sufficient qualified staff members? 2.7 Do authorities have sufficient powers to induce change where needed? Effective 2.8 Are regulations sufficiently transparent and do they ensure a level playing field? supervision 2.9 Do regulations reflect the PFMI requirements? 2.10 Do authorities, where needed, cooperate and coordinate and is this reflected in a memorandum of understanding? 2.11 Did authorities conduct a self-assessment against the five responsibilities of the PFMI? 2.12 Is an overall post-trade strategy in place to further develop the financial markets with a road map outlining next steps? Coordination 2.13 Do all relevant authorities and market participants take part in the development of the post-trade and strategy and execution of the road map? cooperation 2.14 Does the governance structure support the consideration of the interests and input of all relevant stakeholders? 2.15 Are timely prices available to calculate margin requirements? Does trading take place on a continuous basis or does it work with opening/closing rotations? Are market makers active? Is the market characterized by frequent trading activity? Are historical prices available? Pricing 2.16 Are reliable prices available to calculate margin requirements? Are the prices executable? Are these actual or theoretical prices? Are price sources reliable? 2.17 Are market regulations in place that govern price setting? Are market regulations in place requiring pre- trade and post-trade transparency of prices? 2.18 Do market participants (trading members, clearing members) have sufficient CCP and risk management expertise to manage counterparty credit risk exposures? Market 2.19 Do governance arrangements exist in the (potential) CCP to manage all relevant types of risks sophistication (for example, a risk committee or risk working groups to oversee the development of the CCP risk management framework)? 2.20 Are instruments, that are potentially subject to CCP clearing, standardized to allow for multilateral Product netting? suitability 2.21 Do the characteristics of instruments allow for appropriate risk management? EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 34 Market CBA EFFICIENCY 3.1 Would a CCP, compared with an alternative clearing model, allow for more efficient trading on the (regulated) market by allowing anonymous trading? Market 3.2 Would a CCP (or alternative model) attract additional market participants (for example, foreign inves- efficiency tors), which may positively contribute to market efficiency? 3.3 Would a CCP (or alternative model) result in additional cost for market participants? 3.4 Would a CCP (or alternative model) result in relevant netting benefits? 3.5 Would a CCP, compared with an alternative clearing model, allow for other operational benefits (for Operational example straight-through processing) compared to the current clearing model? efficiency 3.6 Would a CCP, compared with an alternative clearing model, result in additional operational costs (for example, investments in a new platform and new connections and ongoing operational cost), compared with the current clearing model? 3.1 Would a CCP, compared with an alternative clearing model, result in lower capital requirements for intermediaries than the current clearing model? Capital 3.2 Would a CCP qualify as a QCCP (Qualifying CCP) under Basel regulations? Would this result in re- efficiency duced capital requirements? 3.3 Would a CCP, compared with an alternative clearing model, result in an increase or decrease of funding needs for clearing members compared with the current clearing model? SAFETY 3.10 Would a CCP, compared with an alternative clearing model, reduce the net credit exposure of market participants under normal and stress market conditions compared with the current clearing model (con- sidering the application of netting)? Credit risk 3.11 Would a CCP, compared with an alternative clearing model, change the risk distribution amongst mar- ket participants compared with the current model? 3.12 Would a CCP, compared with an alternative clearing model, reduce the credit profile of counterparties for trading participants? 3.13 Would a CCP, compared with an alternative clearing model, change funding liquidity pressures (under stress situations) for market participants compared with the current clearing model? Liquidity risk 3.14 Would a CCP, compared with an alternative clearing model, change funding liquidity pressures (under stress situations) for the infrastructure operator compared with the current clearing model? 3.15 Would a CCP, compared with an alternative clearing model, change the legal risk faced by market partici- Legal risk pants and operators (resulting from legal deficiencies) compared with the current clearing model? 3.16 Would the risk of a single point of failure increase by introducing a CCP, compared with an alternative clearing model, compared with the current clearing model? 3.17 Would a CCP, compared with an alternative clearing model, change the concentration of risks within Systemic risk only a few participants? 3.18 Would a CCP, compared with an alternative clearing model, reduce or increase contagion risks, follow- ing the default of a market participant? Operational 3.19 Would a CCP, compared with an alternative clearing model, change operational risks (cyberattack, risk fraud, operational outage) in the market? FAIRNESS 3.20 Would a CCP, compared with an alternative clearing model, treat market participants fairly and distin- guish only on the basis of the risks they bring to the system? Market 3.21 Would a CCP, compared with an alternative clearing model, provide incentives16 to market participants to pursue safe operations, protect customer assets, adequately manage their risks, and more generally reduce negative externalities related to clearing? 16 Incentives for peer risk management are mutualized loss-sharing or member exposures through appropriate margining. EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 35 Business CBA 4.1 Would the CCP collect revenues from the guarantee process (for example, per cleared transaction)? 4.2 Would the CCP collect revenues from collateral and investment services (for example, spread between remuneration returned to member and obtained by CCP in the market)? 4.3 What additional trading revenues can be collected due to establishment of a CCP (if exchange is Revenues investor in CCP)? 4.4 Are there potential synergies from operating a CCP for multiple markets under the same legal and operational structure? 4.5 Are there any other quantitative and qualitative (public) benefits resulting from a CCP (in case of a public investor)? 4.6 What are the IT costs for operating the clearing systems? Costs 4.7 What are staff costs (for example, management, operational staff, risk experts, lawyers)? Discount rate 4.8 What is an appropriate discount rate given the type of investors and the specific country risks? 4.1 What is the result of calculating the net present value of future income? 4.2 How does this result relate to quantitative and qualitative (public) benefits? Evaluation 4.3 In conducting a sensitivity analysis, what are the potential downsides (business risk) in case some of the assumptions in the business case change? 4.12 What kind of parties have an interest in the CCP? What is their interest? Investment 4.13 Which of these parties are interested in investing in the CCP? What kind of structure can be created so that there is sufficient investment and all interests in the CCP are adequately addressed? PFMI Compliance 5.1 Has the design of a potential CCP been subject to a PFMI assessment? 5.2 What gaps and issues of concern have been identified, what is the risk assessment, and in what time frame can these be addressed? PFMI 5.3 Has an assessment report been prepared with (1) a clear identification of the issues of concern that assessment need to be addressed, if any, and (2) an indication of an appropriate time frame for addressing each identified issue of concern? 5.4 Are relevant stakeholders committed to pursuing compliance of the (potential) CCP with the PFMI before implementation of the CCP? EQUITABLE GROWTH, FINANCE & INSTITUTIONS INSIGHT <<< 36