The Future of Clearing

Reflecting on the future of clearing today is a challenging task and while it is impossible to cover such a broad enterprise in a single article, let me try to map out some key areas and trends where the CCP Supervisory Committee (CCP SC) is expected to focus in the coming years.

After a longer period of relative stability for markets, we are again witnessing frequent and more extreme events, with deeper shifts in macroeconomic fundamentals.

Over the last two years, which corresponds to the time of existence of the CCP SC, the Covid-19 pandemic and Russia’s invasion of Ukraine have led to significant price corrections and volatility in financial markets. The first event impacted equity markets, before affecting other areas, and the second has hurt energy and commodity markets, especially metals (at least for the time being).

We have entered a time of increased risks and heightened volatility that poses challenges for market participants and regulators. This will be a period where effective and efficient risk management and the containment functions of CCPs will become even more relevant.

It is natural that our perspective as CCP supervisors remains risk driven. I will try to outline some of the key trends we see as part of the future of clearing, which could materialise as risks – if inappropriately managed.

Operational Risk

When thinking about the future, one of the first images that comes to mind is the increasing use of technology. This is led by technical innovations that play an ever-increasing role in the financial domain, and of course CCPs, creating new service offerings and also new dependencies.

Related to this, and a preoccupation for CCP supervisors in recent years, is the risk linked to increased cyber-threats, which may be linked to (over)dependence on a limited number of critical service providers.

Cyber-attacks (e.g. denial-of-service attack, ransomware) against infrastructure and service providers pose an increasingly grave threat to the financial system. The materialisation of cyber risk might produce ripple effects for the financial system at large, in particular when targeting entities with nodal functions, such as CCPs.

The good news is that we are seeing an increasing array of industry and regulatory responses, not least with the recent trilogue agreement on EU legislation for digital operational resilience for financial entities, or DORA, which should help introduce the wider financial sector to standards already used by CCPs.

At ESMA, we are currently finalising the analysis of the results of the fourth EU wide stress-testing exercise, which for the first-time included operational risk elements, focusing in particular on the increasing reliance of CCPs on shared third-party providers.

ESMA’s 2021 Peer Review – which should be published soon – concentrates on national competent authority assessments of CCPs’ business continuity under remote working arrangements, as indeed the entire way we work has changed since the pandemic.

These efforts contribute to a common supervisory culture on how we understand and manage these risks.

Innovation and Technological Changes

Financial innovation is always evolving and brings with it regulatory challenges, as it can impact the type and nature of products that CCPs clear and the underlying technology that CCPs may use.

New types of assets and services, decentralised, disintermediated, or integrated, are constantly being created and developed, based on new technology such as DLT, blockchain, AI, quantum computing, and so on.

These assets can take different forms, ranging from cryptocurrencies to digital assets in the broadest sense of the word. These new assets can be directly or indirectly referenced in products, especially derivatives, that are submitted to CCPs for central clearing.

This creates challenges for CCPs and supervisors, as these assets might have risk profiles that are difficult to square with existing risk models.

New technologies also have the potential to alter and optimise existing operational and risk management processes at CCPs with, for example, smart contracts that could possibly change the way collateral and netting are managed.

However, big questions remain as to the suitability or desirability of certain technological changes and potential secondary effects, which may be more difficult to anticipate.

For example, a push for immediate settlement or automatic liquidation might reduce counterparty risk, but at the same time may have negative impacts on liquidity, on the price formation mechanism and on the ability of financial markets to absorb supply or demand shocks.

CCP Evolution

Unlike in previous rounds of innovation, new technical propositions have the potential to affect the whole value chain for financial instruments, changing how clearing services may be provided in the future – either potentially by integrating with the trading and the settlement layer, or by segregating risk management and loss absorption services away from trading and settlement.

There are clearing services emerging that no longer build on the central role of sophisticated clearing members and some even do away with the central counterparty function completely, challenging the Pittsburgh consensus and reintroducing more traditional clearing house or facilitator structures.

These developments pose significant issues for the regulatory perimeter, as we are now seeing crypto platforms employing clearing-house (non-CCP) or insurance-style models that not only explore the boundaries of existing clearing regulation, but also raise old questions around the role of CCPs.

Further, if CCP membership continues evolving, what kind of control mechanisms would then be appropriate? How will we ensure the right alignment of incentives to ensure proper risk management? How can we better manage conflicts of interests? We will have to answer these questions eventually.

Climate Risks

The other image that comes to mind when thinking about the future is perhaps dimmer, as it relates the build-up of environmental and climate risks. There is unfortunately no reason to believe that CCPs would be exempt from these developments.

At ESMA, the CCP SC has also done some truly innovative work to better understand how climate risks could impact CCPs.

The most obvious one is physical risk for the CCP, which can be both acute or longer term and damage the operations of the CCP, its counterparties, its service providers, as well as markets – such as floods or fire hazards.

Climate change could also impact the way CCPs function, as, for example, climate change transition could affect collateral posted by the clearing members in terms of availability, suitability and legal requirements.

This transition could be abrupt – due to a rapid correction of risk perception by investors or a regulatory ban – or long term due to deeper business model changes or investor preferences – and could challenge the CCP’s risk management.

Climate change could also make life harder for CCPs to appropriately calibrate their risk models and to identify possible future stress scenarios, when most models have a backward-looking approach for risk calibration based on historical data.

As you will know, we recently issued a call for evidence to see which type of climate risks may be included as part of our stress tests to ensure that CCPs remain resilient to these forward-looking trends. We are still analysing the feedback we have received and are discussing different options.

Global Markets and Local Supervision

It would be impossible for me to discuss the future of clearing without mentioning the potential mismatch between global clearing activities and a supervisory approach that remains essentially local.

On the one hand, we have global FMIs providing efficiencies due to economies of scale and netting opportunities, with a depth of liquidity products and services, and a reliance on global membership that also supports the CCP in case of default management.

This is particularly salient for derivatives, where the global character of derivatives markets facilitates efficient cross-border risk sharing and redistribution – with notable differences depending on the segment (e.g. equity, repo clearing vs. IR, FX, CDS, certain commodities).

On the other hand, we have a traditionally decentralised regulatory and supervisory approach towards CCPs, with a split between a primary role for the home regulators and supervisors of the CCP, and potentially an underrepresentation of the concerns of host country supervisors and central banks , e.g. when it comes to losses and liquidity strains on host country clearing members and clients through CCP risk mutualisation.

A number of initiatives have been developed to fill this gap both on the regulatory front – with international minimum standards with the PFMI – as well as on the supervisory front, with the creation of global supervisory colleges, which support the exchange of information on a BAU basis and crisis management groups (CMGs) to enhance preparedness for the management and resolution of a cross-border financial crisis.

However, certain CCPs are of systemic importance for one or more host countries and may require additional supervisory scrutiny by host authorities to be able to request information, conduct annual reviews and stress tests, and validate significant changes to risk models – to appropriately manage these cross-border risks. In this sense, the Tier 2 status was developed under EMIR 2.2 and the cooperation we have with the Bank of England helps assuage certain concerns.

However, there are still cases where the risks may be so substantial that existing – even enhanced – supervisory arrangements remain insufficient to address and mitigate spill-over risks.

As part of our comprehensive assessment of Tier 2 CCPs, we identified three clearing services as being of such substantial systemic importance for the European Union or one or more Member States, namely LCH Ltd. SwapClear for the euro and Polish zloty, and ICE Clear Europe CDS and STIR services for euro products. The assessment highlighted the dependence of the EU financial system in case of disruption to these services, with potentially material cross-border impacts on financial stability and the conduct of monetary policy.

While ESMA did not recommend derecognising these services at this point in time as the costs would outweigh the benefits, ESMA outlined areas for further work to better address the risks, both by identifying incentives to reduce exposures to the UK and enhancing ESMA’s supervisory toolkit in respect of Tier 2 CCPs.

Reviewing the EU Clearing Framework

These conclusions have fed into the targeted consultation by the European Commission on the review of the central clearing framework in the EU – which asked for feedback both on how to reduce excessive exposures towards UK CCPs and how to build alternative clearing capacities in the Union.

ESMA has welcomed the breadth of the measures considered by the European Commission. It takes into account the multi-layered nature of the clearing ecosystem and looks at measures impacting clearing members, clients and beyond EMIR.

As part of our high-level response to the European Commission, ESMA identified a number of measures that we find more promising, noting that no single measure seems sufficient on its own.

In terms of measures to help build liquidity in the EU, ESMA has put forward, among other considerations regarding the scope and implementation of the clearing obligation, thoughts on leveraging the recent workstreams and analyses, such as the recommendation for pension scheme arrangements (PSAs) to clear as from June 2023, and also for new avenues to be explored, such as supporting the coordination of voluntary central clearing by public entities at EU CCPs.

In our high-level response, we have also tried to identify possible incentives for EU clearing participants to reduce their exposures to certain clearing services deemed to be of substantial systemic importance by ESMA.

Further work is necessary to consider whether prudential treatments of clearing member exposures, exposure reduction targets and the active clearing account requirements – or a combination thereof – could help further build liquidity at EU CCPs.

This would require a thorough assessment of the risks and benefits of each option or combination to ensure that the costs of these options are not disproportionate to the expected benefits to the financial stability of the Union.

This analysis should also consider how certain measures compare with similar requirements over non-systemic CCPs, so as to avoid creating an unlevel playing field for EU participants or a shift of activities to other third-country CCPs, where the EU has limited oversight.

In addition, ESMA engages in a continuous dialogue with EU central banks and market participants to better understand how settlement arrangements and the liquidity management of CCP financial resources affect the attractiveness of EU CCPs.

We look forward to working with the European Commission and co-legislators to identify the mix of policy responses that can best support a reduction of excessive dependence on UK CCPs in order to strengthen our capacity to withstand crises – given that CCPs are core to safeguarding financial stability.