Through centralized clearing, market participants mitigate so-called counterparty credit risk.
Clearing is “built over time through trust, and it becomes especially important if there’s a failure or breakdown in the market,” said Sunil Cutinho, President of CME Clearing. “Clearing cannot prevent a crisis, but it does provide vital resiliency for the marketplace.”
A Buyer for Every Seller, a Seller for Every Buyer
Clearing, for financial and commodity markets purposes, is about having an umpire of sorts - a neutral party with established risk management practices designed to ensure every trade is settled expeditiously and efficiently and to make sure buyers and sellers fulfill their obligations.
Cattle ranchers in Kansas, for example, can go to the futures markets and hedge their production and exposure to potential risks -- say, a winter storm, or an economic slump – months or years in advance.
“They can buy and sell with high confidence that they’ll get money owed them if prices move adversely against the people taking the other side of those trades,” said Craig Pirrong, Director of the Gutierrez Energy Management Institute at the University of Houston. Through centralized clearing, “we establish a counterparty that everybody can trust.”
Clearing organizations, aka clearing houses, have been around in some form for at least a few centuries. One early version was formed in London around 1781 to facilitate trading in “to arrive” cotton contracts, according to a report by Federal Reserve Bank of Chicago researchers.
In 1919, the Chicago Butter and Egg Board, the Chicago Mercantile Exchange’s predecessor, established its own clearing house, now known as CME Clearing and one of the world’s largest centralized clearing operations. In October, CME Clearing marked its 100th anniversary.
“Markets run on promises, so we need to have a mechanism that ensures people live up to their promises,” Pirrong said, referring to centralized clearing generally. “This is particularly the case if you have anonymous, centralized trading, because you need to make sure everyone is equally attractive as a counterparty.”
Market Drivers and Milestones
Agriculture and the inherent risks in producing food propelled early futures trading and clearing houses. Over more recent history, technology, interconnected global economics and “Black Swan” events, such as the 2008 global financial crisis (which led to the Dodd-Frank act mandating centralized clearing for many derivative contracts), have combined to drive the markets in general.
But CME Group’s own growth is most responsible for the increasing importance of CME Clearing, says Cutinho.
The launch of several innovative contracts that became global benchmarks propelled CME Clearing’s growth over the past five decades. These included the 1972 launch of the International Monetary Market (IMM), which introduced physically deliverable foreign exchange futures cleared by CME Clearing. In 1981 came Eurodollar futures, dollar-based, short-term interest rate contracts which were the first cash-settled futures contract. In 1982, CME launched futures contracts based on the S&P 500 index.
The International Monetary Market launch in 1972 began a series of expansions into financial asset classes for CME Group.
Clearing activity accelerated further in the 2000s, after, in 2004, the Chicago Board of Trade agreed to have CME Clearing clear its products (at the end of 2004, average daily cleared margin surged 25% from a year earlier, to $25.4 billion).
Other milestones included 2008, when CME Group acquired the New York Mercantile Exchange (NYMEX) and CME Clearing began clearing COMEX metals contracts and NYMEX energy contracts.
“Extreme Yet Plausible Stresses”
As screens and increasingly high-powered computers supplanted face-to-face, open-outcry trading, markets sped up and the trading day now never really ends. With Asian trading hours handing off to European hours handing off to the U.S., clearing systems such as CME Clearing’s must also be on point round the clock, Cutinho said.
CME Clearing evolved accordingly. Demands of centralized clearing now require daily “stress-testing” and effectively asking the same question over and over: what could go wrong?
“As electronic trading grew, CME Group became a global clearing house,” said Cutinho. “We have teams that ‘follow the sun,’ monitoring risk 24 hours a day. We also take a ‘portfolio risk’ approach and conduct daily stress-testing, so we try to understand hypothetical risk exposures under extreme yet plausible stresses.”
When market stress occurs, it often starts in Asian hours. For example, the night of the 2016 U.S. Presidential election, CME Clearing processed nearly 20 million trades during Asian hours alone. At the time, that was bigger volume than CME Clearing typically handled on a full day overall.
Figure 1: Total futures and options risk for market participants at CME Clearing
Over the past 20 to 30 years, “the type of risk exposures we clear have changed greatly,” said Cutinho. In the early 2000s, CME Clearing began backing over-the-counter (OTC) derivatives based on energy, interest rates and other markets – a “level of complexity beyond futures,” he said.
Today, CME Clearing has 68 clearing member firms. These represent “well capitalized, closely monitored and carefully approved companies” that stand behind all trades made through CME Group exchanges, according to CME Group’s website.
The "What If" of Any Market Scenario
Market meltdowns, if you’re there when it’s happening, tend to stick in your memory. For Pirrong, a former Chicago futures trader, the “Black Monday” market crash of October 1987 brought home a few lasting lessons, including: good clearing houses matter.
As markets nosedived that October day, rumors of various financial system breakdowns swirled through and around the Chicago trading pits and offices, said Pirrong, who at the time was working for a futures commission merchant based in the Chicago Mercantile Exchange building. He said he quickly gained appreciation of clearing’s critical role as market backstop.
Clearing systems and financial systems overall were under heavy duress, “and I basically had a front-row seat,” he said. “I saw frantic and heroic efforts to make sure markets navigated the huge stresses.”
Every market crisis presents learning opportunities for the clearing industry, Cutinho said.
For example, following the 1987 market crash, CME Clearing created the Standard Portfolio Analysis of Risk Framework (SPAN), a methodology aimed at calculating performance bond requirements at a portfolio level with capability to assess “what-if” of virtually any market scenario.
Much has changed over the past 30 years, meaning SPAN has also evolved and centralized clearing houses must adapt.
“The ‘87 crash underscored the need to assess risks from a portfolio basis, meaning the entire portfolio of the client, not just individual products or strategies,” Cutinho said. SPAN “had to be simple enough so clearing members could calculate margin on their own, and not operationally depend on CME Clearing. Transparency is important.”
CME Clearing plans to launch the first phase of its SPAN 2 framework update in the second half of 2020, subject to regulatory approval.
The Next 100 Years
Cutinho said he sees an intensifying focus on operational simplicity and capital efficiency for centralized clearing in coming years as the financial industry adapts to stepped-up regulation and margin requirements.
“There will be even more focus on optimal use of capital at a portfolio level,” he said. “We have to ensure our clearing clients have the right amount of capital to cover their risks and manage their exposure.”
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