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ESSAYS ON ISSUES THE FEDERAL RESERVE BANK OF CHICAGO NOVEMBER 1994 NUMBER 87 Chicago Fed Letter What is multilateral clearing and who cares? regular and dependable, so they rarely attract notice. This probably explains why the public knows little To signify the im portance of a finan about clearing systems, even though futures m arkets have used m ultilater cial news event, the m edia often al clearing procedures for nearly present pictures of excited traders seventy years. screaming their orders in the pits of the futures exchanges. But such But this hasn’t always been the case. events are transient. More im por Prior to the adoption of m ultilateral tant is the way these exchange trades systems, futures m arkets cleared are handled after leaving the pits: bilaterally. In those days, exchange They are multilaterally cleared, that m em bers suffered the consequences is, through a third-party clearing of trades placed with financially house. weak m embers. To avoid these Over-the-counter (OTC) derivatives, consequences, m em bers attem pted to avoid trading with weak m em bers by contrast, are not traded on orga nized exchanges, but rather via elec when possible and im posed margin requirem ents to mitigate the rem ain tronic com m unications networks. ing risks. Despite these efforts, fail Such products include swap con ures were frequent and sometimes tracts, forward contracts, options, extensive. For example, the 1902 and a variety of hybrids. Unlike fu bankruptcy of G.D. Phillips resulted tures, they are cleared bilaterally, in losses for over 40% of the m em that is, directly between originating bers of the Chicago Board of Trade. counterparties. As the num ber of OTC transactions has increased, so Since 1925, all U.S. futures exchang have proposals that they be cleared es have used m ultilateral clearing multilaterally. systems. This m eans that all traded contracts are cleared through a m em While such proposals tend to be ber of an exchange-affiliated clear motivated by a concern for private inghouse. The clearinghouse is in economies, regulators find m ultilat eral clearing attractive because of its terposed in each contract between a buyer and a seller so that the original public economies. This Chicago Fed contract is replaced by two contracts. Letter explores m ultilateral clearing in the context of OTC derivatives. It As a result, the original seller obtains identifies the private econom ies that a contract to sell to the clearinghouse and the original buyer obtains a con m ultilateral clearing would yield, as tract to buy from the clearinghouse. well as its potentially even greater Substituting the clearinghouse for public benefits. the original counterparties implies that the financial standing of the What is multilateral clearing? counterparties is not a consideration Clearing is the back-office processing in the trade.1 Rather, the clear of traded contracts. It involves deter inghouse guarantees all positions created between its clearing m em m ining the am ounts due between bers. The presence of this guarantee counterparties and, through cash exposes the clearinghouse to losses transfers, settling these am ounts. While spectacular gains or losses get which, in turn, creates a powerful incentive for the clearinghouse to attention, back-office events are m onitor the financial ability of its clearing m embers. This m onitoring further strengthens the surety of contracts placed with clearing m em bers. How well does m ultilateral clearing work? The best evidence is the per form ance of the futures markets. Since m ultilateral clearing was intro duced in 1925, all losses due to fail ure of a counterparty have been covered by exchange-affiliated clear inghouses. In contrast with earlier years, losses such as those realized in the Phillips bankruptcy have been prevented from propagating. This isolation of risk gives the public a layer of protection from contract default. Private economies In recent years, some have encour aged m ultilateral clearing for OTC derivatives because of the significant private benefits it would yield. U n der bilateral contracting, counter parties are obligated to make due-to and due-from payments. A simpler form of this process is to net pay m ents bilaterally; that is, to net the payments due on all contracts be tween each pair of counterparties and then have a single paym ent m ade between the pair. Bilateral netting clearly reduces the num ber of payments required between coun terparties. Further econom ies can be obtained if payments are netted across many different counterpar ties—a practice called m ultilateral netting. For instance, banks placing contracts on behalf of their custom ers often create positions that offset their previous exposure to m arket risks. Despite this m itigation of m ar ket exposure, such banks retain pay m ent obligations to each of their counterparties. Making payments is costly. A system of m ultilateral clear ing substantially reduces these costs. O ther costs, too, can be reduced through m ultilateral clearing. Be cause a contract exposes counterpar ties to credit risks, collateral is fre quently required for each contract even when any price-change expo sure stemming from the position has been offset. As assets dedicated to collateral purposes generally have m ore valuable uses, m aintaining this redundancy imposes cost burdens. Substituting the clearinghouse for the original counterparties collapses the separate contract obligations into a single net contract and a sin gle collateral obligation. For an institution with an extensive gross contract position (many contracts with many different counterparties), this represents a significant cost reduction. The com bined costs of operating a payments facility and m aintaining collateral deposits in excess of actual risk levels represent a strong incentive to pursue m ul tilateral clearing arrangem ents, which directly reduce those costs. M onitoring is an im portant com po nent of the risk m anagem ent activity of bilateral contractors. As each contractor m ust m onitor the finan cial ability of each of its counterpar ties, m uch of this activity is redun dant. Centralizing m onitoring activity at the clearinghouse insures that each m arket participant is m oni tored at significantly reduced cost. As the num ber of transactions in foreign currency m arkets has grown rapidly since 1971, the econom ies available from a m ultilateral system have becom e especially attractive to potential and actual participants. Pursuit of such econom ies has moti vated a group of twelve banks to develop a proposal for a m ultilateral clearing system called MULTINET for institutions transacting in foreign currency markets. The system would begin with m ultilateral clearing of U.S. and Canadian dollar transac tions and ultimately would handle transactions in all of the world’s major currencies. Similarly, the Chicago Board of Trade is developing a system called the Hybrid fnstrum ents Trading System (HITS) that will perm it m ul tilateral clearing of OTC swap con tracts. This system will be im ple m ented in three stages. First, facilities will be provided to handle payments and collateral require m ents between counterparties. Sec ond, models will be evaluated to determ ine the am ounts required to settle contracts. Third, guarantees of paym ent obligations will be ex tended by interposing the exchange clearinghouse as counterparty to all swap contracts cleared through HITS. In this third stage, swap con tracts will trade with the same non default guarantees that futures con tracts have had since 1925. Public economies In addition to the private econom ies outlined above, m ultilateral clearing also offers public economies. In bilateral systems, counterparties have incentives to collect credit inform a tion on their counterparties in order to protect against contract default. However, a full assessment of any single counterparty requires com plete knowledge of all its outstand ing contracts. Since any single insti tution has full knowledge of only the positions between itself and its coun terparties, it can only estimate the extent to which it may be exposed to contract defaults affecting its im m e diate counterparties. For example, suppose institution A has a contract with institution B. Assume further that institution A can correctly assess its exposure to default on that con tract. At the same time, however, institution B also has a contract out standing with institution C. Should C default on its contract, B may be come financially weaker, thereby increasing the exposure A faces from B. Assessing this indirect exposure is both difficult and costly. Further, if an institution underestim ates its indirect exposure, it may inade quately protect itself against the risk of loss. M ultilateral clearing systems solve this problem by shifting contract loss exposure to the clearinghouse. Such a shift is efficient because the clearinghouse has full knowledge of the contracting activities of all its members; thus the shift yields an econom y in inform ation collecting. Moreover, centralizing the infor m ation gathering substantially im proves the ability of m em bers to react appropriately. W here a single m em ber in a bilateral arrangem ent can estimate its exposure from de fault propagation, it will tend to protect itself against its own estima tion error. With a central clearing house, the individual estimates m ade by individual institutions are re placed with full-information esti mates m ade by the clearinghouse. Thus, centralization concentrates inform ation at the point where it is best utilized. Centralization has a further benefit. While each participant in a bilateral system has incentives to protect itself from contract defaults by its counter parties, its interests end there. No participant has an incentive to con cern itself with system-wide risks. The m em bers of a m ultilateral clear ing system, on the other hand, are exposed to defaults created by sys tem-wide problems. As each clearing m em ber accepts the liabilities en tered into by the cleared trades of every other m em ber, each m em ber has strong incentives to m onitor this risk. This m utualization of risk in sures that contracts accepted by clearing m em bers will be scrutinized for their system-wide risk implica tions. M embers can be expected to adopt trading rules that lessen the probability that a buildup of these risks will occur, and they can be ex pected to respond quickly to any unanticipated buildup. In sum, a m ultilateral system has incentives to identify systemic risks and has the resources to respond to these incen tives. It is this com bination that best explains the success of the futures markets in controlling contract de faults since 1925. Regulatory authorities represent an alternative mechanism for dealing with system-wide risks. Legislation entitles the regulatory agencies to access defined categories of inform a tion. Legislation also stipulates the steps that regulators may take to mitigate systemic risks. As legislation develops slowly, often in response to actual problem s, regulatory agencies are less capable of responding quick ly to rapid buildups in system-wide risks. The ability of m ultilateral clearinghouses to adapt m ore quick ly makes them particularly useful. This rapid-response feature is espe cially beneficial in the derivatives markets, where contracting activity has grown exponentially and innova tion may be exceeding the capacity of regulators to keep pace. These circumstances have piqued the interest of banking regulators in m ultilateral clearing arrangem ents. While they recognize the dangers posed by poorly structured clearing house arrangem ents,2 the possibility of obtaining a facility whose opera tions are consistent with the public’s interest in controlling system-wide risks is attractive. The clearinghous es operated by the futures exchanges for most of this century offer an excellent m odel for how these bene fits can be obtained for the broader category of derivative products that trade today. Regulators are now in the process of evaluating m ultilateral clearing ar rangem ents. The Lamfalussy Report offers guidelines for operating a m ultilateral clearing facility in for eign exchange.3 It does not address m ultilateral clearing of derivative products, an area that poses special problems. Most im portant, in con trast to foreign exchange contracts, cash settlem ents do not extinguish the exposures that rem ain in an outstanding derivatives contract. Since a derivatives contract may not expire for years, each contract may represent a considerable dollar am ount of exposure. It is im portant for clearinghouse settlem ents to extinguish as m uch current expo sure as possible. Futures markets accomplish this by m arking the con tract to m arket daily, using in most cases the m arket-determ ined settle m ent price for each contract. This approach is based on the idea that m arket prices provide the best possi ble estimate of current value. W hen publicly observed prices are less informative, as in a customized OTC derivative, they m ust be replaced by calculated values. Developm ent of a satisfactory m ultilateral clearing facility will require an effective ap proach to solving this issue. As noted earlier, the search for pri vate economies has motivated many of the proposals for multilateral clearing arrangem ents. Assessments of these proposals need to focus on both the operating procedures for these proposed organizations and on the strength of clearinghouse incen tives to adapt to the innovations occuring in our evolving markets. At this date, attention has focused on the operating procedures with little recognition of the power brought to bear when loss-sharing arrangem ents cause private firms to have loss expo sures stemming from systemic prob lems. For example, the Lamfalussy guidelines do not cover the loss sharing arrangem ents adopted by the clearing organization. As loss-shar ing arrangem ents determ ine how the organization mutualizes its exposure to counterparty risk, this is a signifi cant omission. that are of greatest significance. Centralized inform ation gathering makes it possible for m ultilateral systems to identify system-wide prob lems that may escape notice in bilat eral arrangem ents. As the clearing house may be exposed to systemwide risks, it has incentives to devel op means of m anaging them. More over, unlike a public regulator, the clearinghouse can adapt rapidly to changing m arket conditions. —-James T. Moser ^ h e term for the substitution of coun terparties is “novation.” 2Patrick Parkinson presented these views at the 1993 annual Conference on Bank Structure and Competition of the Feder al Reserve Bank of Chicago. For a sum mary, see James T. Moser, “Systemic risk in interbank markets,” Summary: FDICIA: An Appraisal, Federal Reserve Bank of Chicago, May 1993, pp. 20-24. 3See Group of Ten, Committee on Inter bank Netting Schemes of Central Banks, “The Lamfalussy report,” Basel, Switzer land, November 1990. Summary Multilateral clearing presents oppor tunities for substantial economies. In terms of private economies, it reduces the costs of making con tractual payments, of collateralizing paym ent obligations, and of m oni toring the financial well-being of counterparties. These benefits m oti vate private institutions to adopt m ultilateral systems. In addition, m ultilateral clearing offers public economies, including the centralization of inform ation gathering and the m utualization of risks. From a public interest per spective, it is these public econom ies David R. Allardice, Vice President and Director of Regional Economic Programs and Statistics; Janice Weiss, Editor. Chicago Fed Letter is published monthly by the Research Department of the Federal Reserve Bank of Chicago. The views expressed are the authors’ and are not necessarily those of the Federal Reserve Bank of Chicago or the Federal Reserve System. Articles may be reprinted if the source is credited and the Research Department is provided with copies of the reprints. Chicago Fed Letter is available without charge from the Public Information Center, Federal Reserve Bank of Chicago, P.O. Box 834, Chicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 M anufacturing output gathered increased m om entum in the region during recent months, according to the Midwest M anufacturing Index. Production in cyclically sensitive sectors such as industrial machinery, fabricated metals, transportation equipm ent, and chemicals accounted for m uch of the renewed m om entum . Purchasing m anagers’ surveys point to further strengthening during Septem ber, particularly in Detroit and western Michigan. Sources: The Midwest Manufacturing Index (MMI) is a composite index of 15 industries, based on monthly hours worked and kilowatt hours. IP represents the Federal Reserve Board industrial production index for the U.S. manu facturing sector. Autos and light trucks are measured in annualized physical units, using seasonal adjustments developed by the Board. The purchasing managers’ survey data for the Midwest are weighted averages of the seasonally adjusted production components from the Chicago, Detroit, and Milwaukee Purchasing Managers’ Association surveys, with assistance from Bishop Associates and Comerica. IlIS-22£ (2l£) b£80~06909 siounn ‘oSeaito f £8 xog O d •I91U33 uopeuiiojui apqnj OOVOIH3 TO X N W 3AHTS3H TVHTQTT i o i h v i p a j o S i ’D i i p )
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