Full text of Economic Perspectives (Federal Reserve Bank of Chicago) : Fourth Quarter 2006, Volume XXX, Issue 4

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Call for Papers

Federal Reserve Bank
of

2007 Conference on
Bank Structure and
Competition

Fourth Quarter 2006

RESEARCH LIBRARY

Economic

Federal Reserve Bank
of St. Louis

DEC 1 8 2006

perspectives
Policymakers, researchers, and practitioners discuss
the role of central counterparties
Overview of a conference, titled “Issues Related to Central Counterparty
Clearing,” cosponsored by the Federal Reserve Bank of Chicago and
the European Central Bank held in Frankfurt, Germany, April 3-4, 2006.

22

Derivatives clearing and settlement: A comparison
of central counterparties and alternative structures

32

Speeches delivered at the conference by:
Gertrude Tumpel-Gugerell, member of the Executive Board
of the European Central Bank
Randall S. Kroszner, governor, Board of Governors of the Federal
Reserve System
Tommaso Padoa-Schioppa, Minister of Economic Affairs and Finance ofItaly
andformer member of the Executive Board of the European Central Bank
Michael H. Moskow, President of the Federal Reserve Bank of Chicago
Jean-Claude Trichet, President of the European Central Bank

54

Index for 2006

Economic

perspectives

President
Michael H. Moskow
Senior Vice President and Director of Research
Charles Evans
Research Department
Financial Studies
Douglas Evanoff, Vice President

Macroeconomic Policy Research
Jonas Fisher, Economic Advisor and Team Leader
Microeconomic Policy
Daniel Sullivan, Vice President

Payment Studies
Richard Porter, Vice President
Regional Programs
William A. Testa, Vice President

Economics Editor
Craig Furfine, Economic Advisor
Editor
Helen O’D. Koshy
Associate Editors
Kathryn Moran
Han Y. Choi
Graphics
Rita Molloy

Production
Julia Baker
Economic Perspectives is published by the Research
Department of the Federal Reserve Bank of Chicago. The
views expressed are the authors’ and do not necessarily
reflect the views of the Federal Reserve Bank of Chicago
or the Federal Reserve System.

© 2006 Federal Reserve Bank of Chicago
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& Chicago fed. org
ISSN 0164-0682

Contents

Fourth Quarter 2006, Volume XXX, Issue 4

2

Policymakers, researchers, and practitioners discuss the role
of central counterparties
Douglas D. Evanoff, Daniela Russo, and Robert S. Steigerwald
This article summarizes a conference, titled “Issues Related to Central Counterparty Clearing,”
cosponsored by the Federal Reserve Bank of Chicago and the European Central Bank on April 3-4,
2006. The conference brought together industry executives, policymakers, and research economists
to evaluate current public policy issues involving central counterparties.

22

Derivatives clearing and settlement: A comparison of central
counterparties and alternative structures
Robert R. Bliss and Robert S. Steigerwald
Most exchange-traded and some over-the-counter (OTC) derivatives are cleared and settled through
clearinghouses that function as central counterparties (CCPs). Most OTC derivatives are settled bilat­
erally. This article discusses how these alternative mechanisms affect the functioning of derivatives
markets and describes some of the advantages and disadvantages of each.

30

Conference on Bank Structure and Competition call for papers

32

Issues related to central counterparty clearing: Opening remarks
Gertrude Tumpel-Gugerell

37

Central counterparty clearing: History, innovation, and regulation
Randall S. Kroszner

42

Central counterparties: The role of multilateralism and monopoly
Tommaso Padoa-Schioppa

46

Public policy and central counterparty clearing
Michael H. Moskow

51

Issues related to central counterparty clearing: Concluding remarks
Jean-Claude Trichet

54

Index for 2006

Policymakers, researchers, and practitioners discuss
the role of central counterparties
Douglas D. Evanoff, Daniela Russo, and Robert S. Steigerwald

Introduction and summary
Central counterparties (CCPs) are structures that help
facilitate the clearing and settlement process in financial markets. They have long been utilized in the derivatives markets, more recently have been adopted in
cash securities markets, and currently are experiencing
a growing interest in a further expansion of their use.
Typical examples of CCPs in the U.S. include the clearinghouses for the derivatives markets in Chicago—
the Chicago Mercantile Exchange Clearing House,
the Options Clearing Corporation, and the Clearing
Corporation.1 Examples in the European Union include
LCH.Clearnet and Eurex Clearing. A more comprehensive, but non-exhaustive, list of U.S. and European
central counterparties, with characteristics of each arrangement, is included in Bliss and Papathanassiou
(2006) and reproduced in appendix 1.
What are the benefits associated with CCPs?
If properly structured, they can offer more effective
risk-management procedures than is possible in markets that do not use central clearing and settlement arrangements, resulting in superior safety and soundness.
This, in turn, can lead to increased liquidity and deeper markets.
How are these gains realized? The CCP interposes itself between the counterparties to a financial contract. Thus, the CCP becomes the counterparty to each
side of the contract. A transaction initiated between
customer X and customer Y becomes two separate
contracts: one between X and the CCP and one between
Y and the CCP. If the CCP has appropriate risk-management processes in place, this “substitution” of the
CCP as the common counterparty to each transaction
results in a decrease in counterparty risk.2 Because
traders are exposed only to counterparty risk from the
CCP, they need not spend time and resources evaluating
and managing the risk of other market participants—
a job that is performed instead by the CCP. In fact,



traders in a centrally cleared market that uses a CCP
are completely indifferent to the identity of other
market participants, a fact that leads to anonymous
trading. This decreases transaction costs and contributes to an increase in market liquidity. In addition,
since the CCP is the common counterparty to each
trade, the CCP framework naturally allows for multilateral netting of positions, which leads to additional
decreases in transaction costs.
In recent years, we have seen significant changes
in the financial markets for which CCPs are utilized.
Trading volumes have surged, new financial products
have been developed, technology has gotten cheaper
and become more fully incorporated into the clearing
and settlement process, and electronic trading has increased. Risk-management procedures have improved,
cross-border trading activity has increased, and exchanges and clearinghouses have consolidated. These
developments have had important implications for
CCP operations, ownership, and governance. While
CCPs have traditionally served one market in one
country, they have more recently expanded to serve
multiple markets across national borders. The interest
of traders in a more efficient use of collateral tends to
reinforce this trend and adds to the impetus for a reconsideration of CCP structures.
In response to this growing interest in CCPs, the
Federal Reserve Bank of Chicago and the European
Douglas D. Evanoff is a senior financial economist and
vice president in the Economic Research Department of
the Federal Reserve Bank of Chicago. Daniela Russo is
the deputy director general on payment systems and market
infrastructure at the European Central Bank. Robert S.
Steigerwald is a senior professional in the Financial
Markets Group of the Federal Reserve Bank of Chicago.
The authors also served as the conference coordinators
and would like to thank Richard Lamm and Jens Tapking
for their help in developing the conference program.

4Q/2006, Economic Perspectives

Central Bank sponsored a joint conference on “Issues
Related to Central Counterparty Clearing” on April 3
and 4, 2006, in Frankfurt, Germany. The conference
featured a multidisciplinary “law and economics” discussion of key legal, risk-management, and public
policy issues associated with CCPs, with a special
emphasis on issues that arise in cross-border and
cross-product transactions.
Over the two-day conference a number of industry executives, policymakers, and research economists evaluated an array of topics associated with
CCPs, including:3
n 	 Efficiency and systemic importance of current and
evolving CCP structures, including ownership and
governance structures;
n 	 Management of credit, liquidity, operational, legal,
and other risks by CCPs;
n 	 Mutualization of counterparty credit risk;
n 	 Costs and benefits of CCP structures;
n 	 Innovation, competition, and integration initiatives
among CCPs;
n 	 Relationships between central banks and CCPs
and their clearing participants;
n 	 Similarities and differences in the potential for using
CCPs in over-the-counter (OTC) and exchangetraded products;
n 	 Cross-product clearing; and
n 	 Policy issues related to the design, operation, oversight, and supervision of CCPs.
This article provides an overview of the conference
and an introduction to this special conference issue of
Economic Perspectives. Next, in an article that builds on
the discussion at the conference, Robert Bliss and Robert
Steigerwald discuss common problems of risk management, operational efficiency, liquidity support, and
information that are inherent in both exchange-traded
and OTC derivatives markets. The article discusses
typical clearing and settlement arrangements for those
markets and compares the bilateral clearing arrangements typically found in OTC markets with markets that
utilize centralized clearing arrangements, such as CCPs.
The remainder of the issue features presentations
by the keynote speakers, Gertrude Tumpel-Gugerell,
member of the Executive Board of the European Central Bank; Randall S. Kroszner, governor, Board of
Governors of the Federal Reserve System; Tommaso
Padoa-Schioppa, Minister of Economic Affairs and
Finance of Italy and former member of the Executive
Board of the European Central Bank; Michael H.
Moskow, president of the Federal Reserve Bank of
Chicago; and Jean-Claude Trichet, president of the

Federal Reserve Bank of Chicago

European Central Bank. Given their inclusion in this
special issue, little coverage of the keynote addresses
is included in this summary article.
Foundations of central clearing parties
Setting the stage
A CCP imposes itself as the legal counterparty to
every trade.4 This substitution of the counterparties by
the CCP typically occurs through a process known as
novation, which discharges the contracts between the
original trading entities and creates two new, legally
binding contracts—one between each of the original
trading parties and the CCP.
This arrangement places the CCP in a unique position in that it has direct interaction and counterparty
risk exposure with each trading party.5 This gives the
CCP the incentive to closely monitor traders, as well
as access to the information needed to manage its risk.
Market participants, by contrast, are essentially indifferent to the creditworthiness of anyone but the CCP,
which significantly decreases the cost of risk monitoring. This is typically considered the most important
role of the CCP: what John Trundle (2006) of Euroclear SA/NV called the “collective investment of the
market in risk management.”
The CCP uses a variety of tools to manage risk.
First, it can establish membership requirements, including capital requirements, which the members must
satisfy to continue to participate in the arrangement.
Again, this eliminates the need for individual participants to be concerned with the risk of the trading partners, because they know that participants must satisfy
certain minimum standards to continue to participate
in the centrally cleared market.
The most common tool used to manage risk, and
many would argue the single most important, is collateral. CCPs typically hold collateral (sometimes called
initial margin) from each market participant to serve
as a cushion against adverse market fluctuations. The
CCP also monitors the position of members and may
periodically require additional collateral following
market movements to reestablish an acceptable cushion against future losses. Rules are established dictating what assets are allowed to serve as collateral, how
much of a “haircut” should be given to specific assets
in determining their value as collateral, and how often
margin calls should take place.6 Some have argued that
the single most important reason for the existence of
CCPs is to have them serve as a collateral facility.7
CCPs also typically require members to make
periodic payments (sometimes called variation margin)
to prevent a buildup of market losses. Payments equaling the “mark-to-market” from a recent settlement



price—often the closing price from the previous trading day—are made to the CCP by those traders whose
positions have lost value as a result of market fluctuations. The CCP, in turn, makes payments that, in effect, pass through market gains to those traders
whose positions have gained value as a result of market fluctuations. This process of exchanging variation
margin permits the CCP to set collateral requirements
as low as possible while maintaining its value as a
cushion against future losses.
CCPs also use loss-sharing arrangements to cover
any additional losses incurred beyond those covered
by a defaulting trader’s collateral. Mutualization of
losses is a final layer of protection that insures the
ability of the CCP to perform its obligations notwithstanding the failure of one or more traders. This also
should reduce the potential spillover effects on other
members when individual members in the arrangement fail, since the combined group should be better
able to absorb losses. There is a realization, however,
that mutualization may encourage market participants
using a CCP to trade more and establish larger positions, increasing the potential risk for the CCP, and
that decisions concerning loss allocation procedures
have distributional effects that must be considered
when developing the loss-sharing arrangement. For
example, setting high (low) margin requirements
shifts the burden of individual firm failure toward the
defaulting (surviving) firms. Collateral is expensive
and imposes costs on all CCP participants. Clearly,
the perceived value to the members must offset the
potential cost before the specifics of the loss-sharing
arrangement can be agreed upon.
The CCPs unique position of being a common, substituted counterparty to all trades in a centrally cleared
market greatly simplifies the multilateral netting of
trade obligations. Past studies have shown that multilateral netting can result in significant decreases in
risk exposure relative to the underlying gross positions—
reductions exceeding 90 percent in some cases.8 This
contributes to improved liquidity and deeper markets.
As a result of the centralization of information
flows and the standardization of processes, a CCP in
a centrally cleared market may enjoy economies of
scale and/or scope in the performance of these riskmanagement functions. For similar reasons, it may
also realize economies of scale in the provision of additional administrative services, which may generate
cost savings. Consider, for example, the default of a
trader with outstanding contracts in a market that is
not centrally cleared. Each of the defaulting trader’s
counterparties must take steps—such as closing out
open positions, liquidating collateral, and, if necessary,



instituting legal action—to protect itself against losses arising from the default. In a centrally cleared market, however, the CCP acts on behalf of all users of
the market in taking actions to protect itself against
loss from a trader’s default. Finally, there may also be
cost advantages in the centralization of various backoffice services, such as trade capture, trade matching,
reporting requirements, netting calculations, centralized collateral valuation, and settlement services for
CCP members.
What does the market want from CCPs?
Diana Chan (2006) from Citigroup started the
conference discussion by describing how market participants want to see the CCP environment evolve.
At the time of the conference, Citigroup was a member of 38 different CCPs worldwide. Many of Chan’s
points were echoed by other conference participants
throughout the conference.
Chan (2006) stated that the role of CCPs could
be expected to grow in the foreseeable future and that
new ones would be developed to bring about the associated benefits in other markets. She observed that CCPs
create a virtual cycle in growing transaction volumes
as they increase participants’ ability to trade through
a netting process that reduces both regulatory capital
requirements and the number of trades to be settled.
However, while CCPs are thought to create significant benefits, the proliferation of disjointed CCPs
creates potential problems. As the number of CCPs
grows, the coordination cost involved in operating in
multiple arrangements increases. Additional pools of
collateral must be held and managed, and administrative costs increase as firms need to work with multiple infrastructures having potentially different legal
environments, controls, compliance procedures, and
processes.9 Ideally, the heterogeneity across CCPs
would be decreased. While this could be achieved in
a number of ways, including CCP consolidation, processing harmonization, linkages across CCPs, and CCP
cross-memberships, most of the discussion over the
two-day conference concentrated on the recent groundswell, particularly in Europe, for CCP consolidation.
Chan emphasized that as consolidation occurs,
the market will have to invest heavily to adapt technology and reconfigure processes. However, these expenditures could be justified if they result in internal
efficiency gains and maintain an adequate degree of
safety. These safety concerns underscored the need
for uniform regulatory standards, particularly uniformity across borders, and Chan said she welcomed the
recent best practice recommendations for CCPs.10 However, she suggested there might be a need to go even

4Q/2006, Economic Perspectives

further in a number of respects. For example, CCPs
could be required to be as robust as top tier banks,
meaning they would be subject to the Basel Accord’s
capital adequacy requirements. This is not uniformly
the case—in some countries CCPs are considered banks,
while in others they are considered clearinghouses,
with correspondingly different regulatory requirements.
Chan also offered a wish list of additional safety
issues that Citigroup was interested in including in
future CCP arrangements, such as capped loss-sharing
for each counterparty when loss-sharing arrangements
are negotiated, firewalls between asset classes to protect participants from potential losses in markets for
assets they may not use, the ability to opt out of using
the CCP for certain products and instead use other
means (perhaps bilateral arrangements) to access the
product, and differentiated rules for general clearing
members that may differ from those of associate members. The desire was to realize the full benefits of the
CCP arrangement and to realize and address the specific needs of various segments of the CCP membership.
What does the regulator want from CCPs?
As discussed above, CCPs may generate significant benefits by supporting the netting of positions,
providing procedural standards, increasing market liquidity, and allowing for enhanced risk management.
However, while risks on these arrangements may be
shifted to the CCP, they are not eliminated. Instead
risk becomes concentrated at the CCP, which becomes
a potential source of systemic risk. Additionally, when
the risks are shifted to the CCP and potential losses
are mutualized, the incentives of participants may
change, and moral hazard makes them more willing
to take on additional risks. The financial regulatory
authorities, therefore, have a significant interest in ensuring that risk is well managed. Based on economic
theory, this is a classic case where there is an economic justification for regulatory involvement.
Stated differently, Trundle (2006) emphasized
the need for a role for regulatory authorities based on
their unique perspective of market activity. He argued
that CCP participants will focus mainly on the management of day-to-day risks, and the public authorities
will place more emphasis on the potential for extreme
events (with systemic implications). These are low
probability, but exceptionally high impact, events in
the tails of the probability distribution. Given the mutualization of risk, CCP participants may have an inherent tendency to underestimate the probability of
these types of events, since the cost of protecting
against such remote events falls principally upon the
group of participants. This tendency supports a role
for the public sector.

Federal Reserve Bank of Chicago

There appeared to be almost complete agreement
among conference participants in favor of some regulatory oversight of CCPs.11 At a minimum, most agreed
that there is value in having regulators play a role
as coordinators to bring market participants together
to develop best practices and standards for CCPs.
The example most frequently cited in support of this
coordinator role was the recent development of CCP
recommendations by the Task Force on Securities
Settlement Systems.12 Given the growing interest in
CCPs and the interest in expanding them across both
countries and products, the recommendations were
developed to help promote safety and stability in financial markets as CCPs expand. The Task Force’s report
addressed the major types of risk that CCPs encounter and provided general recommendations to manage
these risks. The report also includes a methodology
for assessing how well the recommendations have
been implemented at CCPs. The recommendations
are included in appendix 3.
The recommendations were embraced by most of
the conference participants and were making inroads
into practice. In fact, Yvon Lucas (2006) of Banque de
France discussed a recent assessment of LCH.Clearnet
against the CPSS–IOSCO standards. LCH.Clearnet is
a multi-product CCP that serves exchanges in Paris,
Amsterdam, Brussels, Lisbon, and London. It also
has a link to the Italian CCP Cassadi Compensazione
e Garanzia. LCH.Clearnet is subject to “cooperative
oversight” based on Memoranda of Understanding
with authorities in countries where it provides services.
For the purpose of the assessment, Banque de France
coordinated the contributions of the various regulatory authorities.
The assessment was performed using the methodology of the CPSS–IOSCO framework and was based
on available data supplemented by interviews. For
most of the recommendations, the assessment was
considered straightforward and the overall result was
that LCH.Clearnet was generally in compliance with
the standards. In the areas where deficiencies were
found, LCH.Clearnet was asked to provide an action
plan to improve future compliance.
However, the exercise brought out a number of
issues that other CCPs may find problematic in performing their own assessments. For example, how
should links to other CCPs be treated relative to other
membership relationships, given the unique nature
of these links? The thought was that CCP links bring
very different risks into play than those brought by
other participants. Additionally, there was a feeling
that certain recommendations—particularly those
dealing with efficiency and governance—were open



to interpretation. Finally, some felt terms, such as
“normal market conditions,” should be more clearly
defined. Generally, however, the standards were seen
as a valuable first step in assessing the resiliency of
CCPs and in guiding their evolution.
Discussion of the major issues
The conference presentations and discussion frequently returned to the issues of CCP consolidation,
the appropriate public policy role in the evolution of
CCPs, governance issues, and risk management.
Consolidation
Many participants expressed a desire to take advantage of potential economies of scale and economies
of scope from CCP consolidation, thereby significantly reducing the number of CCPs, particularly across
Europe. Lucas (2006) argued that consolidation was
probably the single most important issue facing the
industry today. There were differences of opinion,
however, on the perceived benefits of consolidation,
the tradeoffs associated with it, and how the process
should proceed.
Alberto Giovannini (2006) of Unifortune Asset
Management SGR and others insisted that fixed cost
within CCPs made up the bulk of operational expenses
and that the marginal cost of clearing and settlement
operations was essentially zero over a wide range of
output levels. Thus, there were obvious reasons for
consolidation, since the industry has the textbook characteristics of a natural monopoly. This aligned well with
a general view by many European market participants
that it is an opportune time to break down current barriers and encourage cross-border and cross-product
consolidation with a goal of a single European CCP.13
Some speakers, however, did question the extent
of the benefits that could be realized from consolidation. In response to the claim that marginal costs
were zero, Daniel Gisler of Eurex, David Hardy of
LCH.Clearnet Limited, and Kimberly Taylor of the
Chicago Mercantile Exchange stressed in their panel
discussion that all costs were not fixed and, although
low, marginal costs were not zero. Gisler (2006) indicated that personnel costs could change, and expenditures directed at innovation were significant and
“lumpy” as CCP activity increases.
However, most of the disagreement centered on the
role of competition in determining the direction of industry consolidation. The audience tended to fall into
two general camps: one supporting the idea that competition should be the driving force leading industry
structure and consolidation, and the other indicating



that competition in the industry “was not real” and artificial barriers stood in the way of a movement toward
a single CCP with natural monopoly characteristics.14
The former camp emphasized that it was not
obvious that there is a need for public authorities in
Europe to push for consolidation of clearinghouses.
Private entities operating in their own self-interest
should be allowed to determine whether consolidation would, on net, be beneficial to stakeholders.
With any movement toward a more concentrated industry, certain parties will benefit from the change and
others will be harmed. The views of all stakeholders,
including the CCP owners, users, full members, and
associate members, as well as large and small participants, should be considered. The marketplace is probably best situated to allow the net benefits to be analyzed
and decisions made as to how industry structure should
change. Competition across CCPs does exist, as does
competition between CCPs and alternative clearing
mechanisms, such as those used for over-the-counter
products. The marketplace should determine how to
proceed.
The “pro-coordination” camp held that, to a great
extent, CCPs have developed as “silos” because of
unique legal characteristics and other peculiarities of
the countries in which they operate. Economies do
exist, but cannot be exploited as long as these national barriers remain in place. Competition will not drive
the industry toward the optimal structure because each
CCP has monopoly-like control over the market it
serves. The potential cost savings from decreasing the
number of CCPs in Europe to one or two are so great
that coordination may be justified to overcome barriers to consolidation.
Another difference between the two camps is in
the type of inefficiency they identify. The “pro-consolidation” camp takes the view that significant economies of scale could be exploited if consolidation
took place because, they assert, CCPs have natural
monopoly characteristics. Per unit costs could be driven significantly lower with consolidation.
An alternative form of efficiency that the other
camp is considering is technical efficiency, which is a
measure of how effective management is at operating
efficiently, given the current scale of operations. Stated differently, economies of scale are captured by a
movement along a declining average cost relationship
as output is increased and is a function of the production process. Technical efficiency is a measure of how
close firms are to operating on the average cost relationship, where the cost relationship is representative
of the best practices in the industry and is a function
of the effectiveness of management.

4Q/2006, Economic Perspectives

In banking in the U.S., technical efficiency has
been shown to dominate scale inefficiency.15 This
may or may not be the case for CCPs, but certain
speakers expressed concern that technical inefficiency might offset any efficiencies that may be realized
from increasing the scale of production. Taylor (2006),
for example, questioned any policy encouraging the
development of a monopoly, since history has shown
monopolies to be relatively slow in innovating and
notoriously poor in providing high quality service. She
gave the example of the Department of Motor Vehicles
(DMV) in the U.S., where state governments monopolize the provision of automobile drivers’ licenses.
Taylor said she did not “believe many people think
of the DMV as a model of efficiency.”
A possible alternative to CCP consolidation would
be to have some form of interoperability through linkages across CCPs. This could take the form of CCPs
having memberships with other CCPs in an attempt
to allow participants in any one of the linked organizations to have indirect access to each of the other
linked organizations. While this was generally viewed
as being suboptimal, it was considered a possible intermediate step before actual changes took place in
industry structure. Hardy (2006) argued that while
some “spaghetti” form of interoperability would likely gravitate toward one CCP in the longer run, the
market might accept this as a short-term, second-best
solution. However, concerns were also expressed about
the potential costs of moving in this direction, and
some argued that CCPs would have to make significant investments to develop the linkages.
Among those that favored industry consolidation,
a significant proportion thought the idea of one single, pan-European CCP was unrealistic. Concerning
the optimal number of CCPs, Chan argued that while
there was significant room for industry consolidation,
two CCPs were probably better than one. While there
are significant scale advantages from consolidation,
the differences between cash and derivatives markets
are so significant that separate CCPs may be necessary. As a result, Chan argued, it may be necessary to
forego some potential cost savings of consolidation.
Trundle (2006) also stressed these market differences.
With derivatives, there is a time gap between the initial trade and the settlement of the transaction. This
gap is the essence of the product, as traders explicitly
want to take (and manage) position risk. In the cash
market, the gap is shorter, is incidental to the process,
and, ideally, could be eliminated. The general impression was that while there could be potential economies of scope from combining the cash and derivative
markets, in practice there may be few cost synergies
to be realized.

Federal Reserve Bank of Chicago

Finally, Jill Considine (2006) of the Depository
Trust and Clearing Corporation (DTCC) discussed
the evolution of the DTCC, which provides clearing
and settlement services for the U.S. securities markets
and has subsidiaries that act as CCPs for various segments of the market.16 She characterized the DTCC as
a monopoly created by the marketplace—because the
market wanted a monopoly to take advantage of industrywide economies of scale in the clearing and
settlement of the cash securities market. While being
careful to emphasize that different considerations
came into play in determining the structure of the
DTCC than those for the European markets, she noted that the cost savings from consolidation were significant. These occur in the form of collateral savings
and other standard processing efficiencies, as well as
at the periphery in the form of reduced business continuity and technology costs. Considine emphasized,
however, that consolidation in these markets was industry driven and was not the result of a mandate by
industry regulatory forces.
As is perhaps evident from the preceding discussion, the most significant disagreement at the conference concerned the appropriate role of regulators and
policy setters in “assisting” industry consolidation. The
current push toward CCP consolidation in Europe was
originally encouraged by statements from the European
Commission.17 Therefore, it was no surprise that conference participants were looking forward to the comments of Mario Nava of the European Commission.
Nava (2006) began by stating that he would not present a new directive from the Commission aimed at a
further integration of European clearing and settlement
institutions and instead discussed limitations to the
Commission’s ability to have influence in this area.
He discussed the role of the Commission in industry structure issues and the scope of competition
rules. The internal market rules of the Commission
are intended to encourage competition and allow it to
intervene in cases of anti-competitive behavior. While
the rules may address the framework for a pro-competitive environment, the Commission cannot set up
new institutions. Most importantly, Nava explained,
the Commission does not have the power to establish
a single CCP. Rather, it will rely on other means such
as competition and moral suasion to achieve its goals.
He stressed that the industry should critically evaluate its options and move forward, with full consolidation and interoperability offered as current alternatives.
Nava described interoperability as pragmatic, although
it may not bring the level of efficiency associated
with full consolidation. The Commission’s “intervention role,” if there is indeed such a role, would be to



assist the industry by facilitating movement toward
the industry’s choice of outcomes.
Exchange & CCP relationships and governance
In the U.S., there has been a recent movement
away from the traditional model of mutual ownership
of exchanges and their clearing and settlement providers, toward a for-profit, stock ownership.18 The movement could have a potential impact on the incentive
structure and, possibly, the risk aversion of the organizations. Similarly, since 2001, there has been a robust
dialogue within the European Union on adequate governance arrangements for central securities depositories and CCPs for two reasons. First, there is concern
that vertical integration of stock exchanges with depositories and clearinghouses in a vertical silo may impede integration across national borders. The European
markets aspire to ensure open access to financial market clearing and settlement services, regardless of the
nationality of the participant.19 Thus, structures that
hinder open access would not be in line with European
Union policies. Second, there has been significant debate in Europe as to what extent governance is a tool
that can ensure appropriate management of service
providers that combine a wide range of services having different risk profiles in the same legal entity. At
the conference, this discussion of governance focused
on two issues: the relationship between exchanges and
CCPs, and the perceived advantages and disadvantages of the mutual governance model.
Tomoyuki Shimoda (2006) of the Bank of Japan
discussed the relationship between exchanges and the
CCPs that serve them. He stressed the need for close
communications and cooperation when dealing with
exposure control, the monitoring of participant positions, and price movements. Exchanges and the CCPs
that serve them are normally both interdependent (for
example, the number of contracts is a source of revenues for both parties, since they have the same participants) and complementary (it may be possible to reduce
the costs for participants if exchanges and CCPs
jointly monitor the common members). However, he
expressed concerns about situations where there may
be potential conflicts between the exchange and the
CCP. For example, if an exchange is the monopolist
owner of the CCP, conflicts may arise if the financial
resources for risk management of the exchange and
the CCP are pooled.
The recent rush toward demutualization and public
listing has resulted in more complex situations involving potential conflicts among the various stakeholders
in exchanges and the CCPs that support them. Shimoda
illustrated this potential for conflicts by relating recent



events involving the Osaka Stock Exchange. Following public listing of the exchange, an investment fund
acquired a large position and ultimately became the
exchange’s largest shareholder (10 percent of the capital). The investor then sought a “cashing out” of the
financial resources held by the CCP for use in case of
a member default. A cashing out of the resources used
by the CCP to mitigate counterparty risks would have
reduced the market’s ability to absorb the losses and
would have transferred the cost of losses to members
of the exchange through the loss-sharing arrangement.
This case brought to the attention of the Japanese regulators the need for what has been called an “optimal
degree of intimacy” among different stakeholders
when designing the governance mechanisms of exchanges and CCPs.
While there can be a number of governance
models for exchanges and CCPs—nonprofit, mutual
ownership, for profit, and hybrids of these models—
the main advantage typically associated with the mutual governance model is that the users have a long-term
interest in the viability of the institution and are less
likely to sacrifice those interests for short-term gains.
This is sometimes thought to ensure that financial
markets operate in line with public policy objectives.
Concerns are sometimes expressed that moving away
from this governance model may make the alignment
of public and private concerns more difficult. However,
even with the mutual governance model, Lee (2006)
argued that there are numerous practical obstacles in
the application of governance rules and that the purported benefits of the model may not be realized.
For example, often there are strict confidentiality
requirements for the members of the governing boards
of exchanges and CCPs. They are not supposed to
share confidential information, nor are they to make
decisions based on their own self-interests. However,
since board members are often users of the exchanges
and CCPs they govern, inherent conflicts arise. Additionally, Lee questioned whether it is possible to achieve
the goal of reflecting the diversity of the user community in its governing board, noting that such boards
typically have only 20 to 25 members. Alternatively,
a board of 20 to 25 members can have practical problems in decision-making, particularly when the very
nature of the business necessitates an understanding
of many technical details to evaluate policy implications of such decisions. However, board members
may tend to have a strategic vision of the business
rather than detailed knowledge of the technical aspects
of the business. These strategic and technical needs
can be very difficult to reconcile. Lee therefore stressed
that the differences across governance models may

4Q/2006, Economic Perspectives

not be as great as implied by the theory. There are difficulties in each model. This is somewhat consistent
with Taylor’s view that CCP behavior and performance
are not necessarily driven by the ownership structure
of the firm.
Risk management
Risk management may be the single most important function of CCPs, because they are a substitute for
active risk evaluation and management by users of the
CCP. As the markets evolve, there are issues as to how
effective current risk-management procedures are and
how the cost of these processes may change in light of
projected changes in the structure of the CCP industry.
Papers presented at the conference aimed to describe
the current state of the art in CCP risk management
and to address some of these projected changes.
One session presented research evaluating the
use of collateral and margins in the securities and
settlement industry. Froukelien Wendt (2006) of De
Nederlandsche Bank described the role of margin,
the various types of margins collected by CCPs within their risk-management frameworks, the current use
of intraday margins in Europe, and the costs and benefits of intraday margin.
Replacement cost risk is the risk that a counterparty to a transaction will default before final settlement has occurred. Since the CCP is the counterparty
to each transaction, it is exposed to the cost of replacing the original transaction at current market prices.
Because prices may have changed since the contract
was originated, the CCP could suffer a loss when it
fulfills its side of the contract. To manage replacement
cost risk, CCPs require member firms to deposit collateral or margin. Initial margin is set to cover potential future losses on open positions and is typically
based on calculations of the greatest loss that the position could sustain. Variation margin calls are periodic
supplements to manage risk that bring the margin back
into line with recent changes in market prices, and
Wendt argues that they are typically made at the end
of the day. In her definition, the variation margin can
be held at the CCP (actually collateral to supplement
initial margin) or passed through from trading losers
to winners.20 She discussed the increasing use of intraday margin calls that allow the CCP to offset replacement risk and position changes on a timelier basis.
Wendt identified three types of potential intraday
margin: a routine intraday margin call (similar to the
end of day call), a nonroutine call that is triggered by
a significant price change, and a nonroutine call that
is triggered by a significant position change by a particular trading member (that is, the trigger is quantity

Federal Reserve Bank of Chicago

driven). The major benefit of an intraday margin call
is to enable the CCP to better manage counterparty
risk by reducing it in a timely manner and/or to allow
for the early detection of a troubled member. It may
also better align collateral with the trading patterns
and resulting exposure of day traders. Additionally,
since traders are maintaining margin in line with the
risks they pose to the CCP, they are bearing the additional costs of holding their positions. Such arrangements should decrease moral hazard, since traders have
risk-management incentives that are consistent with
the interests of the CCP and the market as a whole.21
However, these benefits come at a cost. The CCP
will have to put systems in place that allow for the
prompt determination of positions and margin needs.
Similarly, the members must have facilities in place
to obtain the necessary funding to satisfy the call and
back-office procedures in place to verify their positions and reconcile any discrepancies.
Wendt noted that all European CCPs currently
have the authority and operational capacity to initiate
an intraday margin call on a nonroutine basis, and more
are moving toward having a routine intraday call.
While she described the routine call as an industry
best practice, she said it may not be optimal for all
CCPs. There are associated costs and benefits from
putting procedures in place, and each arrangement
should be carefully analyzed for the net benefits of
initiating this change.
Next, Alejandro García of the Bank of Canada
and Ramo Gençay (2006) of Simon Fraser University
discussed how they combined statistical methods with
risk measures to determine how best to value collateral, particularly to protect against unexpected market
events. Accurate valuation is important because there
is delay between the time the collateral is pledged
and the time when it has to be sold to cover losses.
In the interim, the collateral can change value and to
account for this possibility, haircuts are placed on the
value of the collateral. García and Gençay focused on
the tradeoff between requiring additional (costly) collateral as a result of increasing the haircut and the resulting lower risk associated with an extreme (tail)
event because of the additional collateral. Their work
evaluates commonly used practices to calculate the
haircuts and finds favor with extreme value theory,
arguing that it leads to efficient haircuts and adequately
accounts for events that could significantly affect the
value of the collateral.
The researchers’ goal is to develop a measure of
the risk–cost frontier that indicates the tradeoff between the probability of an extreme tail event occurrence and the increased costs associated with holding



additional collateral. To develop the measure, García
and Gençay used alternative measures of the cost of
risk—measured as value at risk (VaR) and expected
shortfall (the average loss given that the VaR has been
exceeded, also noted as ES)—and alternative distributional assumptions concerning the returns on the
assets. Extreme events are in the tails of the distribution, and past studies have shown that the assumption
of normally distributed returns probably understates
the true probability of the extreme events. To account
for this, the authors use extreme value theory, which
allows for a return distribution with “fat tails.” They
then do a comparison using the alternative return distributions and different measures of the cost of risk—
VaR or ES. Using simulated equity returns data, they
find that using extreme value theory results in accurate risk measures when using either VaR or ES. Thus,
extreme value theory leads to efficient measures of
haircuts that adequately reflect the risk derived from
the tail of the return distribution.
Additional analysis using real data from the
Canadian airline industry produced similar results.
In future research, they intend to extend the analysis
to cover portfolios of collateral instead of individual
securities and to analyze the valuation of debt instruments for extreme events.
The final paper in this session was by John Cotter
of University College Dublin and Kevin Dowd of
Nottingham University and was in the same vein as
García and Gençay. However, Cotter and Dowd (2006)
focused on the choice of a risk measure and the resulting characteristics of the measure. The risk measures
considered include VaR, ES, and the spectral risk
measure (SRM). Moving from VaR to ES allows the
model to take into account additional information by
calculating the average loss once the VaR is exceeded. Going still further, the SRM allows the model to
take into account the degree of risk aversion of the
users—that is, the attitude toward losses. It could do
this by placing different weights (greater, for example)
on higher losses further out in the tail of the loss distribution. Thus, a clear expected pecking order emerges,
with ES being preferred to VaR, and SRM estimators
better in principle than the ES.
The authors applied the analysis to real data on
heavily traded futures contracts—S&P500, FTSE100,
DAX, Hang Seng, and the Nikkei225—from 1991 to
2003. Somewhat surprisingly, they find all risk measures
lead to similar estimates. The S&P500 and FTSE100
contracts appear to be the least risky and the Hang
Seng the most risky contract. The VaR and ES estimates
have fairly similar degrees of precision, but SRM estimators were found to be somewhat less precise.

10

The discussant for this session, Jean-Charles
Rochet of the University of Toulouse, praised the authors for providing clear descriptions of current stateof-the-art risk-management approaches. However, he
argued that he would like to see a clearer conceptual
framework for evaluating the alternative measures. Is
there a means to determine how to optimally combine
different risk-management tools, such as margin requirements, clearing funds, and capital? How are risks and
costs traded off? And how is it optimally done with
a multiple tool set? He stressed the need for a more
comprehensive optimization process that should take
into account all relevant parties and not just the clearing service providers.
Another session evaluated the implications of alternative CCP risk-management arrangements in light
of recent industry innovations. John P. Jackson and
Mark J. Manning (2006) of the Bank of England considered the potential impact of two distinct trends in
the clearing arena: an expansion in the range of products cleared via CCPs and the recent trend toward CCP
industry consolidation. They approached the problem
by constructing an analytical framework that expands
upon the central idea of earlier work by Baer, France,
and Moser (2004) that collateral has a cost that must
be incorporated when deciding on optimal risk-management procedures. They then simulate the implications of the industry moving from a single product,
bilateral clearing arrangement to a multiproduct, multilateral clearing arrangement for replacement costs
and risk.
To summarize their results, moving from bilateral
to multilateral netting results in significant decreases
in risk and costs. Benefits increase, but at a decreasing
rate, as the number of members in the clearing arrangement increases. Margin-pooling benefits are also realized when multiple assets are cleared through a single
CCP. The extent of the risk reduction is shown to depend on the variance and covariance of price changes
and trading positions in the assets held. Finally, the
benefits of consolidation were found to increase more
if margin was set on a portfolio basis instead of an asset-by-asset basis. Applying data from LIFFE (London
International Financial Futures Exchange) on open
interest in the EURIBOR (Europe Interbank Offered
Rate) and FTSE100 futures contracts, their analysis
shows that the expected replacement cost losses were
20 percent lower when contracts cleared through separate CCPs were consolidated into one.
Finally, Rajna Gibson and Carsten Murawski
(2006) of the Swiss Banking Institute emphasized the
distinct difference in the performance of exchangetraded derivatives and OTC derivative products.

4Q/2006, Economic Perspectives

While exchanges have not recently experienced notable credit events, the same cannot be said of OTC
market products. On the surface, they suggest that it
appears that risk-mitigation mechanisms used by the
exchanges have been relatively more effective than
those used in the OTC market. In general, however,
the authors argued that the impact of risk-mitigation
mechanisms is not fully understood and needs to be
more fully analyzed. To initiate that analysis, they
evaluate the affect of various mechanisms on market
liquidity, default risk, and the wealth of market participants. The risk-mitigation procedures considered
include initial margin, initial margin plus variation
margin, and initial and variation margin combined
with a CCP arrangement.
The authors conducted their analysis within a
dynamic model of swap contracts where all market
participants are hedgers—thus, there are no speculators to add liquidity to the market. Banks are given an
initial endowment and use the funds to trade derivatives contracts with each other to hedge the price risk
to their initial endowment. Given the complexity of
the model with numerous nonlinearities, the model is
analyzed via simulations. While the model is an abstraction from actual markets, it is thought to capture
the features of derivatives markets. These features include significant market concentration, significant
credit exposures in derivatives contracts, participants’
requirement to pledge cash as collateral, and a zero
capital requirement to cover default risk exposure for
contracts supported by a CCP.
The analysis is conducted in a period of extreme
stress when risk-mitigation mechanisms are deemed
to be most needed. Under these conditions, the authors’
analysis indicates that default rates actually increase
as risk-mitigation efforts are increased. Introducing
initial margin generates perverse effects as it increases
default severity (losses given default). Having margin
combined with a central counterparty tends to reduce
loss-given default but, in some cases, impairs a bank’s
ability to hedge and, on net, has negative consequences for the bank’s wealth. Thus, the authors conclude
that default-risk-mitigation mechanisms might have a
negative effect on wealth at times when market participants expect them to be most valuable.
The discussant for this session, James Moser of
the Commodity Futures Trading Commission, raised

Federal Reserve Bank of Chicago

issues related to the assumptions employed in the
modeling of risk-mitigation behavior. However his
major point was one directed at market regulators.
There is frequently a tendency to believe that, without regulators, exchanges would be slow to respond
to risks. In fact, Moser’s research finds exactly the
opposite result, that is, the market responds relatively
quickly to mitigate risks. This does not occur because
exchanges are more risk averse, but rather because
the inclination to manage risk results from an interest
in increasing trading volumes. Thus, it is in the interest
of the exchanges to mitigate risk. Firmly establishing
the self-interest of exchanges adds to the credibility
of their risk-mitigation efforts and affects policy choices.
Research, such as the two papers in this session, can
be seen as attempts to identify and begin to understand the linkages between trading activities and the
risk-management practices of exchanges.
Conclusion
One goal of the conference was to bring together
policymakers, researchers, and industry practitioners
to engage in a multidisciplinary discussion of key legal,
risk-management, and public policy issues relating to
central counterparty clearing arrangements. Toward
that goal, the participants debated how these structures might best evolve to meet the clearing and settlement needs of the dynamic and growing financial
markets around the world.
Another goal of the conference sponsors was to
encourage further research concerning the clearing
and settlement of payments, with special interest in
risk-mitigation processes. Thus, there was an attempt
to bring together top researchers in this area to discuss
their current work and explore the potential for future
research. The conference clearly succeeded in gathering together in one place researchers who have done
seminal work in this area. This was evident in John
Jackson’s comments about the state of the economic
literature concerning CCPs. Looking at the audience
and his fellow panelists, Jackson noted “…. you’re all
here!” Whether the conference promotes further research in this area remains to be seen. The sponsors
are hopeful that it will.

11

NOTES
The Clearing Corporation, formerly known as the Board of Trade
Clearing Corporation, was the clearinghouse for the Chicago Board
of Trade until the creation of the “common clearing link” for the
Board of Trade and the Chicago Mercantile Exchange.
1

As further discussed later in this article, it is imperative that the
substitution of the CCP for each of the counterparties be legally
binding. This is often achieved via a process known as novation.
2

The complete program is included in appendix 2. Additional information, including drafts of some of the presentations, is available
at www.ecb.int/events/conferences/html/ccp.en.html

The push for consolidation in Europe is exemplified in comments
by McCreevy (2005) and joint statements by AFEI/Assosim/FBF/
LIBA/SSDA (2005, 2006). The 2006 statement is exceptionally far
reaching and calls for “…the imposition of the unbundling of the
vertical silos if private stakeholders do not start the process on their
own” [italics added].
13

Broadly speaking, Gisler and Taylor took positions consistent
with the former group, and Giovannini and Chan with the latter.
14

3

For discussions of the historical evolution of clearing and settlement arrangements, see Moser (1994, 1998), Kroszner (2000), and
Schaede (1991).
4

More accurately, it has exposure to each clearing member of the
CCP. Traders that are not members of the CCP must have their
trades cleared by clearing members.
5

Haircuts are discounts applied to the market value of securities
that have been posted as collateral.
6

See Koeppl and Monnet (2006).

7

See for example, Considine (2001). See also Baer and Evanoff
(1991) for a discussion of netting in payments more generally.
8

Bliss and Papathanassiou (2006) stressed the problems associated
with legal uncertainty and the efforts in both the U.S. and Europe
to address the concerns.
9

See appendix 3 for the Bank for International Settlements,
Committee on Payment and Settlement Systems and the Technical
Committee of the International Organization of Securities
Commissions (CPSS–IOSCO) best practice recommendations
for CCPs.
10

While not disputing the point, Rubin Lee (2006) of the Oxford
Finance Group made the argument that he thought that concerns
about the systemic risk associated with clearing and settlement institutions were “exaggerated.”
11

See Bank for International Settlements, Committee on Payment
and Settlement Systems and Technical Committee of the
International Organization of Securities Commissions (2004). The
Task Force was jointly established by the Committee on Payment
and Settlement Systems (CPSS) of the central banks of the Group
of Ten countries and the Technical Committee of the International
Organization of Securities Commissions (IOSCO).
12

12

See, for example, Berger, Hanweck, and Humphrey (1987) and
Evanoff and Israilevich (1995).
15

The National Securities Clearing Corporation (NSCC) acts as a
CCP for broker-to-broker equity, corporate bond and municipal
bond, exchange-traded funds, and unit investment trust (UIT)
trades in the U.S.; the Fixed Income Clearing Corporation (FICC)
acts as a CCP for government securities and certain mortgagebacked securities; and the Emerging Markets Clearing Corporation
(EMCC) acts as a CCP for emerging market securities.
16

See McCreevy (2005) and joint statements of AFEI/Assosim/
FBF/LIBA/SSDA (2005, 2006).
17

CCPs are typically associated with exchange-traded products.
However, there has been a recent push to move OTC contracts to
CCPs when the characteristics of the products allow it; for example,
when products are sufficiently standardized. The conference discussion covered some of these issues, but most of the discussion
concerning a (non-CCP) facility introduced by the Depository
Trust and Clearing Corporation to help in administrative issues,
such as trade confirmation, matching, assignment, and reconciliation. See the comments of Peter Axilrod (2006) of the DTCC.
18

The Directive on Markets in Financial Instruments of 2004 has
already required this for CCPs (2004/39/EC).
19

Wendt uses the term to describe the funds that are paid by a clearing
member to settle any losses resulting from price changes, independent of whether the funds are maintained at the CCP or are passed
through to the members profiting from the price change. However,
whether the funds are held or passed through by the CCP has implications for its ability to manage member defaults.
20

21

This point was raised by the discussant, Jean-Charles Rochet.

4Q/2006, Economic Perspectives

Federal Reserve Bank of Chicago

APPENDIX 1: derivatives and OTc CENTRAL COUNTERPARTIESa

A. Organizational information on CCPs in the European Union
Member state	

CCP	

Austria	
	

Ownership structure	

Instruments and products cleared

Central Counterparty Austria 	
Commercial entity	
GmbH (CCP.A)b		

50% Wiener Börse, 50% Oesterreichische 	
Kontrollbank (the settlement bank)	

Derivatives and securities

Belgium	
	

LCH.Clearnet S.A., a subsidiary	
of LCH.Clearnet Group	

Bank	

See France	

See France

Denmark 	

Stockholmsbörsen ABc	

Commercial entity	

Group owned; see Sweden	

Derivatives

Finland	

Stockholmsbörsen ABd 	

Commercial entity	

Group owned; see Sweden	

See Sweden

Bank authorized by the	
“Comité des Etablissements	
de Crédit et des Entreprises	
d’Investissement” with their	
ongoing supervision being 	
performed by the “Commission 	
Bancaire.” Its rules have to be	
approved by the Autorité des 	
Marchés Financiers (AMF)	

Subsidiary of Euronext, branches in 	
Belgium and Amsterdam. LCH.Clearnet 	
Group is owned 45.1% by exchanges; 	
45.1% by former members of LCH; and	
9.8% by Euroclear.	
Of the 45.1% owned by exchanges,	
Euronext owns 41.5%, but its voting rights	
are limited to 24.9%

Equities and bonds; warrants;
exchange-traded derivatives; swaps; 	
commodity and energy; interest rate
& commodity futures and options;
equity and index futures & options;
OTC-traded bonds and repos

Public company, 100% affiliate of Eurex 	
Frankfurt AG, an 100% affiliate of Eurex 	
Zurich AG, which owned in equal parts 	
by Deutsche Börse AG and the SWX Swiss 	
Exchange

Equities, derivatives, repos and bonds,
OTC options, and futures corresponding
to those contracts admitted for trading
on Eurex Deutschland and Eurex Zurich

France	
LCH.Clearnet S.A., 	
	
(Banque Centrale de 	
	
Compansation) a subsidiary	
	
of LCH.Clearnet Group	
		
		
		
		
		

Corporate form	

Germany	
EUREX Clearing AG	
Commercial entity	
			
			
			
			
	

Clearing Bank Hannover	

Commercial entity		

Greece	
ADECH 	
Commercial entity	
			
			
	
Hungary	
KELER	
Public limited company	
			
			

Agricultural and energy products

A 99% subsidiary of Hellenic Exchanges, 	
which is owned by local banks and foreign
and local investors

Derivatives and repos

Owned by Magyar Nemzeti Bank (53.33%), 	
Budapesti Stock Exchange (26.67%), and
the Budapest Commodity Exchange (20%)	

Derivatives, spot markets, OTC

13

Irelande 	
EUREX Clearing AG	
See Germany	
See Germany	
				

Irish securities and exchange-traded
funds (ETFs)

14

APPENDIX 1: derivatives and OTc CENTRAL COUNTERPARTIESa (continued)
Member state	

CCP	

Corporate form	

Ownership structure	

Instruments and products cleared

Italy	
Cassa di Compensazione e	
		

Commercial entity 	
Garanzia (CC&G)	

Since 2000, the Italian Stock Exchange has	
the majority with 86%	

Exchange-traded derivatives and equities	
since 2003

Netherlands 	
	

LCH.Clearnet S.A., a subsidiary	
of LCH.Clearnet Group

Bank	

See France	

See France

Portugal	

LCH.Clearnet S.A.	

Bank	

See France	

See France

Spain 	
MEFF 	
		

Commercial entity, division of 	
MEFF Exchange	

Group-owned by MEFF–AIAF–SENAF	
Holding de Mercados Financieros	

Exchange traded derivatives; OTC trades

Sweden 	

Commercial entity	

Group-owned by OMHEX Group 	

Derivatives; OTC fixed income products

Commercial entity; recognized	
Clearing House (RCH) supervised 	
by the FSA under the UK’s Financial
Services and Market Act 2000
(FSMA).

Group-owned, a subsidiary of LCH.Clearnet 	
Group, see also France

Equities, derivatives, repos, and swaps

Stockholmsbörsen AB	

United 	
LCH.Clearnet Ltd; founded in 	
Kingdom 	
1888 as The London Produce 	
	
Clearing House, Limited 	
		
		

From Bliss and Papathanassiou (2006). The list should not be considered exhaustive.
Operational as of January 2005.
c
Operational as of February 2006.
d
Operational as of January 2005.
e
As of December 5, 2005.
a

b

4Q/2006, Economic Perspectives

Federal Reserve Bank of Chicago

APPENDIX 1: derivatives and OTc CENTRAL COUNTERPARTIESa (continued)

B. Organizational information of derivatives clearing organization in the U.S.
CCP	

Corporate form	

Ownership structure	

Instruments and products cleared

AE Clearinghouse, ILLC	
Subsidiary of the Actuarials Exchange	
Exchange owned 	
			
			
			

Cash settled OTC contracts excluded from
the Commodity Exchange Act (CEA)
executed on a board of trade exempted
from the CEA.

The Clearing Corporation	
(CCorp)	
	

Euro denominated products traded on Eurex

Commercial entity; first founded in	
Owned by its members	
1925 as the Board of Trade Clearing
Corporation		

Chicago Board of Trade (CBOT)	
As of 2005, stock company (exchange 	
	
founded in 1848)	
		
		
		
		

As of 2005, stock, for-profit holding	
company with stockholders (CBOT 	
Holdings) and Board of Trade of the 	
City of Chicago, Inc., a nonstock, 	
for profit derivatives exchange subsidiary
with members (CBOT)	

Futures and options on futures
From 2004 to 2008, the CME provides clearing
for CBOT and CME products, with the possibility
of extension through the Common Clearing Link.
Futures and options on futures

CME Clearing House	
Clearing division of the Chicago 	
Exchange owned. Since 2002, CME has	
	
Mercantile Exchange Holding, Inc. 	
been (the first) publicly traded exchange	
	
(CME), a Delaware corporation	
in the U.S.	
	
founded in 1898		
			
			

CME provides clearing to CME products;
futures and options related to agricultural
commodities, equity index, foreign exchange,
interest rate, weather, energy. With effect
as of 2004, CME provides clearing for all
CBOT products

Hedge Street, Inc.	
Division of Hedge Street Inc. a 	
Exchange owned; affiliate of Hedge 	
	
Delaware corporation	
Street Inc.	
			

Fully collateralized cash settled futures and
options listed for trading on the market
HedgeStreet Inc.

Kansas City Board of 	
Trade Clearing	
Corporation	

Commercial entity, wholly owned	
subsidiary of the Exchange Kansas	
Trade Clearing Corporation 	

Futures and options

LCH.Clearnet Ltd.	
(LCH)	

Commercial entity, subsidiary of	
See Belgium	
LCH Ltd		

OTC interest rate swaps and commercial
energy products, financial futures and options

MGE Clearing House	
	

Department of the Minneapolis Grain 	
Exchange, a private company (MGE)	

Futures and options

Exchange owned; the exchange is member	
owned

Exchange owned. The MGE is a nonprofit,	
membership organization	

15

16

APPENDIX 1: derivatives and OTc CENTRAL COUNTERPARTIESa (continued)

B. Organizational information of derivatives clearing organization in the U.S.
CCP	

Corporate form	

Ownership structure	

New York Clearing Corporation	
(NYCC)	
	
	
	
	
	
	
	

Not-for-profit Corporation under the	
Exchange owned, subsidiary of the NYBOT, 	
Laws of the State of New York founded 	
a member owned exchange.
in 1915, designated clearing organization 		
for the Board of Trade of the City of New
York, Inc. (NYBOT). NYBOT is the only
designated contract market after the merger
of the Coffee, Sugar & Cocoa Exchange,
Inc. (CSCE) and the New York Cotton
Exchange (NYCE) was completed in 2004

NYMEX Clearing House	
Division of the New York Mercantile 	
Exchange owned	
	
Exchange (NYMEX)
	
The Options Clearing Corporation 	
Corporation under the laws of Delaware	
Exchange owned. It is equally owned by the	
(OCC)	
founded in 1973	
American Stock Exchange, the Chicago Board
		
Options Exchange, the International Securities 	
		
Exchange, the Pacific Exchange, and the
		
Philadelphia Stock Exchange 	
			

Instruments and products cleared
Futures and options	

OTC energy contracts, futures
Equity derivatives, securities options.	
Security futures
Commodity futures and options on
commodity futures

From Bliss and Papathanassiou (2006). The list should not be considered exhaustive. Summary information on CCPs associated with the DTCC is provided in footnote 16 of the article.
Operational as of January 2005.
c
Operational as of February 2006.
d
Operational as of January 2005.
e
As of December 5, 2005.
a

b

4Q/2006, Economic Perspectives

	

APPENDIX 2: 	Issues related to Central Counterparty Clearing
	
Joint Conference of the EUROPEAN CENTRAL BANK and
	the FEDERAL RESERVE BANK OF CHICAGO
	

Monday, April 3, 2006
Opening Remarks: Gertrude Tumpel-Gugerell, Member of the Executive Board of the European Central Bank
Panel 1 Setting the Context
Chair: Patrick M. Parkinson, Board of Governors of the Federal Reserve System
Diana Chan, Citigroup
Yvon Lucas, Banque de France
Tomoyuki Shimoda, Bank of Japan
John Trundle, Euroclear SA/NV
Lunch
Keynote Speech: Randall S. Kroszner, Governor, Board of Governors of the Federal Reserve System
Invited Session I
CCP Foundational Issues
Chair: Robert Steigerwald, Federal Reserve Bank of Chicago
Derivatives clearing, central counterparties and novation: the economic implications
Robert Bliss, Wake Forest University, and Chryssa Papathanassiou, European Central Bank
Central counterparties
Thorsten Koeppl, Queen’s University, and Cyril Monnet, European Central Bank
Discussant: Charles Kahn, University of Illinois
Invited Session II
Collateral and Margins
Chair: Douglas Evanoff, Federal Reserve Bank of Chicago
Intraday margining of central counterparties: EU practice and a theoretical evaluation of benefits and costs
Froukelien Wendt, De Nederlandsche Bank
Valuation of collateral in securities settlement systems for extreme market events
Alejandro García, Bank of Canada, and Ramo Gençay, Simon Fraser University
Extreme spectral risk measures: an application to futures clearinghouse margin requirements
John Cotter, University College, Dublin, and Kevin Dowd, Nottingham University
Discussant: Jean-Charles Rochet, University of Toulouse
Conference Dinner
Dinner Speech: Tommaso Padoa-Schioppa, Minister of Economic Affairs and Finance, Italy, and
Former Member, Executive Board, European Central Bank

Tuesday, April 4, 2006
Panel II
Industry Structure and Developments
Chair: Alberto Giovannini, Unifortune Asset Management SGR
Peter Axilrod, The Depository Trust and Clearing Corporation
Daniel Gisler, Eurex
David Hardy, LCH.Clearnet Limited
Kimberly S. Taylor, Chicago Mercantile Exchange

Federal Reserve Bank of Chicago

17

APPENDIX 2: 	 Issues related to Central Counterparty Clearing
	
Joint Conference of the EUROPEAN CENTRAL BANK and
	the FEDERAL RESERVE BANK OF CHICAGO (continued)

Session III
CCP Risk Management
Chair: Jens Tapking, European Central Bank
Comparing the pre-settlement risk implications of alternative clearing arrangements
John P. Jackson and Mark J. Manning, Bank of England
Default risk mitigation in derivatives markets and its effectiveness
Rajna Gibson and Carsten Murawski, Swiss Banking Institute
Discussant: James T. Moser, Louisiana Tech University and Commodity Futures Trading Commission
Lunch
Keynote Speech: Michael Moskow, President, Federal Reserve Bank of Chicago
Panel III
CCPs and the Future Development of Financial Market Clearing and Settlement
Chair: Daniela Russo, European Central Bank
Jill Considine, The Depository Trust and Clearing Corporation
Ruben Lee, Oxford Finance Group
Mario Nava, European Commission
Concluding Remarks: Jean-Claude Trichet, President, European Central Bank

Appendix 3: 	CPSS–IOSCO technical committee recommendations for central
	counterparties (CCPs)
	
CPSS–IOSCO Recommendations for Central Counterparties (CCPs)
1. Legal risk
A CCP should have a well founded, transparent, and enforceable legal framework for each aspect of its activities in all relevant jurisdictions.
2. Participation requirements
A CCP should require participants to have sufficient financial resources and robust operational capacity to meet obligations
arising from participation in the CCP. A CCP should have procedures in place to monitor that participation requirements are
met on an ongoing basis. A CCP’s participation requirements should be objective, publicly disclosed, and permit fair and
open access.
3. Measurement and management of credit exposures
A CCP should measure its credit exposures from its participants at least once a day. Through margin requirements, other
risk-control mechanisms or a combination of both, a CCP should limit its exposures to potential losses from defaults by its
participants in normal market conditions, so that the operations of the CCP would not be disrupted and participants that are
not in default would not be exposed to losses that they cannot anticipate or control.
4. Margin requirements
A CCP that relies on margin requirements to limit its credit exposures to participants should have sufficient margin requirements to cover potential exposures in normal market conditions. The models and parameters used in setting margin requirements should be risk based and reviewed regularly.

18

4Q/2006, Economic Perspectives

Appendix 3: 	 CPSS-IOSCO technical committee recommendations for central
	counterparties (CCPs) (continued)
5. Financial resources
A CCP should maintain sufficient financial resources to withstand a default by the participant to which it has the largest exposure in extreme but plausible market conditions.
6. Default procedures
A CCP’s default procedures should be clear and transparent, and they should ensure that the CCP can take timely action to
contain losses and liquidity pressures and to continue meeting its obligations. Key aspects of the default procedures should
be publicly available.
7. Custody and investment risks
A CCP should hold assets in a manner whereby risk of loss or of delay in its access to them is minimized. Assets invested by
a CCP should be held in instruments with minimal credit, market, and liquidity risks.
8. Operational risk
A CCP should identify sources of operational risk and minimize them through the development of appropriate systems, control, and procedures. Systems should be reliable and secure and have adequate, scalable capacity. Business continuity plans
should allow for timely recovery of operations and fulfillment of a CCP’s obligations.
9. Money settlements
A CCP should employ money settlement arrangements that eliminate or strictly limit its settlement bank risks, that is, its
credit and liquidity risks from the use of banks to effect money settlements with its participants. Funds transfers to the CCP
should be final when effected.
10. Physical deliveries
A CCP should clearly state its obligations with respect to physical deliveries. The risks from these obligations should be
identified and managed.
11. Risks in links between CCPs
A CCP that establishes links either cross-border or domestically to clear trades should evaluate the potential sources of risks
that can arise, and ensure that the risks are managed prudently on an ongoing basis. There should be a framework for cooperation between the relevant regulators and overseers.
12. Efficiency
While maintaining safe and secure operations, CCPs should be cost-effective in meeting the requirements of participants.
13. Governance
Governance arrangements for a CCP should be effective, clear and transparent to fulfill public interest requirements and to
support the objectives of owners and users. In particular, they should promote the effectiveness of the CCP’s risk-management procedures.
14. Transparency
A CCP should provide market participants with sufficient information for them to identify and evaluate accurately the risks
and costs associated with using its services.
15. Regulation and oversight
A CCP should be subject to transparent and effective regulation and oversight. In both a domestic and an international context, central banks and securities regulators should cooperate with each other and with other relevant authorities.

Sources: Bank for International Settlements (BIS), Committee on Payment and Settlement Systems of the central banks of the Group of Ten
countries (CPSS) and Technical Committee of the International Organization of Securities Commissions, 2004, exhibit 1.

Federal Reserve Bank of Chicago

19

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AFEI (French Association of Investment Firms),
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(London Investment Banking Association), and
SSDA (Swedish Securities Dealers Association),
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Chan, Diana Y., 2006, “Central counterparties: A user’s perspective,” presentation made at the European
Central Bank and Federal Reserve Bank of Chicago
joint conference, “Issues Related to Central Counterparty Clearing,” Frankfurt, Germany, April 3–4.

__________, 2005, “Statement of principles to be
applied to the consolidation of stock exchange and
infrastructure providers in Europe,” joint statement,
February 3.

Considine, Jill, 2006 “Remarks: CCPs and the future
development of financial market clearing and settlement,” presentation made at the European Central
Bank and Federal Reserve Bank of Chicago joint
conference, “Issues Related to Central Counterparty
Clearing,” Frankfurt, Germany, April 3–4.

Axilrod, Peter, 2006, “DTCC Deriv/SERV: Trade
information warehouse,” presentation made at the
European Central Bank and Federal Reserve Bank of
Chicago joint conference, “Issues Related to Central
Counterparty Clearing,” Frankfurt, Germany, April 3–4.

__________, 2001, “Embracing, but risk-managing
our differences: The DTCC perspective on capital markets without borders,” in Capital Markets of the 21st
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Baer, Herbert L. and Douglas D. Evanoff, 1991,
“Financial globalization: Payments system issues and
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Cotter, John, and Kevin Dowd, 2006, “Extreme spectral risk measures: An application to futures clearinghouse margin requirements,” presentation made at the
European Central Bank and Federal Reserve Bank of
Chicago joint conference, “Issues Related to Central
Counterparty Clearing,” Frankfurt, Germany, April 3–4.

Baer, Herbert L., Virginia G. France, and James T.
Moser, 2004, “Opportunity cost and prudentiality: An
analysis of collateral decisions in bilateral and multilateral settings,” Research in Finance, Vol. 21.
Bank for International Settlements (BIS), Committee on Payment and Settlement Systems (CPSS)
and Technical Committee of the International
Organization of Securities Commissions (IOSCO),
2004, Recommendations for Central Counterparties,
Basel, Switzerland, November.
Berger, Allen N., Gerald A. Hanweck, and David
B. Humphrey, 1987, “Competitive viability in banking: Scale, scope, product mix economies,” Journal
of Monetary Economics, Vol. 20, No. 3, December,
pp. 501–520.
Bliss, Robert R., and Chryssa Papathanassiou,
2006, “Derivatives clearing, central counterparties,
and novation: The economic implications,” presentation made at the European Central Bank and Federal
Reserve Bank of Chicago joint conference, “Issues
Related to Central Counterparty Clearing,” Frankfurt,
Germany, April 3–4.

20

Evanoff, Douglas D., and Philip R. Israilevich, 1995,
“Scale elasticity versus scale efficiency in banking,”
Southern Economic Journal, Vol. 61, No. 4, April,
pp. 1036–1046.
García, Alejandro, and Ramo Gençay, 2006, “Risk–
cost frontier and collateral valuation in securities settlement systems for extreme market events,” presentation
made at the European Central Bank and Federal Reserve Bank of Chicago joint conference, “Issues Related to Central Counterparty Clearing,” Frankfurt,
Germany, April 3–4.
Gibson, Rajna, and Carsten Murawski, 2006,
“Default risk mitigation in derivatives markets and
its effectiveness,” presentation made at the European
Central Bank and Federal Reserve Bank of Chicago
joint conference, “Issues Related to Central Counterparty Clearing,” Frankfurt, Germany, April 3–4.
Giovannini, Alberto, 2006, “Industry structure and
developments,” presentation made at the European
Central Bank and Federal Reserve Bank of Chicago
joint conference, “Issues Related to Central Counterparty Clearing,” Frankfurt, Germany, April 3–4.

4Q/2006, Economic Perspectives

Gisler, Daniel, 2006, “Value of CCP in the light of
Basel II,” presentation made at the European Central
Bank and Federal Reserve Bank of Chicago joint
conference, “Issues Related to Central Counterparty
Clearing,” Frankfurt, Germany, April 3–4.
Hardy, David, 2006, “The need to remove structural
barriers to consolidation of CCP clearing,” presentation made at the European Central Bank and Federal
Reserve Bank of Chicago joint conference, “Issues
Related to Central Counterparty Clearing,” Frankfurt,
Germany, April 3–4.
Jackson, John P., and Mark J. Manning, 2006,
“Comparing the pre-settlement risk implications of
alternative clearing arrangements,” presentation made
at the European Central Bank and Federal Reserve
Bank of Chicago joint conference, “Issues Related to
Central Counterparty Clearing,” Frankfurt, Germany,
April 3–4.
Koeppl, Thorsten V., and Cyril Monnet, 2006,
“Central counterparties,” presentation made at the
European Central Bank and Federal Reserve Bank
of Chicago joint conference, “Issues Related to Central Counterparty Clearing,” Frankfurt, Germany,
April 3–4.
Kroszner, Randall S., 2000, “Lessons from financial
crises: The role of clearinghouses,” Journal of Financial Services Research, Vol. 18, No. 2–3, December,
pp. 157–171.
Lee, Ruben, 2006, “CCPs and the future development
of financial market clearing and settlement,” presentation made at the European Central Bank and Federal
Reserve Bank of Chicago joint conference, “Issues
Related to Central Counterparty Clearing,” Frankfurt,
Germany, April 3–4.
Lucas, Yvon, 2006, “Experience of using RCCPs:
Assessment of LCH.Clearnet S.A.,” presentation
made at the European Central Bank and Federal
Reserve Bank of Chicago joint conference, “Issues
Related to Central Counterparty Clearing,” Frankfurt,
Germany, April 3–4.
McCreevy, Charlie, 2005, “Fund management—
Regulation to facilitate competitiveness, growth, and
change,” speech given at the 14th Annual Europe–USA
Investment Funds Forum, Luxembourg, September 13.

Federal Reserve Bank of Chicago

Moser, James T., 1998, “Contracting innovations and
the evolution of clearing and settlement methods at
futures exchanges,” Federal Reserve Bank of Chicago,
working paper, No. WP-98-26.
, 1994, “Origins of the modern exchange
clearinghouse: A history of early clearing and settlement methods at futures exchanges,” Federal Reserve
Bank of Chicago, working paper, No. WP-94-3.
Nava, Mario, 2006, “Issues related to central counterparty clearing,” presentation made at the European
Central Bank and Federal Reserve Bank of Chicago
joint conference, “Issues Related to Central Counterparty Clearing,” Frankfurt, Germany, April 3–4.
Schaede, Ulrike, 1991, “The development of organized futures trading: The Osaka rice bill market of
1730,” in Japanese Financial Market Research,
William T. Ziemba, Warren Bailey, and Yasushi
Hamao (eds.), Amsterdam: North Holland Publishing.
Shimoda, Tomoyuki, 2006, “Exchanges and CCPs:
Communication, governance, and risk management,”
presentation made at the European Central Bank and
Federal Reserve Bank of Chicago joint conference,
“Issues Related to Central Counterparty Clearing,”
Frankfurt, Germany, April 3–4.
Taylor, Kimberly S., 2006, “CCP performance: Structure or behavior,” presentation made at the European
Central Bank and Federal Reserve Bank of Chicago
joint conference, “Issues Related to Central Counterparty Clearing,” Frankfurt, Germany, April 3–4.
Trundle, John, 2006, “The context: Some personal
reflections,” presentation made at the European Central Bank and Federal Reserve Bank of Chicago joint
conference, “Issues Related to Central Counterparty
Clearing,” Frankfurt, Germany, April 3–4.
Wendt, Froukelien, 2006, “Intraday margining of
central counterparties: EU practice and a theoretical
evaluation of benefits and costs,” presentation made
at the European Central Bank and Federal Reserve
Bank of Chicago joint conference, “Issues Related to
Central Counterparty Clearing,” Frankfurt, Germany,
April 3–4.

21

Derivatives clearing and settlement: A comparison of central
counterparties and alternative structures
Robert R. Bliss and Robert S. Steigerwald

Introduction and summary
The past several decades have seen fundamental transformations in the size, structure, and liquidity of world
financial markets. Equity markets have fluctuated in
value (currently about $17 trillion for U.S. equities)
and have introduced new products such as exchangetraded funds (mutual funds that trade like equities).
Increasingly, structured equity products combine derivatives and cash market positions to manage equity
risks. Debt markets have grown rapidly (currently
about $26 trillion for the U.S.1), with the greatest growth
coming from mortgage- and asset-backed securitizations. Recently, credit derivatives (currently $26 trillion
in notional value2) have begun to supplement and even,
in some instances, replace cash markets in debt. Derivatives markets, of which over-the-counter (OTC)
interest rate swaps are by far the largest component,
have grown to $284 trillion in notional value.3
These changes have facilitated economic growth.
Where banks once held the loans and mortgages they
originated, these are now routinely securitized and
sold to domestic and foreign investors, thus increasing the pool of capital that banks intermediate. The
continuing exponential growth of derivatives markets;
the development of new derivatives instruments; their
impact on financial markets generally; the rapid transformation of traditional institutional arrangements;
and occasional operational, liquidity, and credit problems have all focused attention on what happens after
the trade—the post-trade practices, structures, and arrangements that ensure the smooth and efficient functioning of these markets.4
After a trade involving a financial instrument
such as a derivatives contract is executed, it must be
“cleared” and ultimately “settled.” These terms may
have different meanings in the context of different
market practices, which vary from country to country,

22

as well as from market to market. Nevertheless, clearing typically involves post-trade operations, such as
trade matching, confirmation, registration, as well as
risk-management functions, such as netting, collateralization, and procedures (including “variation settlement” or “variation margin”) that mitigate or eliminate
some forms of credit risk. Settlement, by contrast, involves the transfer of money or assets necessary for
the counterparties to perform (and, in legal terms,
“discharge”) their obligations.
Clearing and settlement systems are critical to
the stability of the financial system, a system that is
increasingly interconnected and global in scope. The
significance of these systems, however, is at times incompletely appreciated by observers. For example,
these functions are sometimes referred to as mere
“plumbing.” In a recent speech, President Michael
Moskow of the Federal Reserve Bank of Chicago
took issue with this usage:5
Post-trade clearing and settlement are sometimes referred to as the plumbing of the
financial system. This term may suggest that
clearing and settlement systems are of secondary importance. In fact, however, they are
more like the central nervous system of the
financial system. Clearing and settlement
systems provide vital linkages among components of the system, enabling them to
work together smoothly. As such, clearing
and settlement systems are critical for the
performance of the economy.
Robert R. Bliss is the F. M. Kirby Chair in Business Excellence at the Calloway School of Business and Accountancy,
Wake Forest University. Robert S. Steigerwald is a senior
professional in the Financial Markets Group of the Federal
Reserve Bank of Chicago. The authors thank David Marshall
and seminar participants at the Federal Reserve Bank of
Chicago.

4Q/2006, Economic Perspectives

This article explores the functions performed by
clearing and settlement institutions for financial markets,
with a particular focus on derivatives, as opposed to
securities, clearing and settlement. The nature of the
counterparty credit risks that arise prior to settlement
are essentially the same in both secondary securities
markets and derivatives markets. The risk that either
the buyer or seller of the security will be unable to perform its obligation (to pay for or deliver the security,
respectively) is conceptually indistinguishable from
the risk that the counterparties to a derivatives contract will be able to perform their obligations as they
fall due.
However, securities transactions also involve functions that have no analogues in derivatives markets.
Securities, unlike derivatives, are financial assets. Securities settlement, therefore, involves the transfer of
the asset against the corresponding payment. This involves the services of institutions, such as custodians,
transfer agents, and others, which have no role in typical derivatives markets and necessitates risk-management procedures that are not typically present in
derivatives markets. For example, risk-management
operations for securities transactions and other linked
payment transactions have been developed to ensure
that both legs of the transaction (that is, the transfer
of the asset and the corresponding payment) are completed or, if there is a failure, to ensure that neither leg
is completed. The risk that one leg of the transaction
may be completed but not the other is known as “settlement risk.”6 The kinds of risk-management operations
that have been developed to mitigate or eliminate this
risk are typically called “delivery versus payment”
(or DvP) or “payment versus payment” (or PvP).
Derivatives contracts are agreements to make payments or transact (buy/sell something) at some time
in the future, ranging from a few days (for example,
futures contracts nearing expiry) to many years (for
example, long-dated interest rate swaps), based on the
value of some underlying asset or index and, in the
case of options, the decision of one of the counterparties. As a result, post-trade processing of derivatives
can involve complexities that are typically missing
from securities clearing and settlement. Box 1 lists
many of the separate functions that may need to be
performed over the life of a typical derivatives contract.
In securities clearing and settlement, the length of
time between the execution of a transaction (in which
the counterparties undertake reciprocal obligations to
deliver a security against payment) is dictated primarily
by operational constraints. The parties do not bargain
for deferred delivery and payment in a typical cash

Federal Reserve Bank of Chicago

securities transaction—they seek the transfer of a particular quantity of securities in exchange for an agreed
payment. The economic purpose of the transaction
would be fulfilled if the transfer and payment took
place immediately, without any delay. Time lags between the execution of a trade and settlement, whether
that lag is one or three or five days in duration, result
from the complex and interrelated operations necessary to complete both legs of the transaction.
With derivatives, however, the length of time between the execution of a transaction and settlement is
essential to the contract. Put another way, the fundamental economic purpose of a derivatives transaction
involves the reciprocal obligations of the parties over
the life of the contract. Of course, the creditworthiness of the parties to a derivatives contract can fluctuate in the interim. This is also true in securities
transactions.7 However, unlike long-dated derivatives
transactions, the obligations of the buyer and seller of
a security are settled within a few days, typically no
more than three or five days, depending upon the security and the market involved.
As a result, the parties to a derivatives contract
are principally dependent upon each other’s creditworthiness to assure future performance in the absence of
mechanisms to transfer that risk. The combination of a
much longer time horizon for completing transactions,
greater uncertainty as to the value (and even direction)
of the ultimate transfer obligations, and the unavoidable significance of counterparty credit risk in derivatives transactions means that substantial performance
(that is, credit) risk is an integral factor in the completion of derivatives transactions, compared with securities or payments transactions.
Derivatives markets have evolved practices and
institutional arrangements to deal with these special
characteristics.8 These in turn have affected the development and structure of derivatives markets. Today,
broadly speaking, two parallel systems exist for clearing and settling derivatives: bilateral clearing and
settlement and central counterparty (CCP) clearing
and settlement. Most OTC derivatives are settled bilaterally, that is, by the counterparties to each contract.
Risk-management practices, such as collateralization,
are also dealt with bilaterally by the counterparties to
each contract.9
In contrast, most exchange-traded derivatives
and some OTC derivatives are cleared and settled
through a CCP. In the case of centrally cleared derivatives markets, the original contract entered into by
two counterparties is automatically replaced by two
contracts, each of which arises between one of the
original counterparties and the central counterparty.

23

BOX 1

Example of the functions required to clear and settle a derivative
Consider a ten-year interest rate swap with a notional
value of $10 million and a fixed rate of 5 percent against
a reference rate of six-month London Interbank Offer
Rate (LIBOR), with semiannual payments in arrears.
This contract calls for 20 semiannual payments to be
computed at the beginning of each payment interval
by taking the difference between the prevailing sixmonth LIBOR and 5 percent and then multiplying that
number by $10 million. This payment is then made at
the end of the six-month interval, at which time the
next period’s payment is also being determined. If the
six-month LIBOR at the beginning of the period is
greater than 5 percent, the payment is made by the
“variable payer” to the “fixed payer” and vice versa.
Clearing and settling this swap involves all of
the following:
n	

Confirming the terms of the contract at its inception;
Determining the payment obligation at the beginning of each six-month interval and notifying the
parties;
n	 Settling payments due at the end of each six-month
interval;
n 	 Maintaining the following records: terms of contract, payments made/received by the counterparties, and names, addresses, and account numbers
of the counterparties;1
n	

Critical risk-management functions are typically carried out by the clearinghouse.
In the remainder of this article, we discuss a number of interrelated functions typically performed by
derivatives clearing and settlement arrangements—
regardless of whether they are centralized (as in markets that utilize CCPs) or not—including:
n	 Counterparty credit-risk-management techniques,
such as netting, collateralization, procedures (such
as DvP and PvP) to mitigate settlement risk, procedures (such as variation settlement) to mitigate
replacement cost (or so-called forward) risk, and
other risk-management mechanisms;
n	

n	
n	

24

Market access restrictions, ongoing credit evaluation, and monitoring;
Crisis management and user default administration;
Loss mutualization, insurance, and other measures
that supplement the CCP’s risk-management mechanisms; and

Preparing reports needed for tax, financial, position, risk-exposure reporting, and so on;
n 	 Valuing the swap for purposes of determining
collateral requirements;
n	 Monitoring counterparty creditworthiness;
n 	 Determining collateral requirements (this usually
involves all positions documented under a master
agreement);
n	 Valuation and monitoring of securities posted
as collateral, and determination of “haircuts” to
be applied to securities posted;2
n 	 Monitoring counterparties for compliance with
the terms of the contract, in particular credit
events defined under the contract;
n 	 Determining whether to exercise closeout rights
when credit events occur; and
n	 Pursuing legal remedies for recovering net amounts
owed under closed out positions, or making net
final payments owed and ensuring legal finality of
closeout obligations.
n	

Even if the swap is not assigned to a new counterparty, this
information can easily change over ten years.
2
Haircuts are discounts applied to the market value of securities
posted as collateral. Thus, a bond with a market value of $10
million may only count as $9 million worth of collateral. Haircuts protect the collateral holder against any fluctuation in the
value of the collateral.
1

Related information collection and administrative
functions necessary to the operation of the clearing
and settlement arrangement.
We then consider how the clearing and settlement
structure (for example, bilateral versus CCP) can affect the functioning of markets. However, our comparison between bilateral and centrally cleared alternatives
does not imply that one is a better model than the other. Bilateral and centrally cleared systems have coexisted for almost a century and are likely to continue to
do so. This has occurred due to the heterogeneous nature of derivatives products and their evolution. Each
clearing method has its pros and cons, and these vary
with the characteristics of the derivative being cleared.
n	

Structure of central counterparties
A CCP can be defined as “... [a]n entity that interposes itself between counterparties to contracts traded
in one or more financial markets, becoming the buyer
to every seller and the seller to every buyer.”10 In other words, a CCP becomes a substituted principal to

4Q/2006, Economic Perspectives

contract obligations originating with other members
of a financial market. Because it stands between market buyers and sellers, the CCP bears no net market risk
exposure—such risk remains with the original counterparties to the trade. Credit risk, on the other hand,
is centralized in the CCP itself. As a result, there is no
need for the original counterparties to initially evaluate
or continuously monitor each other’s creditworthiness.
In fact, in a market that utilizes a CCP, the original parties to a trade may be entirely unknown to each other.
The legal process whereby the CCP is interposed
between buyer and seller is known as novation.11 Novation is the replacement of one contract with another
or, in this case, one contract with two new contracts.
The viability of novation depends on the legal enforceability of the new contracts and the certainty that the
original counterparties are not legally obligated to each
other once the novation is completed. As a result of
novation, the contract between the original counterparties is discharged and the CCP becomes the “buyer to
every seller and the seller to every buyer.”
A CCP is legally obligated to perform on the contracts to which it becomes a substituted counterparty
in place of the original counterparties. However, because the CCP enters into two offsetting positions as
a result of each novation, the CCP is “market neutral”—
the number of long positions will equal the number of
short positions to which the CCP is a party, just as the
number of long and short positions across the market
as a whole cancel out. Thus, a CCP normally bears no
market risk.12 But as counterparty to every position,
the CCP bears credit risk in the event that one of its
counterparties fails. Similarly, the CCP’s counterparties bear the credit risk that the CCP might fail.
CCPs mitigate their credit risk exposure through
a number of reinforcing mechanisms, typically including access restrictions, risk-management tools (such
as collateralization), and loss mutualization. These
mechanisms simultaneously serve to make market
participants indifferent to the actual creditworthiness
of the parties with which they trade on the centrally
cleared market. They also have a number of ancillary
effects that reduce costs to the CCP counterparties
and increase liquidity in the market.
Access restrictions (such as membership requirements) are central structural components of the CCP
arrangement. CCPs only deal with parties that meet
the CCPs’ standards for creditworthiness and operational capability and may revoke access privileges for
those who fail to maintain their creditworthiness and
meet their other obligations to the CCPs. This permits
the CCPs to limit their risk exposure to those parties
they are able to monitor.

Federal Reserve Bank of Chicago

In addition, CCPs typically impose some or all of
the counterparty credit-risk-management techniques
described above. For example, trading obligations
(positions) and payment requirements are multilaterally netted, increasing operational efficiency and reducing the amount at risk. CCPs also typically impose
collateral requirements (sometimes known as initial
margin) on those that have direct access to the CCP.
Margining systems are designed to ensure that in the
event that a clearing member fails to meet a margin
call, sufficient funds remain readily available to close
out the member’s positions without loss to the CCP
in most market conditions. As a complementary riskmanagement mechanism, the gains and losses from
open positions are posted to a clearing member’s margin
account on a regular (usually daily) basis and result
in calls for variation settlement (or variation margin).
The variation settlement reflects periodic mark-to-market fluctuations and is an important mechanism for
assuring the collateral held by the CCP is likely to be
sufficient to meet the needs of the CCP in the event of
a default.
Another mechanism becomes operative if the
posted collateral is not sufficient to offset a loss resulting from the failure of a counterparty. After exhausting the counterparty’s collateral, CCPs typically provide
that any remaining loss will be shared among all (or
certain classes of) clearing members. The details of
such “loss mutualization” arrangements vary, but generally include a clearing or capital fund that is either
paid in by clearing members or built up through accumulated undistributed profits or transaction fee rebates.
The result of the credit standards and margining
systems employed by CCPs and enforced on the market is twofold. Firstly, credit risk is homogenized; and
secondly, credit risk monitoring is delegated. Both of
these effects tend to reduce the costs to market participants. Credit risk is homogenized through standardized margining and member capital requirements.
In addition, the CCP’s risk-management mechanisms
are supplemented by mutualization or loss sharing
and other measures, such as third-party insurance. Since
every clearing member’s counterparty is the CCP, it
does not matter which member a market participant
enters into a trade with. Informational costs and asymmetries may also be reduced by having a central counterparty. Instead of a market where participants must
assess the creditworthiness of their counterparties individually and then act on that assessment, either
through trading decisions or pricing, every clearing
member is required to satisfy well-understood requirements. The CCP then monitors and enforces these requirements, relieving the market participants of the

25

need to do so. Market participants need only have confidence in the creditworthiness of the CCP, which may
be ascertained in various ways, such as public ratings.
Because members are collectively liable for losses, up to a predetermined level, and more importantly
perhaps because they have a collective interest in the
survival of the CCP, they have a strong incentive to
work with and through the CCP to resolve issues. Since
the CCP is the only direct counterparty of a clearing
member, it effectively acts on behalf of the other, nondefaulting clearing members in pursuing legal remedies against any clearing member that defaults. In a
bilaterally cleared market, each counterparty of a
failed market participant would have to look out for
its own interests, which, in principle, would significantly raise legal and administrative costs.
Effects of CCP structure
Novation and the credit-risk-mitigation mechanisms utilized by CCPs have a number of important
effects on how centrally cleared derivatives markets
function. The first and perhaps most important is that
credit risk becomes homogenized, at least as far as
clearing members are concerned. All clearing members meet identical credit requirements and are subject to the same oversight. The homogenization of
credit risk and the structure of mutualized loss sharing facilitate anonymous trading among market participants. This greatly reduces the informational costs
of trading. Unlike bilaterally cleared markets—where
assessments of counterparty credit risk influence the
decisions of which counterparties will trade with which
and which must post collateral and in what amount—
in a centrally cleared market using a CCP, everyone is
equal and the CCP ensures that obligations are met.
Clearing derivatives through a CCP also facilitates
liquidity in another way. Recall that a derivatives contract is established between two particular parties. In
the absence of a CCP, the contract could not easily be
exited except by agreement of both parties (unlike a
security that can simply be sold to a third party). Entering into an offsetting contract with a different counterparty may eliminate the market risk of the combined
positions, but credit risk remains. We’ll call the counterparty to both contracts A and the other two counterparties B and C. If B or C defaults, then A may be
left with a loss on that position and an unhedged position in the remaining contract. Furthermore, since A
has two positions, it may need to hold collateral against
both positions. Only by entering into an identical offsetting contract with the original counterparty and then
getting the counterparty to agree to cancel the offsetting positions (as is usually embodied in the relevant

26

master agreements) can a market participant exit a
position with legal certainty.
The result is that positions tend to be left “on,”
although they have become economically redundant.
Furthermore, redundant positions can easily be built
up across networks of participants. Redundant positions increase administrative burdens but, more importantly, increase the number of positions that would
need to be resolved were a member of the network to
fail. The solution, multilateral netting, requires knowledge and analysis of all the positions of all members
in the network—however, the information needed to
accomplish multilateral netting may include proprietary information that the traders involved may not
wish to share with outsiders. That concern may inhibit the cooperation and disclosure needed in the bilateral markets to accomplish multilateral netting.
In a centrally cleared derivatives market with a
CCP, the rules of the clearinghouse typically provide
for the automatic netting and cancellation of offsetting
contracts. Market participants can easily exit positions
by entering into an offsetting trade with the CCP. The
ability to easily enter into positions (which comes from
credit risk homogenization and delegated monitoring)
and the ability to easily exit positions (by having a
single common counterparty) greatly increase the liquidity of the market.
While liquidity is a great benefit of a CCP-cleared
market, CCPs are themselves dependent upon a sufficient level of liquidity to be of value to a particular
market. Many OTC derivatives contracts are too specialized to develop the necessary volume to make
central clearing feasible. However, as markets for
particular contracts mature and as standardized forms
of transacting and standardized contract terms are adopted (as has happened in interest rates swaps, for instance), CCP clearing of OTC derivatives becomes
more and more feasible.
Alternatives to CCPs
In the previous section, we explained that CCPs
bring a bundle of interrelated services to the market,
including credit risk management, delegated monitoring, and liquidity enhancement. However, a CCP is
only one of a number of alternative structures that
could be used to provide these services.13 Next, we
consider how the OTC derivatives markets face the
same issues addressed by these CCP services.
As we discussed earlier, netting and position closeout are natural outcomes of a CCP, so long as the legal system recognizes novation (or the applicable
legal mechanism for effecting counterparty substitution). Through the efforts of trade organizations, such

4Q/2006, Economic Perspectives

as the International Swaps and Derivatives Association (ISDA), central banks, and others, legislatures
have provided legal protection for netting and collateral under covered master agreements for derivatives
transactions. Thus, OTC derivatives market participants
may enjoy netting and collateral benefits vis-à-vis a
single counterparty similar to those enjoyed by CCP
members with respect to their sole counterparty, the
CCP. As noted above, there are practical constraints
upon the ability of OTC market participants to multilaterally net their positions, payments, and other obligations. However, these markets have developed other
innovations to facilitate multilateral netting. An example is TriOptima.14 Subscribers to TriOptima’s
web-based service input their positions. TriOptima
then runs algorithms to detect redundant positions
and notifies subscribers of the early termination
trades needed to eliminate redundancies.
Organizations such as ISDA have also worked to
reduce legal uncertainty through the use of standardized contract language and terms. As a result, some
types of OTC derivatives contracts have become standardized in all but their economic specifics. This increases liquidity and reduces the costs of transacting.
Likewise, the standardization of collateral arrangements
reduces the costs of managing collateral. Moreover,
recent movements to standardize the process for the
assignment of contracts—that is, mutually agreed
substitution of one counterparty with another—and
greater market acceptance of assignments have the
potential to enhance market liquidity.15
Mutualized loss sharing occurs in many forms in
the economy. The most common mechanism is insurance. Customers pay nonrefundable fees to the insurance company, which in turn agrees to cover customers’
losses. Insurance, in the form of third-party guarantees,
is routine in fixed income, securitization, and some
derivatives markets. While insurance and performance
guarantees rely on a single guarantor, rather than a
pool of members, the business model effectively spreads
the cost across the client base (or the company would
not make a profit). Unlike mutualized loss sharing
across a CCP’s member base, expected losses in an
insurance arrangement are paid ex ante through premiums, rather than being assessed ex post through attachment of member funds and additional assessments.
A CCP member only shares the losses after they have
occurred and after the defaulting member’s funds have
been exhausted. Meanwhile, the members may retain
a legal interest in the funds from which losses are to
be paid. Insurance customers, on the other hand, have
no right to excess premiums they pay in and rely on
market competition to keep these to an appropriate

Federal Reserve Bank of Chicago

minimum. As with CCPs, the insurance company also
centralizes risk assessment, pricing, mitigation, legal
standing to pursue claims, collection and processing
of payments, and so on.
Another function performed by CCPs is centralized bookkeeping. A similar function is performed in
securities markets by securities depositories, which
track beneficial ownership of securities, record changes
in ownership, provide mailing lists for proxies and
dividend payments, and so forth. These mundane functions occur on such an enormous scale that centralization provides overwhelming economies.16 Securities
depositories are expanding their range of securities
and the ancillary functions they perform. A recent proposed innovation by the Depository Trust and Clearing Corporation (DTCC) working with major dealers
was to set up a database of “golden copies” of all credit
derivatives in the U.S. This is to serve as the repository
of the legally binding copy in the event of disagreement. In the case of credit default swaps, the DTCC
also assists in the determination of credit events by
collecting information from individual counterparty
actions and, when these reach a critical level for a
particular underlying reference entity, informing the
market.
Conclusion
The CCP structure we know today is, to a certain
extent, an artifact of the origins of exchange-traded
contracts. At the same time, OTC markets have evolved
other means of dealing with similar problems of credit risk management and efficiency.
Today both CCP and bilaterally cleared market
structures are evolving rapidly. Much of the attention
has focused on CCPs, in part because they represent
identifiable legal entities. The historical linkages between CCPs and specific exchanges have sometimes
been viewed as important to the competitiveness of
those exchanges and to the countries in which the CCPs
and exchanges are located. Pressures to consolidate
CCPs across exchanges, to free CCPs to clear OTC
products, and to clear across borders continue to be
controversial. Bilateral clearing is a market practice
rather than a legally identifiable institution. Nonetheless, the sheer size of the dealers at the center of the
OTC market, the relative opacity of the markets, and
some operational problems have begun to draw attention to clearing in these markets as well.17
While CCP and bilaterally cleared markets deal
with similar issues, they also have dissimilarities. OTC
market products tend to be customized, to be less liquid, and to involve less turnover of positions. In contrast, derivatives cleared through a CCP tend to be

27

highly standardized and highly liquid. While it is too
strong to say that the two systems are converging, it
is the case that both are evolving and in the process
adapting ideas from each other: increasing scope and
coverage on the part of CCPs and increasing efficiencies through standardization on the part of the OTC
derivatives market.
An important public policy issue is whether and
how to encourage these developments. In considering
these questions it is important to distinguish the benefits from the structures. Economies of scale can be
achieved both by cross-border consolidation of CCPs
and by cross-border consolidation of dealers. Credit
risk management can be done by CCPs or by insurance
companies. Operational efficiency can be obtained by
centralizing processing in CCPs or in securities depositories. It is true that CCPs perform all these functions

in a single institution. There may be some synergies
to doing so, though this is not necessarily obvious.
As the discussion proceeds, it is important to note that
markets have generally been successful in evolving
mechanisms for dealing with collective risks. Both
CCPs and the structures and practices of bilateral
clearing were, for the most part, developed by markets and not mandated by regulators. If the goal of
policymakers is to create an environment in which
market mechanisms can evolve to provide greater
societal benefits while containing systemic risks, it
may be useful to recognize the multiplicity of possible approaches to any given problem. The CCP,
where it has the necessary market depth to function,
may turn out to be the most attractive and efficient
solution. But, then again, in some cases it may not.

notes
1

The Bond Market Association (www.bondmarkets.com).

See Moser (1998) and Kroszner (1999).

8

In the late nineteenth century, a third arrangement existed on some
futures exchanges known as ring clearing, but this evolved into
central counterparty clearing. Ring clearing involved agreement by
a group of market participants to treat each other’s contracts as
more or less interchangeable, allowing transfer and termination of
offsetting positions. The recent development and acceptance of
standardized procedures to assign derivatives (substitute counterparties) and their use on a regular basis has some of the characteristics of ring clearing. See Moser (1998) for history and details.

2

International Swaps and Derivatives Association (www.isda.org).
The “notional value” of a financial contract is the principal amount
involved in the transaction. For example, an option to buy 100
barrels of oil at $65/barrel would have a notional value of $6,500.
Derivatives contracts typically call for periodic payments over the
life of the contract of amounts that may be based upon the principal amount, but not the principal itself. Thus, the parties’ credit exposure is typically measured by the “replacement cost” of the
contract, not the notional value.

9

According to the most recent semiannual survey of derivatives
market statistics published by the Bank for International Settlements,
the outstanding notional value of OTC derivatives contracts (including both futures and options) was $284 trillion (Bank for International
Settlements, 2006b, table 19). By comparison, exchange-traded derivatives exceeded $83 trillion (Bank for International Settlements,
2006a, table 23A). Data are for December 2005 and June 2006,
respectively.

10

3

See, inter alia, Bliss and Papathanassiou (2006), Bank for
International Settlements (2001), Bank for International
Settlements (1997), Bank for International Settlements (1998),
Bank for International Settlements (2004), Counterparty RiskManagement Policy Group II (2006), Kroszner (1999), Moser
(1998), Moskow (2006), Murawski (2002), Ripatti (2004), and
Russo, Hart, and Schönenberger (2002).
4

5

See Moskow (2006).

Settlement risk, sometimes referred to as “Herstatt risk,” is the
risk that arises because of a temporal disjunction between two related payments or other financial transactions. It is not unique to
foreign currency transactions, as it arises whenever two linked payments or financial transactions occur sequentially. The 1974 failure
of Herstatt Bank has become the classic illustration of settlement
risk. See, for example, Steigerwald (2001).
6

In recent years, securities markets have begun to use mechanisms
(such as central counterparties) to mitigate the counterparty credit
risks associated with securities transactions prior to settlement.
See, for example, Bank for International Settlements (2004).
7

28

Bank for International Settlements (2004).

An alternative approach to establishing a central counterparty relation, known as open offer, is used in some European countries. In
this case, the CCP makes an offer to enter into pairs of contracts on
terms agreed upon by two markets participants, under certain rules.
The market participants agree upon the terms but never formally
enter into a contract vis-à-vis each other. Instead, they report their
agreement to the CCP, which then enters into the two contracts.
11

Were a counterparty to default, the CCP’s position would become
unbalanced and exposed to market risk until the CCP reverses out
the defaulting member’s positions.
12

13

See, for example, Hills et al. (1999), pp. 122–124.

14

See www.trioptima.com.

The assignment of a contract, if legally effective, results in the
substitution of a new counterparty for one of the original parties to
a financial transaction.
15

With the exception of securities derivatives and government
bonds, most securities in the U.S. are processed through a single
depository, the Depository Trust Corporation (DTC) and its affiliates, which provide a variety of risk-management functions.
16

See Counterparty Risk Management Policy Group II (2005),
Bliss and Kaufman (2006), and Bliss and Papathanassiou (2006).
17

4Q/2006, Economic Perspectives

REFERENCES

Bank for International Settlements, 2006a, BIS
Quarterly Review, September.
, 2006b, Semiannual OTC Derivatives
Statistics, June.
Bank for International Settlements, Committee
on the Global Financial System, 2001, Collateral
in Wholesale Financial Markets: Recent Trends,
Risk Management, and Market Dynamics, Basel,
Switzerland, March.
Bank for International Settlements, Committee
on Payment and Settlement Systems, 1997, Clearing Arrangements for Exchange-traded Derivatives,
Basel, Switzerland, March.
Bank for International Settlements, Committee
on Payment and Settlement Systems and Eurocurrency Standing Committee, 1998, OTC Derivatives: Settlement Procedures and Counterparty Risk
Management, Basel, Switzerland, September.
Bank for International Settlements, Committee
on Payment and Settlement Systems, and Technical
Committee of the International Organization of
Securities Commissions, 2004, Recommendations
for Central Counterparties, Basel, Switzerland,
November.
Bliss, Robert R., and George G. Kaufman, 2006,
“Derivatives and systemic risk: Netting, collateral,
and closeout,” Journal of Financial Stability, Vol. 2,
No. 1, April, pp. 55–70.
Bliss, Robert R., and Chryssa Papathanassiou,
2006, “Derivatives clearing, central counterparties,
and novation: The economic implications,” Wake
Forest University, working paper.
Counterparty Risk Management Policy Group II,
2005, Toward Greater Financial Stability: A Private
Sector Perspective, report, New York, July 27.

Federal Reserve Bank of Chicago

Hills, Bob, David Rule, Sarah Parkinson, and
Chris Young, 1999, “Central counterparty clearing
houses and financial stability,” Financial Stability
Review, Bank of England, June, pp. 122–134.
Kroszner, Randall S., 1999, “Can the financial markets privately regulate risk: The development of derivatives clearing houses and recent over-the-counter
innovations,” Journal of Money, Credit, and Banking,
Vol. 31, No. 3, Part 2, August, pp. 596–618.
Moser, James T., 1998, “Contracting innovations
and the evolution of clearing and settlement methods
at futures exchanges,” Federal Reserve Bank of
Chicago, working paper, No. WP-1998-26.
Moskow, Michael H., 2006, “Public policy and central counterparty clearing,” speech delivered at the
European Central Bank and Federal Reserve Bank of
Chicago joint conference, “Issues Related to Central
Counterparty Clearing,” Frankfurt, Germany, April 4.
Murawski, Carsten, 2002, “The impact of clearing
on the credit risk of a derivatives portfolio,” University
of Zurich, Swiss Banking Institute, working paper, June.
Ripatti, Kirsi, 2004, “Central counterparty clearing:
Constructing a framework for evaluation of risks
and benefits,” Bank of Finland, discussion paper, No.
30/2004, December.
Russo, Daniela, Terry L. Hart, and Andreas
Schönenberger, 2002, “The evolution of clearing
and central counterparty services for exchange-traded
securities in the United States and Europe: A comparison,” European Central Bank, occasional paper,
No. 5, September.
Steigerwald, Robert S., 2001, “Coordinated regulation of financial markets and payment systems,”
Journal of Global Financial Markets, Vol. 2, No. 1,
Spring, pp. 45–52.

29

43

CDANK
STRUCTURE &

Competition

Federal Reserve Bank of Chicago

he Federal Reserve Bank of Chicago invites the submission of research-

T

and policy-oriented papers for the 43rd annual Conference on Bank Structure and

Competition to be held May 16-18, 2007, at the Westin Hotel in Chicago. Since its incep­

tion, the conference has fostered a dialogue on current public policy issues affecting the

financial services industry. As in past years, the program will highlight a conference theme

(to be announced) but will also feature numerous sessions on topics unrelated to the

theme. We therefore welcome submissions of high-quality research on all topics related
to financial services, their regulation, and industry structure. A non-exhaustive list of
possible session topics includes:
■ The mixing of banking and commerce;
■ The Basel II capital accord;

■

Deposit insurance reform;

■

Financial industry consolidation;

■

Small business finance;

■

Nonbank financing;

■

Fair lending and the Community Reinvestment Act;

■

Payments innovations;

■ Competitive strategies of financial institutions;
■ Credit derivatives;
■ Analysis of whether banks are straying too far from their core function;
■ The burden of bank regulation;
■

Retirement finance; and

■ The role and potential liability of Fannie Mae, Freddie Mac, and pension
guaranty funds.
If you would like to present a paper at the conference, please submit your completed paper

or a detailed abstract (the more complete the paper, the better), along with your name,

address, affiliation, telephone number, and e-mail address, and those of any co-authors,
by December 11,2006. Manuscripts should be submitted via email to:

BSC_submissions@frbchi.org

Additional information will be posted to the conference website as it becomes available:

www.chicagofed.org/BankStructureConference

Or, you may contact the conference chairman directly:

Douglas Evanoff at 312-322-5814 or devanoff@frbchi.org.

Issues related to central counterparty clearing:
Opening remarks
Gertrude Tumpel-Gugerell

First of all, I would like to say that I am extremely
delighted to welcome you to this conference and to
Frankfurt—a city that offers a huge variety of facets
based on almost 2,000 years of history. Frankfurt was
not only the home of important writers and philosophers, such as Goethe, Schopenhauer, and Adorno,
it has also over the centuries prospered as a marketplace and magnet for business. Key to this success was
its central location at the crossroads of large trading
routes between the North and South and the East and
West. Finance followed trade, and early on, Frankfurt
became not only the home of large trade fairs but also
an important financial center. It was one of the birth
places of our modern stock exchanges, bringing about
early financial innovations, such as trade with derivatives or bonds. When I look at the history of Chicago,
I see a lot of similarities to Frankfurt: Chicago developed from a trading hub of agricultural products into a
financial metropolis with a very potent stock exchange.
I am therefore very proud that this conference is
a joint conference organized by both the European
Central Bank (ECB) and the Federal Reserve Bank
of Chicago (Chicago Fed), and I would like to give
a particularly warm welcome to all our colleagues
from Chicago. Cooperation between the ECB and the
Chicago Fed is very well established: We have close
bilateral exchanges and meet regularly in international
meetings. Yet, most of our cooperation is often rather
invisible to the public at large. Thus, I am particularly
glad that this conference highlights visibly the close
collaboration between the ECB and the Chicago Fed.
It also demonstrates that we witness similar developments in both the United States and Europe and that
we can benefit from each other’s experiences by analyzing these developments together.
As you can see from the program, this two-day
conference aims at exploring the foundations of central
counterparties (CCPs), the importance of collateral

32

and margining, issues related to risk management, and
future developments of financial market clearing and
settlement. The conference provides a unique forum
for discussion and will allow participants to interact
with industry executives, policymakers, central bankers, and academics. I am confident that by the end of
the conference, we will all have a better understanding of the driving forces, practical arrangements, and
the legal environment within which the CCPs operate
in the European Union (EU) and the United States, as
well as the future developments of financial market
clearing and settlement.
Before I give the floor to the panelists, I would
like to set the stage by presenting ten statements on
key issues related to central counterparty clearing.
I will emphasize our wish to achieve an efficient,
sound, and stable “domestic” securities market infrastructure in Europe.
Central banks have a keen interest in the smooth
functioning of central counterparty clearing
Central counterparties represent an integral element of securities settlement systems. Although a CCP
has the potential to reduce the risk exposures of market participants, it also concentrates risks and the responsibility for risk management. In the light of the
growing interest in developing CCPs and expanding
the scope of their services, central banks have a strong
interest in the development of a coherent and integrated securities clearing and settlement infrastructure.
This article is a reprint of a speech by Gertrude TumpelGugerell, member of the Executive Board of the European
Central Bank, on April 3, 2006, at “Issues Related to
Central Counterparty Clearing,” a joint conference of
the Federal Reserve Bank of Chicago and the European
Central Bank, held in Frankfurt, Germany, April 3–4, 2006.
The conference agenda and presentations are available
at www.ecb.int/events/conferences/html/ccp.en.html.

4Q/2006, Economic Perspectives

Although the Eurosystem is not directly involved in
the regulation of CCPs, issues related to the clearing
and settlement infrastructure touch on the key responsibilities of central banks:
n	 The smooth functioning of payment systems, and
n 	 The preservation of financial stability.
Guided by these objectives, the Eurosystem has
explicitly expressed its interest in monitoring, understanding, and promoting the development of sound,
efficient, and safely functioning financial market infrastructures. In this light, the ECB and the Chicago
Fed have organized this joint conference on the role
of CCPs.
The importance of post-trade processes and
services for the overall economy will grow
significantly
Capital markets play a vital role for the global
financial system and for long-term economic prosperity.
In particular, securities markets facilitate the effective
allocation of capital by funneling society’s resources
to promising productivity-enhancing investments
across space and time. The marketplaces operated by
exchanges and clearing and settlement institutions have
grown at an unprecedented pace. This gives them a
central role and responsibility in the global financial
environment. In particular, post-trading processes and
services, typically referred to as clearing and settlement,
are a key part of modern capital markets. From a market perspective, their importance derives from the fact
that clearing and settlement costs can be viewed as a
subset of transaction costs. These are the costs faced
by an investor when carrying out a trade. Expensive
and inefficient clearing and settlement limit the development of efficient markets.
The most recent performance figures for the five
major European clearinghouses confirm this trend. After the introduction of the euro, the volume of trades
cleared increased by a factor of 2.5, reaching a record
of around 670 million trades in 2004, which represented a value of close to 350 trillion euro. These figures
clearly show that a significant amount and value of securities are held and transferred in these systems. It is
therefore crucial that the safe, sound, and reliable functioning of clearing and settlement systems is ensured.
Financial innovations and technological advances
will continue to be the key drivers for the
financial infrastructure industry
The practices and procedures involved in clearing
and central counterparty services are currently undergoing a process of evolution in Europe and the United

Federal Reserve Bank of Chicago

States. Developments in technology, advances in the
design of financial products, and progress in techniques
for management of financial risk have prompted some
market participants to advocate the development of
clearing arrangements on an international basis. This
would allow capital to be used as efficiently as possible. At the same time, the financial soundness of existing clearing arrangements needs to be maintained.
There are two main trends that present numerous
challenges for market participants, infrastructure providers, central banks, and financial market regulators:
first, developments regarding operational arrangements
and the functions of clearinghouses, which I will elaborate on in the following section, and second, consolidation initiatives in the clearing infrastructure, which
I will address later.
Central counterparty clearinghouses will
increasingly perform essential functions
in the transaction value chain
Let me now turn to the operational and technical
arrangements of clearinghouses. A clearinghouse determines the obligations that result from debit and credit
positions arising from the trading of financial assets.
It calculates the amounts that need to be settled, typically through securities settlement systems. The clearinghouse may act as a buyer to the seller and as a seller
to the buyer. It thus creates two new contracts that replace the original single contract.
Many of the benefits of central counterparty clearing can be attributed to multilateral netting. Multilateral
netting allows for a substantial reduction in the number of settlements and, therefore, in operation costs,
including settlement fees. In addition to multilateral
netting, central counterparty clearing creates benefits
mainly by providing risk-management services. Central counterparty clearinghouses thereby enable market
participants to trade without having to worry about
the creditworthiness of individual counterparties.
Central counterparty clearing not only creates
benefits for individual participants, but it is also essential for the economy as a whole. This is because
central counterparty clearinghouses increase market
liquidity, reduce transaction costs, and improve the
functioning of the overall capital market.
There is a need for adequate risk-management
procedures and standards for clearinghouses
Securities infrastructures, in particular central
counterparty clearing systems, are vulnerable to failure if they are not sufficiently protected against financial and nonfinancial risks. In fact, if such risks do
materialize, the consequences for the stability of the

33

financial system could be enormous. It is therefore particularly important that appropriate measures are taken
to mitigate these risks. Consequently, the effectiveness
of a CCP’s risk controls and the adequacy of its financial resources are critical aspects of the infrastructure
of the market it serves. Clearinghouses have developed
different methods of limiting the potential losses arising from the default of a participant. Some of these
safeguard measures and their effectiveness in limiting
risk exposures will be addressed in the course of this
conference.
Given the potential systemic implications of securities clearing and settlement systems, the establishment of standards for risk management is essential.
The process of setting standards has already started,
with initiatives being driven by market participants or
pursued in the framework of international cooperation
between regulatory bodies.
Competition, transparency, and open access are
important to address the interests of customers
and public authorities
The Eurosystem is of the view that competition
is important to achieve the overall objective of creating
a safe, efficient, and integrated EU clearing and settlement infrastructure. The basic conditions for this goal
are transparency and open access. Efforts undertaken
by a CCP help to improve transparency and foster confidence of market participants in its safety and efficiency. It is therefore essential that a CCP provides market
participants with sufficient information for them to
identify and evaluate accurately the risks and costs
associated with using its services. To avoid discrimination against classes of participants and competitive
distortions, participation requirements should be fair
and open within the scope of services offered by the
CCP. However, these rules and requirements for fair
and open access should be balanced against and aimed
at controlling and limiting risks.
Looking ahead, the adoption of a harmonized regulatory regime for securities clearing and settlement
systems should be considered in order to complete
the internal market. In this respect, an approach that
sets out requirements for transparency and participation as instituted in a jurisdiction seems to be preferable.
In this light, the Eurosystem welcomes the initiatives specified in the European Commission’s communication on clearing and settlement. The Eurosystem,
in principle, supports the adoption of a framework directive on clearing and settlement. A directive could
complement the market-led removal of the existing
barriers to efficient EU clearing and settlement arrangements. This is a necessary condition for competition

34

to come into full effect. It may contribute to ensuring
open and fair access and price transparency. However,
the Eurosystem cautions that the concerns and responsibilities of central banks as regards a safe and integrated securities infrastructure need to be adequately
reflected in a potential directive on clearing and settlement. The Eurosystem also understands that a legal
and regulatory framework will not impede the continuing cooperation in the area of supervision and oversight of securities clearing and settlement systems.
This is essential in order to further improve and follow up on the establishment of common European
standards on clearing and settlement.
Integration of European securities clearing
infrastructures will proceed at different speeds
and with more diversified and enlarged businesses
In the euro area, most countries have established
central counterparty clearinghouses. Projects to set up
new central counterparty clearinghouses are also under
consideration in several countries. Typically, CCPs are
attached to particular local organized markets, that is,
stock or derivatives exchanges. The European clearing
infrastructure inherited from the pre-euro era was a
patchwork of national systems operating within their
geographical boundaries.
However, the pattern of a single central counterparty clearinghouse serving one market in one country
has been changing. Since the start of the European
Monetary Union (EMU), a process of integration and
consolidation has been under way in the field of CCP
clearing. Integration within the securities clearing infrastructure has taken the form of vertical and horizontal consolidation. In the past five years, the number of
CCPs for financial instruments has dropped from 14
to seven in the euro area.
In the European context, there have been significant changes in central counterparty clearing, and these
have led to increased consolidation among securities
clearinghouses. The majority of trades are cleared in
a very small number of clearinghouses in Europe. However, a high number of CCPs with a relatively small
market share still operate in parallel at the local level.
As a result, the Eurosystem is of the view that the process toward further consolidation is making progress
but is still in its infancy. On account of the economies
of scale and network externalities inherent in the securities clearing business, further cost savings and increased technical efficiency can be expected from
more integration and consolidation.
In addition to the tendency toward consolidation
of CCPs, another trend can be observed in the field of
CCP clearing. At the start of the EMU, almost all

4Q/2006, Economic Perspectives

CCPs in the euro area cleared only derivatives transactions. However, in recent years many CCPs have
expanded their activities and now also cover repos
and securities trades. The CCPs appear to be seeking
new business opportunities in an increasingly competitive market. In this context, there is another field
of business opportunities for CCPs that has not yet
been fully exploited. I am referring to the over-thecounter derivatives markets. These markets have grown
substantially in recent years, but their post-trading infrastructure remains somewhat underdeveloped.
The consolidation of CCPs and the expansion of
business tend to go hand in hand with the growing
volumes in securities trading, advances in technology,
and the internationalization of the activities of clearing and settlement infrastructures.
Comparing experiences in the United States
and Europe for achieving a consolidated and
efficient clearing infrastructure
Looking across the Atlantic, it is interesting to
compare the existing organization of domestic clearing
arrangements in the United States and the European
Union. Recently, major market participants have repeatedly expressed support for the idea of a single
European central counterparty clearinghouse, which
would be designed as multicurrency and multiproduct.
Such a single central counterparty in Europe would
be expected to create clearing arrangements that mirror
those in the United States. It is often said that clearing
arrangements in the United States are more consolidated and cost-effective than those in Europe. However,
an examination of the case of derivatives clearing suggests that the main features of central counterparties
in the two currency areas are not fundamentally different. In particular, when looking at the level of consolidation, the situation is far more complex than is
commonly thought. For example, in the United States,
the decentralized clearing of futures transactions derives primarily from the business decisions of exchanges
and clearinghouses to maintain separate operations.
In addition, sectoral regulation in the United States
impedes the development of cross-product clearing,
leading to seemingly less integrated clearing arrangements than those in Europe.
The Eurosystem’s guiding principles are neutrality,
market forces, public policy decisions, and
cooperation at the global level
As yet it is unclear which model of integration
will eventually prevail in the euro area. The Eurosystem is of the view that the process of consolidation of
the central counterparty clearing infrastructure should

Federal Reserve Bank of Chicago

be driven by the private sector. Public intervention
might be needed if there are clear signs of market failure. For example, a persistent lack of interoperability
and the need for standards among clearinghouses are
examples that call for coordinated public action.
Irrespective of the final architecture, it is essential that access to clearing, as well as trading and
settlement, facilities should not be unfairly impeded.
The policy of open and fair access should ensure the
safety, legal soundness, and efficiency of securities
clearing and settlement systems; guarantee a level
playing field; and avoid excessive fragmentation of
market liquidity.
The Eurosystem supports cooperation in central
counterparty clearing at the global level. Key concepts
in this respect are legal feasibility and interoperability. Interoperability means agreeing on common processes, methods, protocols, and networks to enable
cooperation between central counterparties at the technical level. This would allow central counterparty
clearinghouses worldwide to develop links between
one another. As a final outcome, this may or may not
lead to the creation of international or global clearinghouses. Furthermore, when global multicurrency
systems handling euro begin operations, the Eurosystem should be involved in their oversight, given its
interest in the smooth functioning of such systems.
The financial infrastructure industry needs to
take advantage of the opportunity window that
integration offers
Tomorrow’s global securities market infrastructures
will be characterized by ongoing integration and consolidation initiatives. However, the message that I would
like to convey is that action to promote financial integration in the field of clearing and settlement is urgently needed. In a fast-evolving global financial system,
there is a window of opportunity to raise the euro area’s
financial infrastructure to the highest levels of efficiency, competitiveness, sophistication, and completeness.
The window of opportunity was opened by the euro,
but it will not remain open forever. The shape of the
euro financial system is likely to be determined in the
next few years and remain crystallized in that shape
for a very long time.
In this respect, post-trading service providers
should devise strategic responses in a number of directions in order to best increase business opportunities and to meet investors’ demands for lower trading
costs, improved liquidity, and immediate access to
international clearing and settlement. Economies of
scale, efficiency gains, greater risk diversification,
and global networks encouraging competition and

35

consolidation in the securities infrastructure industry
will be key to this development. Transatlantic linkages
or cooperation would also stimulate financial market
infrastructure dynamics. Moreover, the Eurosystem
takes the view that the finalization and implementation of the European System of Central Banks–Committee of European Securities Regulators (ESCB–CESR)
standards for clearing and settlement in the EU based
on the recommendations by the Committee on Payment
and Settlement Systems–International Organization
of Securities Commissions (CPSS–IOSCO) are essential to ensure the sound and smooth functioning
of the financial clearing infrastructure in the EU.
Conclusion
I would like to conclude my speech with a reference to German literature—quoting Johann Wolfgang
Goethe, who was born here in Frankfurt more than
250 years ago. He said that the best that history teaches
us is the enthusiasm that it evokes (“das Beste, was
wir von der Geschichte haben, ist der Enthusiasmus,
den sie erregt”). In the spirit of Johann Wolfgang
Goethe, my wish for the future is that all relevant

36

market participants, actors, and authorities in the
field of securities market infrastructure take their lesson from the past and promote with their best efforts,
dynamism, and enthusiasm the development of a better, integrated, efficient, and safe financial infrastructure landscape. Moreover, we should learn from each
other: from our analytical work and from our cooperation. A priority for the future is to pursue a consistent
implementation and application of the EU-wide and
harmonized rules for clearing and settlement. Successful cooperation among the relevant European and national supervisors and authorities is an important and
challenging task. The private sector also has to play
its role and take up its responsibility to foster further
integration. In this context, it is time for the financial
industry to leverage its efforts to higher degrees of
efficiency and take full advantage of the opportunities
that integration offers. To this end, technological advances and financial innovation will be the factors of
success to keep pace with increasing competition at
the global level. And financial innovations should go
hand in hand with adequate risk measures for an efficient, but also safe and stable, financial sector.

4Q/2006, Economic Perspectives

Central counterparty clearing: History, innovation,
and regulation
Randall S. Kroszner

As many of you know, I became a member of the
Board of Governors of the Federal Reserve System
only a month ago. I am delighted to be giving my first
speech as a governor at a conference that has resulted
from the kind of international cooperation that I see
as essential in today’s world. The joint sponsorship of
this conference by the European Central Bank (ECB)
and the Federal Reserve Bank of Chicago (Chicago
Fed) represents an extremely fruitful collaboration of
researchers, market participants, and policymakers
from both sides of the Atlantic. Having been a research
consultant at the Chicago Fed for many years and having visited the ECB numerous times since its founding less than eight years ago, I have many friends at
both institutions and am pleased to see so many of
those friends here today.
In addition, I am delighted that the topic of this
cooperative venture and my maiden speech is central
counterparty (CCP) clearing. As an academic, I wrote
several papers on clearing arrangements and participated in many conferences such as this one. I am very
pleased to be in a room filled with others who share
that interest.
In recent years, public policymakers have demonstrated growing interest and concern about the effectiveness of CCP risk management. In particular,
in November 2004 the Committee on Payment and
Settlement Systems (CPSS) of the Group of Ten central
banks and the International Organization of Securities
Commissions (IOSCO) jointly issued comprehensive
international standards for CCP risk management.1
I have often cited CCPs for exchange-traded derivatives
as a prime example of how market forces can privately regulate financial risk very effectively.2 Indeed, it
is hard to find fault with the track record of derivatives
CCPs, many of which have managed counterparty
risk so effectively that they have never suffered a
counterparty default.

Federal Reserve Bank of Chicago

But perhaps it is not unreasonable to ask whether
that track record will be maintained. I see that good
track record as a result of innovations that, over time,
produced organizational arrangements that have provided market participants with the incentives and capabilities to ensure effective CCP risk management,
thereby serving the public interest as well as the interests of market participants. Significant changes to those
arrangements could result in less effective risk management. Furthermore, some CCPs have begun to clear
new products, some of which may be less liquid or
more complex than exchange-traded derivatives, and
thus may pose challenges to traditional risk-management procedures. Finally, more intense government
regulation of CCPs may prove counterproductive if it
creates moral hazard or impedes the ability of CCPs to
develop new approaches to risk management. As crossborder activity becomes ever more important, regulatory
differences across countries may become an increasingly serious impediment to innovation by CCPs.
In my remarks today, I will begin by reviewing
the historical development of CCPs. I do this not for
antiquarian interest but because this history illustrates
how market forces led to the evolution of organizational and contractual features that have created strong incentives for effective private regulation that addressed
both market participants’ and public policymakers’
concerns about risk control. I will then discuss the
possible implications of recent variations on traditional
arrangements. Next I will discuss the challenges
This article is a reprint of a speech by Randall S. Kroszner,
governor, Board of Governors of the Federal Reserve
System, on April 3, 2006, at “Issues Related to Central
Counterparty Clearing,” a joint conference of the Federal
Reserve Bank of Chicago and the European Central Bank,
held in Frankfurt, Germany, April 3–4, 2006. The conference agenda and presentations are available at www.ecb.int/
events/conferences/html/ccp.en.html.

37

involved in clearing certain new products, particularly
over-the-counter (OTC) derivatives. I will conclude
with some views on how government regulation can
provide an environment in which private regulation
of CCP risk management continues to be effective.
Historical development of futures clearinghouses
My review of the historical development of central counterparties will focus on the CCP for grain futures traded on the Chicago Board of Trade (CBOT).
I make no claim that a CCP first arose in the United
States. Indeed, a number of coffee and grain exchanges
in Europe had some form of CCP in the late nineteenth
century, well before any U.S. exchange.3 Rather, I simply am more familiar with developments in Chicago,
in large measure because of the time that Jim Moser
spent digging through the CBOT’s archives while on
the staff of the Federal Reserve Bank of Chicago.4
Furthermore, the market forces that drove the evolution of risk controls at the CBOT likely produced a
broadly similar evolution on other exchanges.
An important lesson from the CBOT’s experience
is that a CCP emerged gradually and slowly as a result of experience and experimentation. Early on, the
CBOT recognized the importance of creating incentives for adherence to its rules, including the contractual obligations of counterparties to contracts traded
on the exchange. Initially, the primary incentive was
the threat that a member that defaulted on its obligations could be barred from the trading floor. No doubt
this consequence was a powerful incentive for solvent
members to meet their obligations, but an insolvent
member might not have assigned significant value to
the loss of trading privileges. By 1873, the CBOT
recognized the importance of evaluating the solvency
of its members and adopted a resolution stipulating
that any member whose solvency was questioned must
open its financial accounts to inspection and could be
expelled if it refused to do so. Around the same time,
the exchange introduced initial and variation margin
requirements for contracts traded on the exchange
and set strict time limits for the posting of margin deposits. Failure to post margin deposits would be considered a default on the member’s contracts.
The next step along the road to addressing private
and public concerns about effective risk control was
the CBOT’s creation of a clearinghouse in 1883. For
many years, the clearinghouse was not a true CCP.
Rather, as created, it was merely a mechanism to reduce transactions costs by calculating members’ net
obligations to post margins and to settle contracts. In
the event of a member’s default, the clearinghouse
assumed no responsibility for settling the defaulting

38

member’s trades or for covering the losses to other
members that exceeded the amount of margin that the
defaulting member had posted.
Only in 1925 did the CBOT form the Board of
Trade Clearing Corporation (BOTCC), a true CCP that
became the counterparty to all transactions on the
exchange. With the creation of BOTCC, members of
the exchange were required to purchase shares in the
clearinghouse, and only the member-shareholders
were permitted to use the facility.5 Members were
also required to post their margin deposits with the
clearinghouse. In the event of a member’s default,
the clearinghouse would take responsibility for settling
the defaulting member’s trades. The clearinghouse
would seek to cover any losses incurred in settling
the defaulter’s obligations by liquidating its margin
deposit. But if the losses exceeded the value of the margin, the deficiency would be charged against the clearinghouse’s capital, including the capital owned by the
nondefaulting members. If the losses were so severe
as to deplete the clearinghouse’s capital, the members
could be required to purchase additional shares.
This organizational arrangement has been adopted
by many other CCPs, both for exchange-traded derivatives and for cash securities transactions. I characterize
this structure as a partial integration of the members
of the exchange into a single unit because each member is now at least in part financially responsible for
the performance of the others’ obligations arising from
contracts traded on the exchange.6 The mutualization
of risk creates incentives for all of the exchange’s members to support the imposition of risk controls that
limit the extent to which the trading activities of any
individual member expose all of other members to
losses from defaults. Moreover, because the members
own the clearinghouse, they have the capability to act
on their incentives for effective CCP risk management.
I see this alignment of incentives for effective risk
management with the ability to act on those incentives as the key to the strong historical track record
of derivatives CCPs.
What is interesting and instructive about the history of these arrangements is that it illustrates how
market forces can produce private regulations that
address the concerns about safety, soundness, and
broader financial stability.
Potential challenges raised by recent changes
to central counterparty organization
During the twentieth century, various changes
occurred in the historical organizational arrangements
that I have characterized as a partial integration of the
members of the exchange. And in the twenty-first

4Q/2006, Economic Perspectives

century, the pace of change seems to be accelerating.
Some derivatives exchanges have remained integrated
with their CCP, but even in those cases, there now
tends to be less integration. Members of the exchange
are seldom required to be members of the clearinghouse. Instead, members of the exchange may arrange
to clear through other members, which are referred to
as “clearing members.” When a clearing member
agrees to clear for a nonclearing member, it becomes
responsible to the clearinghouse for the obligations of
the nonclearing member. Only the clearing members
are required to buy stock in the clearinghouse or to contribute to a clearing fund that would be used to cover
losses from defaults by other clearing members, including defaults on their obligations to perform on
positions held by nonclearing members.
In recent years, an increasing number of exchanges
have engaged unaffiliated CCPs to clear their trades.
A “horizontal” integration of CCPs has replaced the
“vertical” integration of an exchange and its CCP. Both
horizontally integrated CCPs and vertically integrated
CCPs have often arranged for insurance policies that
limit the potential losses to their clearing members
from defaults. Finally, many exchanges have converted
from mutual associations of exchange members to
for-profit corporations.
Clearly some of these changes have important
implications for competition among exchanges. But
they may also have implications for the effectiveness
of risk management, which is the focus of my remarks
today. As I have discussed, historically the key to effective risk management has been that the members
of the exchange have borne the risk of losses from
defaults and have had the capacity to institute risk
controls (principally membership standards and margin requirements) that have limited those risks. The
question then is whether any of these changes to the
organization of CCPs have left those bearing the risks
without the capacity to manage those risks.
I would caution against assuming that change is
inherently risky. After all, as we have seen, the partial
integration model that worked so well for so many years
emerged only gradually as a result of experimentation.
Moreover, thinking that “one size fits all” regarding
the organization of financial markets is a mistake. That
said, it seems critical that the organization of any CCP,
including a CCP that follows the traditional partialintegration model, should conform to a pair of broad
principles. First, a CCP’s default rules need to be transparent: The party that bears the risk of default (who
has “skin in the game”) must be clear to all. Second,
a CCP’s governance arrangements must provide those
with “skin in the game” with substantial influence
over the CCP’s risk controls.

Federal Reserve Bank of Chicago

New products
In recent years, appreciation of the possible benefits of a well-organized CCP has been growing. CCP
arrangements have been introduced in a wide variety
of markets that had not previously been served by
CCPs. In the United States, the New York Stock Exchange established a clearinghouse in 1892 and transformed it into a true CCP in 1920. But, outside the
United States, few securities exchanges established
CCPs until late in the twentieth century. Today, a CCP
is in place and functioning in nearly all major securities markets. Increasingly often, CCPs for securities
clear trades, including trades and repurchase agreements involving government bonds, in the over-thecounter securities markets. Since 1999, the London
Clearing House (now LCH.Clearnet) has been clearing growing volumes of some types of OTC derivatives through its SwapClear service.
The clearing of OTC derivatives is an especially
interesting development. Although SwapClear has
been gaining traction, it has been met with resistance
from some OTC derivatives dealers. Some of them
have argued that bilateral credit risk management,
which uses many of the same techniques that CCPs
use (netting and margin requirements), is highly effective. Moreover, not all OTC derivatives are sufficiently standardized to be cleared. Consequently, some
have expressed concerns that CCP clearing of “vanilla” products could increase the risks on noncleared
“exotic” products by limiting the scope for bilateral
netting of vanilla products against exotic products
outside the CCP. Another consideration for the most
creditworthy dealers may be the potential effect of
CCP clearing on mitigating the competitive advantage of their creditworthiness.7
With regard to systemic risk, the key question
about the clearing of OTC derivatives is whether the
risk-management techniques that have proved so effective in clearing exchange-traded products will prove
equally effective in clearing products that are not as
standardized. In particular, the clearing of OTC derivatives tends to entail much less scope for offsetting
transactions. As a consequence, if a default occurred,
a huge volume of transactions would need to be closed
out. The feasibility of a CCP’s achieving closeout
promptly is clearly a critical issue that deserves careful examination. In that regard, a recent report by
leading participants in the OTC derivatives markets
expressed concern about the feasibility of closeout
procedures in the event of default of a large market
participant in stressed market conditions.8 Further experimentation with closeout procedures may be necessary to address that concern.

39

The role of government
In recent years, policymakers have devoted much
attention to oversight and regulation of CCPs, with
the objective of promoting their soundness and stability.
I certainly share that objective, but I would like to
call attention to some possible unintended and undesirable consequences of CCP regulation. The first is
moral hazard. Policymakers must be very careful to
avoid any impression that government oversight comes
with a promise of government financial support in the
event of a risk-management failure; otherwise, privatemarket discipline, which has served private and public interests in the stability of CCP arrangements so
well for so long, may well be eviscerated.
Instead, government regulation should focus on
improving the effectiveness of private-market regulation. In particular, it should enforce the observance of
the two critical principles I identified earlier. First, it
should ensure that a CCP’s risk-management policies
and procedures, especially its policies for handling defaults and allocating the burden of losses from defaults,
are transparent to market participants. Second, it should
ensure that CCP governance arrangements provide
the parties who would bear the losses with substantial
influence over the CCP’s risk-management policies.
My sense is that policymakers are well aware of
the risks that moral hazard poses for financial stability.
But I am concerned that a second unintended consequence of regulation has too often gone unrecognized.
That is the potential for conflicting regulation (and
laws) to impede the evolution of CCP arrangements,
especially the potential for economies of scale and
scope to be achieved through consolidation. I am always puzzled when I hear the United States held up
as the model for the benefits of consolidation of the
clearing and settlement infrastructure. We have achieved
significant consolidation within the securities markets
and within the futures markets. But I am struck by the
lack of consolidation of securities and futures CCPs.
Perhaps there is no business case for such consolidation. Even if a business case exists, however, I believe

40

consolidation would be difficult to achieve due to the
legal and regulatory distinctions in the United States
between securities and futures.
Law and regulation seem also to be placing significant barriers in the way of consolidation of the
securities and derivatives clearing and settlement infrastructure in Europe. Most of the fifteen barriers to
efficient cross-border clearing and settlement that were
identified by the Giovannini Group report in 2001,
seem to be grounded in law and regulation rather than
in the practices of private-market participants.9
Policymakers in all countries need to examine
whether legal and regulatory distinctions are impeding innovation and, if so, whether the distinctions are
meaningful and essential for the achievement of public policy objectives. Policymakers must also resist
the temptation to place regulation in the service of
protectionism. I read with interest and appreciation
European Union Commissioner McCreevy’s recent
speech at the London School of Economics on the development of the European capital markets, in which
he decried the signs of a new wave of protectionism
in Europe.10 As he noted, “Protectionism is a proven
route to economic stagnation and decline.”11 This is
an important message, indeed.
Conclusions
I find the history of financial markets to be enormously instructive. My reading of the history of CCP
clearing is that it teaches us that private-market regulation can be effective for achieving the public policy
goal of safety and soundness and broader financial
stability. Government regulation and oversight should
seek to provide an environment in which private regulation can be most effective. Government regulation
should not place unnecessary barriers—domestically
or internationally—in the path of the future evolution
of private-market regulation. Innovation should be
fostered, and regulatory protectionism should be
rejected.

4Q/2006, Economic Perspectives

notes
Bank for International Settlements, Committee on Payment and
Settlement Systems and Technical Committee of the International
Organization of Securities Commissions, 2004, Recommendations
for Central Counterparties, Basel, Switzerland, November.
1

Randall S. Kroszner, 1999, “Can the financial markets privately
regulate risk? The development of derivatives clearinghouses and
recent over-the-counter innovations,” Journal of Money, Credit,
and Banking, Vol. 31, No. 3, August, pp. 596–618. See also Randall
S. Kroszner, 2000, “Lessons from financial crises:  The role of
clearinghouses,” Journal of Financial Services Research, Vol. 18,
No. 2–3, December, pp. 157–171.
2

See the discussion on pp. 71–72 of Henry Crosby Emery, 1896,
Speculation on the Stock and Produce Exchanges of the United
States, New York: Columbia University. 
3

James T. Moser, 1998, “Contracting innovations and the evolution
of clearing and settlement methods of futures exchanges,” Federal
Reserve Bank of Chicago, working paper, No. WP-1998-26.
4

Later, a member of the exchange was not required to be a member
of the clearinghouse if it could arrange for a clearinghouse member
to assume responsibility for the nonmember’s obligations to the
clearinghouse.
5

Federal Reserve Bank of Chicago

See Kroszner (1999), p. 603. 

6

For one account that argues that the introduction of CCP clearing
in U.S. futures markets was delayed by financially strong members
who were resistant to giving up the advantage of their high credit
quality and to implicitly subsidizing weaker members, see Craig
Pirrong, 1997, “A positive theory of financial exchange organization with normative implications for financial market regulation,”
Washington University in St. Louis, Olin School of Business,
working paper.
7

Counterparty Risk Management Policy Group II, 2005, Toward
Greater Financial Stability: A Private Sector Perspective, report,
New York, July
8

Giovannini Group, 2001, Cross-Border Clearing and Settlement
Arrangements in the European Union, Brussels, Belgium: European
Commission, November.
9

Charlie McCreevy, 2006, “The development of the European
capital market,” speech given at the London School of Economics,
March 9.
10

See McCreevy (2006), p. 3.

11

41

Central counterparties: The role of multilateralism
and monopoly
Tommaso Padoa-Schioppa

It is a great pleasure for me to speak tonight at this
joint conference of the European Central Bank (ECB)
and the Federal Reserve Bank of Chicago (Chicago
Fed) on central counterparty (CCP) issues. Central
counterparties were the topic of the very first workshop in the field of payment and settlement issues
that I organized as a member of the Executive Board
of the ECB. I am also happy to attend a conference
co-organized by the ECB and the Chicago Fed, since
it represents an example of multilateral cooperation
between monopolistic institutions!
Multilateralism and monopoly are indeed the two
issues I would like to deal with tonight. These two issues are essential in order to understand central banks’
concerns in the field of central counterparty issues; they
are also very general issues, going well beyond payment and settlement issues and even beyond economics. Their wide spectrum makes them suitable for a
dinner speech, where the topic should be both related
to the specific occasion and of a general nature. I will
take multilateralism and natural monopoly one by one,
then show how they are interrelated, and finally argue
that it is because of their presence in clearing and settlement that the involvement of public authorities is
indispensable if the “hot” issue of integrating the infrastructure is to be properly addressed.
Multilateralism
Multilateralism is a method or an approach that
involves a relationship between two parties with a
third party coming into play. This third party is the
collectivity itself, the group, the universe of all parties. As a result, it incorporates some notion of “public good” to the extent that breaching a multilateral
agreement implies not only “private” and “individual” but also “social” and welfare costs. Indeed, it constitutes the very essence of money as it is the element
that makes a difference between a barter economy
and a monetary economy.

42

Multilateralism is thus an essential feature of a
payment system, that is, the set of arrangements whereby money performs its function as a medium of exchange. Defined as “a group of independent but
interrelated elements that compose a unified whole,”
the notion of system is thus tantamount to the notion
of “multilateralism.” Indeed, a malfunction in a payment system has the potential to affect all the participants in the system. Clearly, central counterparties are
multilateral entities, since they replace a multiplicity
of bilateral relations between sellers and buyers and
become the single counterparty of each and every
transaction, just as the money is the single counterpart of every exchange in a nonbarter economy.
It is interesting to note that the concept of multilateralism or its converse antonym (unilateralism and/
or bilateralism) exist also in fields remote from the one
you are debating at this conference. In medicine/biology, the terms unilateral and bilateral indicate a condition or disease that occurs respectively on only one
or both sides of the body. As multilateral does not identify any kind of disease, we are tempted to conclude
that a multilateral body is healthier than a unilateral
or bilateral one! In political history, multilateralism
refers to multiple countries working in concert. In
this respect, the first modern experiment in multilateralism occurred in Europe after the Napoleonic Wars,
when the great powers redrew the map of Europe at
the Congress of Vienna and established the Concert
of Europe, as it became known, the practice whereby
This article is a reprint of a speech by Tommaso PadoaSchioppa, Minister of Economic Affairs and Finance of Italy
and former member of the Executive Board of the European
Central Bank, on April 3, 2006, at “Issues Related to Central
Counterparty Clearing,” a joint conference of the Federal
Reserve Bank of Chicago and the European Central Bank,
held in Frankfurt, Germany, April 3–4, 2006. The conference agenda and presentations are available at www.ecb.
int/events/conferences/html/ccp.en.html.

4Q/2006, Economic Perspectives

great and lesser powers would meet to resolve issues
peacefully. So multilateralism becomes rightly, I
think, synonymous with peace! In sociology or political science, the term multilateral has been used as an
adjective to describe the noun institution. What distinguishes the multilateral form from others is that it
coordinates behaviors on the basis of generalized
principles of conduct.
The economic literature shows that in a world
of interdependent economies a number of externalities cut across the individual/national players, requiring commonly agreed solutions. Of course, policies
themselves have spillovers and hence naturally raise
the possibility of inefficiencies: policymakers or market players who pursue an individual objective and
ignore the externalities they impose on others. The
literature also tells us that there are two types of externality: spillover externality, in which each of the
two players is affected by the behavior of the other,
irrespective of his/her own behavior, and network
externality, in which damage only materializes if
the two players act differently.
A network externality is typically described by
the tale of the “battle of the sexes.” As the story goes,
a recently married couple discusses whether to go
shopping or to a football match. In my version of this
story—one which does not affect the reasoning—the
wife prefers that they both go to the football match,
while the husband prefers that they both go shopping.
If they separately go to different places, however,
they both are worse off than joining their partner in
their least preferred activity. It is intuitive that this
tale captures the collective incentives arising from a
network externality.
In the field of payment systems the foremost
example of network externalities is standardization.
If two systems adopt different and incompatible
proprietary networks, participants will be penalized,
since they cannot reach each other. If only one
standard is adopted, everyone will benefit from the
possibility of increasing the number of the potential
counterparties. However, the costs of adopting the
new common solution are unequal. The case of the
CCP provides another example. Imagine market participants who are members of more than one CCP.
Going to one CCP only can be beneficial for these
participants. However, the criteria for selecting the
CCP are not obvious, since the costs for the various
participants to join one or the other are unequal.
Let’s move to the second type of externality, a
spillover externality, which occurs irrespective of the
behavior of the player experiencing it. The parable here
is the well-known one of the prisoner’s dilemma.1

Federal Reserve Bank of Chicago

Two individuals, who jointly committed a crime, are
separately offered the following deal: Defect, give
evidence, and implicate your accomplice. If both refuse, neither gets any time in jail. If both defect and
implicate the other, both go to jail for a short period
of time. If one turns in the other but is not implicated,
he gets off while the one implicated goes to jail for a
long period of time.
The prisoner’s dilemma also applies to payment
and settlement systems; for instance, in the two cases
of standards setting and cross-margin requirements.
When new standards are introduced, if the central
bank decides to adopt them but market participants
do not, the latter will de facto be excluded by monetary
policy operations, unless central banks agree to deal
with old and new standards at the same time. Managing two sets of standards is obviously quite inefficient.
And it is equally obvious that only multilateral coordination would lead to a common set of standards.
Moving from standards to margin, consider now the
case where participants in two CCPs would like to
stipulate cross-border arrangements in order to reduce
the costs associated with margin requirements. The
benefits of cross-margins could be maximized if both
CCPs decide to change one of their operational rules.
If one CCP makes the change, the general benefits for
its participants will be much lower. If both refuse
(thinking that by doing so they will penalize the competitor) the arrangement will not be possible. Now, in
practice, it is likely that neither CCP will change procedures, fearing that the other won’t do so. The only
(Nash) equilibrium would thus be the least favorable
for the users.
Natural monopoly
Let me now turn to the second topic, natural monopoly. The concept of natural monopoly has been
used and abused in the current European Union (EU)
debate on the need for a single CCP. Economic theory
helps in identifying natural monopolies but not in understanding why concrete implementation of monopolistic solutions is so difficult.
Economics teaches us that natural monopolies result from the presence of market failures: externalities,
public goods, asymmetric information, and increasing
returns to scale or decreasing average costs. The concept of natural monopoly generally covers activities
requiring a high level of fixed investment to develop
the infrastructure. When giving examples of a natural
monopoly, reference is often made to the case of network industries, such as telecommunications, transportation (rail and air), and energy markets.

43

The clearing and settlement industry is a network
industry that presents several aspects of a natural monopoly. However, so far, market forces have in practice
established a monopolistic infrastructure for reasons
that are not clearly explained by economic theory.
The first element involves EU and U.S. experience
in the field of securities systems, which seems to demonstrate that the only existing examples of a natural
monopoly in this field are those imposed by law!
A more in-depth look at the EU and U.S. experience,
however, shows that the inability of market forces to
establish monopolistic solutions depends on the existence of regulatory barriers limiting competition, and
indeed competition is the vehicle leading to a monopoly.
For instance, in the euro area, a study by the London
School of Economics for the European Commission
reported two elements limiting competition in the field
of clearing and settlement, namely: 1) legal requirements indicating the clearing and settlement providers
to be used, and 2) trading and clearing membership
rules imposing the use of a specific service provider.
The second element is the “bundling” between
entities providing different services. Integration in the
production and provision of complementary services
is not undesirable. However, standard economic theory
suggests that two (for-profit) entities that offer complementary services should merge, provided that both
entities are monopolistic firms.2
However, in reality the complementary services
are provided by vertically integrated entities that are
not in a monopolistic position in the provision of both
services. In this situation, a vertically integrated structure has the potential to undermine the possibility for
the investors to freely choose the services they want
to use. As a consequence, the incentive for the institutions to provide services as efficient as those offered
under competitive conditions would decrease.
The third element concerns the geographical scope
of the natural monopoly. Economic literature seems
to refer to a stylized situation of one country, one currency, one stylized product, and one market. Reality
confronts us with situations where multicurrency
systems are in operation in a single country. Monetary
unions have created situations where one currency
exists in more than one country. In the European Union’s
very special situation, you have a single market with
13 currencies and a single economic integrated area
with 18 currencies. European experience shows that
CCPs for derivatives have expanded their business so
as to cover cash products as well, unlike in the U.S.
This seems like advocating a “genetically modified”
natural monopoly!

44

Last but not least, technological developments
have a strong impact on the definition of the scope
of the monopoly. Technology may create the need to
remove existing regulations or to create new ones. It
affects the scale and scope of economies; allows for
the further removal of geographical barriers, making
irrelevant location of the parties; and reintroduces
contestability in the market.
Conclusions
Let’s now briefly draw some conclusions. The
first conclusion is that we should note there is a common element in multilateralism and natural monopoly.
This seems to be based on the fact that both embody
a “public good” element. Thus, the existence of an almost natural monopoly is one of the situations calling
for cooperation, in particular when the geographical
scope of the monopoly is hard to define. The emergence
of a monopoly can be the result of a competitive process (war) or of multilateral cooperation between
competitors (peace). Needless to say, the latter is the
less painful.
The second conclusion is that the presence of
elements of a natural monopoly and the failure of
market forces to achieve spontaneously multilateral
cooperation make it necessary for the authorities
(by this I mean institutions mandated to pursue the
public interest) to intervene in the process with a
view to facilitating the development of cooperative
solutions. The history of payment systems provides
innumerable examples. With the exception of the
case of the Society for Worldwide Interbank Financial Telecommunication (SWIFT), which represents
a very remarkable case of multilateral cooperation
leading to the creation of a monopolistic solution by
market forces, the establishment of national and international infrastructures has been only possible thanks
to the intervention of the authorities: Let me just
quote the case of CLS (Continuous Linked Settlement)
and the Depository Trust and Clearing Corporation
(DTCC). The recent Single Euro Payments Area
(SEPA) project of the Eurosystem is another example
of the catalyst role played by the authorities in fostering market agents’ cooperation.
This takes me to my third and final conclusion,
which concerns the role of the authorities. A persistent
lack of cooperation can rightly be interpreted as a
lack of government. There are many ways the authorities can intervene. They can create conditions for cooperation through regulation or by acting as a catalyst,
as well as by being an “enabler,” but not a “constrainer.”
Or, they can provide integrated facilities (when the

4Q/2006, Economic Perspectives

elements of natural monopoly and the financial stability concerns are particularly strong). For example,
almost all central banks provide real-time gross settlement (RTGS) facilities and most of them provide
central security depository (CSD) services for government securities. Third, they can regulate/oversee
the monopolistic solution in order to prevent potential
abuses by the monopolist.

George Bernard Shaw said that democracy is a
device that ensures we shall be governed no better
than we deserve. I would say that cooperation is a device that ensures that we will be governed better than
we deserve. That’s why I would like to conclude by
inviting the authorities to foster multilateral cooperation: It is the best way to obtain the best solutions for
the most difficult problems.

notes
The prisoner’s dilemma, devised by Merrill Flood and Melvin
Dresher in 1950, is the cornerstone of a vast theoretical literature
on cooperation in fields as different as evolutionary biology and international relations.
1

The underlying assumption is that all customers either buy both
services or neither of them, and therefore they only consider the
sum of both prices, but not each price individually. If the sum of
the two prices is low, then the demand for both services is high.
The best situation for one entity is a high own price and a low price
of the other entity. As a result, both tend to set high prices, which
are bad for the customers. If the two firms merge, this upward price
pressure disappears and lower prices are more likely.
2

Federal Reserve Bank of Chicago

45

Public policy and central counterparty clearing
Michael H. Moskow

Good afternoon and thank you for joining us today to
discuss some important issues related to central counterparty clearing. On behalf of the Federal Reserve
Bank of Chicago (Chicago Fed), I want to thank our
host and cosponsor of this conference, the European
Central Bank (ECB). This has been a wonderful opportunity for us to discuss these issues with experts
from around the world, and I hope that the participants
here today have found these discussions helpful. The
ECB and the Chicago Fed have worked together
closely to plan the conference and agenda, and it has
been a very good partnership.
Today, I’d like to share with you my thoughts
about the important role that clearing and settlement
institutions play in supporting financial markets. In
particular, my remarks today will revolve around four
key questions related to central counterparty clearing.
First, what economic functions do central counterparties, or CCPs, perform in the clearing and settlement
of financial transactions? Second, what alternative institutions can perform the same or economically equivalent functions? Third, what are the costs and benefits
of using CCPs as compared with alternative clearing
institutions? And fourth, what do these costs and benefits tell us about public policy decisions that should
be made concerning CCPs and alternative institutions?
I do not expect to give definitive answers to these
questions today. We just don’t know enough to provide
such answers. But I think that careful consideration
of these issues is essential to formulating good public
policy. The wide variation in financial market structures
and the fast pace of financial and technical innovation
mean there may not be a single, “first-best” clearing
solution that meets the needs of all markets. So, as a
practical matter, it is not possible to formulate public
policy without facing fundamental and unavoidable
tradeoffs when comparing alternative structures for the

46

clearing and settlement of financial transactions. I’ll
elaborate on this theme in the course of my discussion.
Post-trade clearing and settlement are sometimes
referred to as the “plumbing” of the financial system.
This term may suggest that clearing and settlement
systems are of secondary importance. In fact, however,
they are more like the “central nervous system” of the
financial system.1 Clearing and settlement systems
provide vital linkages among components of the system,
enabling them to work together smoothly. As such,
clearing and settlement systems are critical for the
performance of the economy. A key role then for public policy is to ensure that these systems function well
when confronted by a variety of stresses.
Centralized clearing arrangements utilizing CCPs
have become more widespread in recent years, both
for exchange-traded and over-the-counter (OTC) markets. This is no surprise, since they are extraordinarily
good at what they do. As a consequence of this growth
in CCP usage, central banks, securities regulators,
and other financial market policymakers have cooperated in recent years to establish appropriate standards
for the design, operation, and oversight of CCPs. This
effort recently culminated in the Group of Ten (G-10)
and International Organization of Securities Commissions’ Recommendations for Central Counterparties.2
The Federal Reserve Bank of Chicago actively participated in the consultative process leading to the adoption of the recommendations and related financial
stability initiatives.3
This article is a reprint of a speech by Michael H. Moskow,
president and chief executive officer of the Federal Reserve
Bank of Chicago, on April 4, 2006, at “Issues Related to
Central Counterparty Clearing,” a joint conference of the
Federal Reserve Bank of Chicago and the European Central Bank, held in Frankfurt, Germany, April 3–4, 2006.
The conference agenda and presentations are available
at www.ecb.int/events/conferences/html/ccp.en.html.

4Q/2006, Economic Perspectives

In the U.S., the regulatory structure has evolved
toward supporting a “hybrid” system of clearing and
settlement. For securities transactions, Congress has
mandated a “national market system,” and the Securities and Exchange Commission has favored centralized clearing and settlement arrangements. But there
is no such policy mandate for the derivatives industry. The U.S. thus provides a mixed example of the
policy approach that I plan to focus on today.
Central counterparty clearing issues also are of
keen interest to public policymakers here in Europe,
particularly because of the ongoing European financial and economic integration. So the issues being
discussed at this conference are both timely and of
first-order importance.
As you undoubtedly know, Chicago is home to
some of the world’s most active exchanges. Chicago
is also home to three major clearinghouses: the Clearing House Division of the Chicago Mercantile Exchange, or CME; the Clearing Corporation, which
you may recognize under its former name, the Board
of Trade Clearing Corporation, or BOTCC; and the
Options Clearing Corporation. Together these institutions represent what is sometimes called the “Chicago
model” of centralized clearing and settlement. This
model is characterized by counterparty substitution.
That is, the clearinghouse becomes the legally substituted buyer to all sellers and the seller to all buyers in
the markets they serve. This typically occurs through
a legal process known as “novation.” Over the past
few decades, this model has been extended to securities markets around the world. The fact that the Chicago
model has been so widely emulated is evidence that it
is a robust and effective way to operate a clearing and
settlement system.
However, this model was not developed in a
monolithic way, which is not surprising when you
think about the historical development of CCPs. This
history demonstrates that risk management is not the
only factor motivating the development of clearing
structures.4 In fact, the first Chicago clearinghouse,
BOTCC, was founded after the enactment of the Grain
Futures Act of 1922. With the passage of this law,
Chicago Board of Trade members faced a choice of
alternatives for keeping trading records, reporting open
positions to federal regulators, and paying stamp taxes.
They could remain in a principal-to-principal relationship with their counterparties and thus keep their records, make their reports, and pay stamp taxes on their
gross transactions. Or, they could clear their transactions
through the clearinghouse and perform those functions
on a multilateral net basis. Clearly, the multilateral
approach saved both recordkeeping costs and taxes.

Federal Reserve Bank of Chicago

There are additional lessons to learn from the evolution of the Chicago markets. Early on, each Chicago
clearinghouse was associated with a single exchange.
While BOTCC was formed as a separate legal entity,
it only cleared trades from the Board of Trade. The
clearinghouse of the Chicago Mercantile Exchange
was and continues to be a division of its parent exchange. Both clearinghouses, however, functioned
effectively as CCPs. This one-to-one association of
clearinghouse with exchange changed with the advent
of exchange demutualization. This forced exchanges
to decide whether they wished to be in the trade intermediation business, the clearing and settlement business, or both. Indeed, the separation of ownership and
governance of BOTCC from that of the Board of Trade
led, in recent years, to a situation where these two institutions pursued somewhat different business objectives. Ultimately, this led to the termination of the
longstanding relationship between the two. The Board
of Trade then took the remarkable step of outsourcing
its clearing operations to its crosstown rival, the Chicago Mercantile Exchange!
Another historical example that illustrates the
possibility of de-linking the clearinghouse from the
exchange comes from the rice futures market of Osaka,
Japan, in the eighteenth and nineteenth centuries. There
were many different institutions serving that market
that we might recognize today as clearinghouses, perhaps as many as 60 at one point.5 This allowed for
trader choice in the selection of a clearinghouse and,
presumably, competition among clearinghouses.
These examples also demonstrate a more fundamental point: Exchanges and clearinghouses are in
very different, but interrelated, lines of business and
serve very different economic functions. To see this,
let’s look at the core functions performed by CCPs.
I think most analysts would include at least five core
functions. All play a role in managing risk in the markets served by the CCP. The first core function is multilateral netting of open positions and payments. The
second is calculation, collection, and custodial management of margin and collateral payments. The third
is the adoption of procedures, such as “delivery versus payment,” that mitigate settlement risk. The fourth
is mutualization of all or part of the risk of default.
And finally, the fifth core function is to respond to crisis situations in the interest of the entire community
of participants in the clearinghouse, not just the interest of a single trader. While other features can be
identified, I believe these five adequately describe the
core economic functions CCPs typically perform.
Let’s consider each of these functions to see whether

47

the use of a CCP is necessary to perform them, starting with netting. Following counterparty substitution
in a CCP arrangement, a single multilaterally netted
position exists between the clearinghouse and each
market participant. Thus, a “many-to-many” chain of
credit is replaced by a “one-to-many” arrangement,
with the CCP at the center of the arrangement. The
gross obligations of the initial counterparties are, as
a result, converted to net obligations with respect to a
single, substituted counterparty, the CCP. This has the
potential to reduce counterparty risk exposures dramatically and reduce operational costs.
Multilateral netting of obligations is, by definition,
one of the results of counterparty substitution. Thus,
CCPs are a convenient mechanism for obtaining the
risk-management and operational benefits of netting.
But is this the only institutional arrangement that can
support netting? The answer is no. First, take the case
of payment netting. Clearing House Interbank Payments
System (CHIPS), the privately owned and operated
U.S. dollar payment system based in New York, conducts continuous netting of dollar payments on both a
bilateral and multilateral basis without becoming the
substituted counterparty to the underlying payment
obligations. Similarly, the CLS (Continuous Linked
Settlement) Bank provides a hybrid clearing arrangement for foreign exchange transactions, which results
in multilateral netting of the funding requirements of
settlement members. At no point does the CLS Bank
become a substituted counterparty to the underlying
payment transactions.
What about netting of open positions? This is a
more complex case than simple payment netting, because open positions involve forward obligations that
may be discharged at a future date. Is counterparty
substitution necessary for multilateral netting of these
types of obligations? Here again, the answer is no, at
least under U.S. law. The calculation of a multilateral
net amount is simple arithmetic. As long as the participants in a financial market agree to conduct transactions or make payments on a multilateral net basis,
and that contract is enforceable under applicable law,
counterparty substitution is not necessary.
Now let’s consider the second role CCPs typically perform, the management of margin and collateral
requirements, such as “mark-to-market” payments.
Derivatives transactions, such as swaps, futures, and
short options, require discharge of the underlying obligations at some time in the future. Because of the
potential for price fluctuations between the time derivatives obligations are undertaken and the time they
are discharged, participants face exposure to forward
or “replacement cost” risk. To mitigate that risk,

48

clearing arrangements for forward transactions typically impose “variation margin” requirements on their
clearing members. These payments are based upon
a daily or even more frequent marking to market. As
a result, traders are forced to realize their net profits
and losses on a regular basis.
Is counterparty substitution necessary to mitigate
replacement cost risk? The answer is no, again under
U.S. law. For example, participants in the OTC swaps
market often collateralize their bilateral net mark-tomarket exposures without the substitution of a central
counterparty. Such collateral requirements, however,
can be multilaterally netted without counterparty substitution. In fact, in the 1990s, the Chicago Mercantile
Exchange proposed to establish a facility to do precisely this. That proposal did not involve the legal
substitution of the CME Clearing House or any other
CCP as counterparty to the underlying swaps transactions. As it happens, that facility never went into operation, but that was for reasons other than its ability
to perform this underlying economic function.
Now let’s consider the last three roles of CCPs:
the adoption of procedures to mitigate settlement risk
(such as delivery versus payment), loss mutualization,
and centralized crisis management procedures.
Delivery versus payment, or DVP, is a means of
assuring that related transactions, such as the delivery
of securities and the corresponding payment, are coordinated and that neither party is exposed to settlement risk. Counterparty substitution is not necessary
to the implementation of such procedures, which are
common in payment and securities settlement systems.
For example, the Federal Reserve’s own system for
transferring U.S. government securities operates on a
DVP basis. Yet at no time does the Fed become a substituted counterparty to the transaction. Similarly, the
CLS Bank operates on a payment versus payment, or
PVP, basis, again without counterparty substitution.
Regardless of whether you call these processes DVP
or PVP, the result is the same: settlement risk mitigation without the use of a CCP.
Loss mutualization has the effect of spreading
losses across some or all nondefaulting traders. This frequently was a feature of clearinghouses for exchanges
that were owned by their members. Today, however,
participants in a market who wish to spread the risk
of loss resulting from default can purchase insurance
or equivalent risk-shifting protection. As long as they
agree to purchase insurance or otherwise spread the
risk of loss, there is no need for counterparty substitution. Nor is there any need for counterparty substitution for a centralized institution, such as a clearinghouse,
to be given authority to respond to market crises.

4Q/2006, Economic Perspectives

Bank clearinghouses, for example, have historically
exercised such power on behalf of their members.
So, it is clear that the core economic functions
performed by CCPs can be provided by a variety of
alternative institutions. How should public policy respond to this multiplicity of possible clearing arrangements? Even though other institutions can perform
these functions, it may be the case that CCPs dominate other clearing arrangements from a social welfare
perspective. If so, then there would be an argument for
public policy to explicitly encourage or even mandate
CCPs for all markets. It might also make sense to consolidate CCPs from different markets into a common
institution. But if CCPs or consolidation do not dominate on a cost–benefit basis, then public policy should
accommodate a wide range of clearing arrangements.
Like all the institutional arrangements I’ve discussed, centralized clearing arrangements have both
costs and benefits. On the benefit side, it has been
widely noted that CCPs can reduce significantly the
risks to market participants and enhance the liquidity
of the market.6 This is because CCPs benefit from economies of scale and scope, compared with more decentralized arrangements. On the cost side, a CCP also
concentrates risks and responsibility for risk management,7 making it a potential single point of failure.
Concentration carries with it systemic implications,
since the failure of a CCP would be, by definition, a
major systemic event.8 This potential risk would only
be exacerbated by a policy that mandated the consolidation of all CCPs into a single institution. A more
decentralized clearing arrangement would disperse
responsibilities for risk management across multiple
institutions. This would serve to reduce the possibility that a single institution’s failure might have a catastrophic impact.
But this discussion omits perhaps the most important advantage from allowing a broader array of clearing
and settlement arrangements: the benefits of competition. Indeed, it is the competition for better ideas, superior risk-management procedures, and new products
that best leads to market innovation in these areas. The
welfare implications of such innovations can be very
large. If CCPs were to be mandated as the only acceptable clearing and settlement arrangement, I fear that a
good deal of financial market innovation would be
stifled, with corresponding losses in economic welfare.
Take, for example, the market for credit derivatives.9 I think most people would agree that there are
real economic benefits generated by these instruments.
At present, credit derivatives are not centrally cleared.
This market may not have developed as rapidly as it

Federal Reserve Bank of Chicago

has if it had been required to utilize a central counterparty arrangement. Alternatively, the imposition of
centralized clearing might have caused the market to
develop in a different form, perhaps in “offshore” jurisdictions, outside the reach of regulations mandating
the adoption of a CCP. This is not merely a speculative concern. When interest rate swaps were evolving
in the 1980s, U.S. law required “futures” to be traded
on exchanges and, by implication, centrally cleared.
As a result of this requirement, the interest rate swaps
market largely moved offshore. The U.S. swaps market only recovered when the so-called swaps exemption freed this market to develop its own trading and
clearing arrangements. More generally, the imposition of constraints or restrictions on markets can have
a significant effect on firm behavior, again with corresponding welfare implications.
Of course, customized financial instruments, such
as credit derivatives, often become more standardized
over time, lending themselves more easily to centralized clearing and settlement facilities. We may have
reached that point with respect to credit derivatives,
and I am aware of some efforts in this direction. It
seems to me that the best policy prescription is to
allow the market to adopt whatever clearing arrangement meets its own idiosyncratic needs while still
satisfying public policy objectives.
New clearing arrangements are emerging all the
time. Such arrangements may provide a wide range
of risk-management and operational functions, either
with or without counterparty substitution.10 I expect
that such arrangements will continue to evolve as financial innovation, supported by advances in computing
and communications technology, continues unabated.
I view these developments favorably, as they have the
potential to create even greater efficiency in the clearing and settlement of financial transactions. I remain
a bit wary, however, that efforts to make CCPs the
preferred clearing and settlement mechanism or to
force different markets to share the same CCP may
suppress a good deal of this beneficial development.
As a longtime Chicagoan, I certainly would not
want to imply any general criticism of CCPs. Properly
structured, they do an excellent job of executing critical
risk-management imperatives. I do see value, however,
in policy environments that allow multiple clearing
and settlement arrangements to emerge. And in that
context, regulation should be flexible, nonprescriptive,
and risk based to avoid thwarting market innovation.
Indeed, that is precisely what the Federal Reserve Bank
of Chicago recommended to the Bank for International
Settlements’ Committee on Payment and Settlement

49

Systems and the International Organization of Securities
Commissions in the formulation of prudential standards for centralized clearing arrangements.

Once again, thank you for joining us at this conference, and we look forward to your continued involvement in these important policy issues.

notes
Robert E. Litan, 1998, “Institutions and policies for maintaining
financial stability,” in Maintaining Financial Stability in a Global
Economy, Federal Reserve Bank of Kansas City, p. 283.
1

As a result, public oversight of CCPs and economically equivalent
clearing arrangements is justified.
8

See Hamish Risk, 2006, “Credit derivatives market expands to
$17.3 trillion,” Bloomberg.com, newswire, March 15. Risk states:
“Credit derivatives are the fastest-growing part of the $270 trillion
market for derivatives, obligations based on interest rates, events
or underlying assets, according to figures from the Bank for
International Settlements. The market expanded more than
fivefold in two years, according to ISDA [International Swaps
and Derivatives Association].”
9

Bank for International Settlements, Committee on Payment and
Settlement Systems (CPSS) and Technical Committee of the
International Organization of Securities Commissions (IOSCO),
2004, Recommendations for Central Counterparties, Basel,
Switzerland, March.
2

The Federal Reserve Bank of Chicago also participated in the consultative process leading to the adoption of the CPSS–IOSCO’s
Recommendations for Securities Settlement Systems (2001), as well
as the CPSS’s Core Principles for Systemically Important Payment
Systems (2001).
3

See, for example, James Moser, 1994, “Origins of the modern
exchange clearinghouse: A history of early clearing and settlement
methods at futures exchanges,” Federal Reserve Bank of Chicago,
working paper, No. WP-94-3, p. 43.
4

Ulrike Schaede, 1991, “The development of organized futures trading: The Osaka rice bill market of 1730,” in Japanese Financial
Market Research, William T. Ziemba, Warren Bailey, and Yasushi
Hamao (eds.), Amsterdam: North Holland Publishing.
5

For example, the Virtual Markets Assurance Corporation (VMAC)
is a relatively new clearing arrangement. The VMAC functions as
a provider of a “suite” of risk mitigation services that, according to
VMAC’s marketing materials, “allows participants to settle all
mark-to-market amounts with a single hedge counterparty, resulting
in a reduction of up to 90% in the amount of capital required....”
See VMAC’s website, www.vmac.com. However, because VMAC
provides clearing services to some, but not necessarily all, of the
participants in the markets it serves, it does not appear that either
VMAC or any other entity becomes the buyer to every seller and the
seller to every buyer, and thus does not technically qualify as a CCP.
10

See, for example, CPSS–IOSCO (2004), at sec. 1.2.

6

CPSS–IOSCO (2004), at sec. 1.2.

7

50

4Q/2006, Economic Perspectives

Issues related to central counterparty clearing:
Concluding remarks
Jean-Claude Trichet

I have the pleasure to conclude a very successful conference, a conference that has been special in many
respects. First, this conference was jointly organized
by the European Central Bank (ECB) and the Federal
Reserve Bank of Chicago (Chicago Fed). As such, it
marks another fruitful example of cooperation among
central banks across the Atlantic. Second, it has featured research on central counterparties (CCPs), a topic
that has not yet received a great deal of attention from
academic researchers. I hope that this conference has
contributed to stimulating more research on this very
important subject. Finally, it has brought together market participants, public authorities, and academics. I
am in no doubt that discussions involving people from
these very different groups are beneficial for all of
them. However, I am also aware that it is not always
easy to initiate such discussions. This conference has
also been very successful in this respect. I wish to
thank the organizers of this conference at the Chicago
Fed and the ECB for all their hard work.
Central counterparties play an important role in
many financial markets. They interpose themselves
between the buyer and the seller of financial assets,
acting as the buyer to every seller and as the seller to
every buyer of a specified set of contracts. This process
mitigates counterparty credit risk, which is the risk
that one party of a trade suffers losses because the
other party cannot fulfill its obligations from the trade.
Through multilateral netting, central counterparties
enhance liquidity and reduce liquidity costs. Finally,
central counterparties ensure post-trade anonymity.
Central banks are interested in the smooth functioning of central counterparties for three reasons:
n	 Central counterparties can enhance financial stability as long as they function smoothly. The failure of
a central counterparty, however, can significantly
destabilize financial markets. It is therefore important that central counterparties have appropriate
risk-management procedures in place;

Federal Reserve Bank of Chicago

Links between central counterparties operating in
different countries can foster financial integration
across those countries by allowing the participants
to trade in a foreign market and to clear that trade
through existing national arrangements. Links between CCPs can take a variety of forms, ranging
from the establishment of direct relations between
two CCPs to arrangements between central counterparties that allow their participants to mitigate
the costs associated with risk control measures
(for example, cross-margining); and
n	 Central counterparties use payment systems and
other infrastructures operated by central banks to
carry out their activities.
For these reasons, central banks closely follow
and contribute to the discussions related to central
counterparty clearing. This conference is an important
element in this respect.
Let me now outline a few central points of this
discussion.
n	

Central counterparties must have adequate
risk-management procedures
Central counterparties play a systemically important role in many financial markets. The failure of a
central counterparty can severely disrupt financial markets. Central counterparties are highly specialized in
managing risks, and failures have been rare. Nevertheless, there is no room for complacency, and any
This article is a reprint of a speech by Jean-Claude Trichet,
president of the European Central Bank, on April 4, 2006,
at “Issues Related to Central Counterparty Clearing,”
a joint conference of the Federal Reserve Bank of Chicago
and the European Central Bank, held in Frankfurt, Germany,
April 3–4, 2006. The conference agenda and presentations
are available at www.ecb.int/events/conferences/html/
ccp.en.html.

51

efforts to improve risk-management methods are most
welcome. As mentioned already several times in this
conference, in November 2004 the Group of Ten
(G-10) central banks and the International Organization
of Securities Commissions (IOSCO) issued a report
that set out 15 comprehensive international recommendations for promoting the safety and efficiency of central counterparties. The European System of Central
Banks–Committee of European Securities Regulators
(ESCB–CESR) working group is working in close
cooperation with European Union CCPs to adapt these
recommendations to the European context. Academic
research can provide additional hints on the specific
situations that are targeted by the recommendations.
This has been shown at this conference by Alejandro
García and Ramo Gençay or John Cotter and Kevin
Dowd with their approaches to extreme market events
and by Froukelien Wendt in her survey on intraday
margining.
The governance structure of central counterparties
should in principle be market driven
The governance structure may have a significant
influence on, for example, risk-management and other
strategic decisions of central counterparties, as pointed
out by Thorsten Koeppl and Cyril Monnet. Although
the optimal governance structure cannot be defined
ex ante, the markets may in many cases be in a good
position to identify and produce it. Public authorities
must, however, step in whenever market failures become significant. In this respect, the ECB supports the
views expressed in the recommendations by the Committee on Payment and Settlement Systems–International Organization of Securities Commissions (CPSS–
IOSCO), according to which governance arrangements
for a CCP should be clear and transparent in order to
fulfill public interest requirements, support the objectives of owners and participants, and, in particular,
promote the effectiveness of a CCP’s risk-management
procedures.
The features of post-trading structure should
also in principle be market driven
We are witnessing fast developments in the field
of financial market infrastructures, especially in Europe,
but also in other parts of the world. With respect to
central counterparties, I would like to mention four
major developments:
Consolidation of central counterparties
Since the start of the European Monetary Union
(EMU), the number of central counterparties for financial instruments has fallen from 14 to seven in the
euro area. This process of consolidation may have a

52

positive impact on financial stability as larger central
counterparties may find it easier to diversify risks. It
may also have a positive impact on the efficiency of
post-trading arrangements due to network effects and
issues related to interoperability. However, the failure
of large central counterparties could have an even
more disastrous impact on financial markets. Moreover,
consolidation may eventually lead to a reduction in
competitive pressures with a negative impact on efficiency. The Eurosystem has formulated this position
in a policy statement on consolidation in central counterparty clearing, which was published as early as
September 2001. As set forth in the policy statement,
the ECB supports any form of market-led integration
or consolidation process that fulfills the ECB’s requirements in terms of financial stability, open access, price
transparency, and efficiency.
Expansion of activities of central counterparties
While in the past most European central counterparties only cleared derivatives, many of them also
now clear securities transactions. The effects of such
an expansion have been assessed differently by different speakers at this conference. On the one hand,
John Jackson and Mark Manning have found that
central counterparties that diversify their activities
across imperfectly correlated assets may often be able
to better manage their risks than single-product clearers. At the same time, securities market participants
have benefited as their exposure to counterparty credit
risk is reduced. This trend towards multiproduct central counterparties could therefore be beneficial from
a financial stability perspective. On the other hand, in
the first panel yesterday, Diana Chan had mentioned
that central counterparties that diversify their activities
across imperfectly correlated assets and reduce the
collateral requirements for their participants by offsetting margins related to these different activities
could significantly underestimate risk exposure and
collateralization requirements, thereby creating additional and unknown risks. These developments need,
therefore, to be carefully observed by market participants and relevant authorities.
Creation and dismantling of vertical “silos”
In Europe, vertical silos encompassing trading,
clearing, and settlement infrastructures have been
created, while other silos have been dismantled. The
discussion on which structure is preferable is ongoing,
and the answer may be different for different markets.
While silos may help infrastructure providers to reduce operating costs and to better coordinate the prices of the different integrated services (for example,
trading, clearing, and settlement), they may reduce

4Q/2006, Economic Perspectives

competition when they are misused, for example, to
favor a central counterparty in the silo over its competitors outside of the silo. As the Eurosystem explained
in its policy statement of September 2001, the disadvantages of vertical silos “can be overcome provided
that customers can choose between systems along the
value chain.… It is therefore crucial that access to essential facilities, whether vertically integrated or not,
should not be unfairly impeded.”
Growing need for adequate infrastructure in the
field of credit derivatives
Volume growth in derivatives—especially over-thecounter (OTC) derivatives—outpaces the cash markets,
spurred on by increased interest in hedge funds and
the ongoing innovation in the types of contract offered.
While the interest rate contract remains the key hedge
instrument (US$187 trillion outstanding), the credit
default contract (US$6.3 trillion outstanding) is growing approximately 90 percent per year, now reaching
10,000 trades per day. Volume growth is expected to
continue over the coming years, causing some concern among operations managers on the OTC market,
given the lack of straight through processing and hence
capacity to manage the volumes. This rapid multidimensional growth (that is, in terms of products, volumes,
market participants, and secondary markets) calls for
an enhancement of the post-trading infrastructure that
may support more careful risk control by the various
participants. As mentioned by Governor Kroszner,
enhancing the post-trading infrastructure does not automatically mean to introduce telles quelles [“just as
they are”] the same techniques that CCPs use in exchanged-traded derivatives but rather to identify the
solutions that are equally effective and take into account the different features of OTC markets.
All these developments refer to the market structure that surrounds central counterparties and are highly
relevant for the interests of central banks in the fields
of financial stability and financial integration. As central banks, we believe that the market structure should

be market driven as long as market failures are not
observed. Significant market failures, however, must
be identified and, in many cases, require appropriate
public intervention.
This brings me to my last point.
What is the role of public authorities and, in
particular, central banks?
Market forces need a sound legal, regulatory, and
oversight basis to work efficiently. In the euro area
with its 12 countries, and in the European Union with
its 25 countries, the creation of such a sound basis
requires first and foremost a certain degree of harmonization of public principles and standards across
countries. Efforts in this direction are ongoing and
the Eurosystem provides active support. Here I should
mention the joint work by the European System of
Central Banks and the Commission of European
Securities Regulators toward establishing standards
for securities clearing and settlement in the European
Union. As indicated in the ECB policy statement of
2001, standards are to be carefully set and then implemented by public authorities with a clear interest
and expertise in the respective field. It appears evident
that the Eurosystem, for example, should be involved
in the oversight of any major infrastructure for eurodenominated assets with a view to being able to properly
address serious threats to financial stability. A paper,
authored by a professor at the Woodrow Wilson School
at Princeton University in 1990, addressing the performance of the derivatives clearing and settlement systems during the 1987 stock market break, concluded,
inter alia, that “the Federal Reserve played a vital job
in protecting the integrity of the clearing and settlement
systems.”1 The name of that professor is Ben Bernanke.
Finally, it is important that cross-fertilization of
experiences and expertise of market participants, academics, and public authorities in this field continues,
and as I said before, this conference has certainly
contributed in this respect.

note
Ben S. Bernanke, 1990, “Clearing and settlement during the
crash,” Review of Financial Studies, Vol. 3, No. 1, pp. 133–151.
1

Federal Reserve Bank of Chicago

53

Index for 2006
Title & author

Issue

Pages

BANKING, CREDIT, AND FINANCE
Earnings announcements, private information, and liquidity
Craig H. Furfine

First Quarter

39-54

Payment instrument choice: The case of prepaid cards
Sujit Chakravorti and Victor Lubasi

Second Quarter

29-43

A comparison of U.S. corporate and bank insolvency resolution
Robert R. Bliss and George G. Kaufman

Second Quarter

44-56

Policymakers, researchers, and practitioners discuss the role
of central counterparties
Douglas D. Evanoff, Daniela Russo, and Robert Steigerwald

Fourth Quarter

2-21

Derivatives clearing and settlement: A comparison of central
counterparties and alternative structures
Robert R. Bliss and Robert S. Steigerwald

Fourth Quarter

22-29

Issues related to central counterparty clearing: Opening remarks
Gertrude Tumpel-Gugerell

Fourth Quarter

32-36

Central counterparty clearing: History, innovation, and regulation
Randall S. Kroszner

Fourth Quarter

37-41

Central counterparties: The role of multilateralism and monopoly
Tommaso Padoa-Schioppa

Fourth Quarter

42-45

Public policy and central counterparty clearing
Michael H. Moskow

Fourth Quarter

46-50

Issues related to central counterparty clearing: Concluding remarks
Jean-Claude Trichet

Fourth Quarter

51-53

ECONOMIC CONDITIONS
The decline in teen labor force participation
Daniel Aaronson, Kyung-Hong Park, and Daniel Sullivan

First Quarter

2-18

Variations in consumer sentiment across demographic groups
Maude Toussaint-Comeau and Leslie McGranahan

First Quarter

19-38

The economic value of education by race and ethnicity
Lisa Barrow and Cecilia Elena Rouse

Second Quarter

14-27
(continued)

54

4Q/2006, Economic Perspectives

Title & author
Right before the end: Asset decumulation at the end of life
Eric French, Mariacristina De Nardi, John Bailey Jones,
Olesya Baker, and Phil Doctor

Issue

Pages

Third Quarter

2-13

The self-employment duration of younger men over the business cycle
Ellen R. Rissman

Third Quarter

14-27

The great turn-of-the-century housing boom
Jonas D. M. Fisher and Saad Quayyum

Third Quarter

29-44

An alternative measure of inflation
Francois R. Velde

First Quarter

55-65

Are U.S. and Seventh District business cycles alike?
Michael A. Kouparitsas and Daisuke J. Nakajima

Third Quarter

45-60

MONEY AND MONETARY POLICY

REGIONAL ISSUES
The geographic evolution of the U.S. auto industry
Thomas H. Klier and Daniel P. McMillen

Third Quarter

2-13

To order copies of any of these issues, or to receive a list of other publications, please telephone (312) 322-5111 or write to:
Federal Reserve Bank of Chicago, Public Information Center, P.O. Box 834, Chicago, IL 60690-0834. The articles are also
available to download in PDF format from the Bank’s website at www.chicagofed.org/economic_research_and_data/
economicjperspectives.cfm.

Federal Reserve Bank of Chicago

55