BoE published a working paper that examines and provides direct evidence of the costs associated with fragmentation in clearing across multiple central counterparties (CCPs). With central clearing becoming a key feature of over-the-counter (OTC) derivatives markets after the financial crisis, questions regarding the scope and size of CCPs are becoming increasingly important due to the economic significance of choosing one option versus another. The paper sheds light on an important aspect of these options, namely what happens when clearing in comparable products is fragmented.
The paper concludes that fragmenting clearing across multiple CCPs is costly. Due to the global nature of OTC derivatives markets, major dealers act as liquidity providers across jurisdictions, meaning that their client trades are cleared in multiple CCPs. This is especially true if clients in a particular jurisdiction only tend to access their local CCP. Thus, the netting opportunities for dealers’ overall portfolios are reduced. This reduction in netting opportunities increases dealers’ collateral requirement as they are forced to pledge collateral with each CCP. Thus increasing their collateral costs. These costs are then passed on to their clients through price distortions that take the form of a price differential (basis) when the same products are cleared in different CCPs.
The authors document an economically significant price differential between the same dollar swap contracts cleared in Chicago Mercantile Exchange (CME) and the London Clearing House (LCH) and argue that this is a result of dealers seeking compensation for bearing increased collateral costs when clearing is fragmented. The authors theoretically argue, and empirically document, that fragmentation in clearing gives rise to economically significant price distortions, which become visible when the same contracts are cleared by different CCPs. These distortions reflect dealers’ collateral costs and represent a real cost to market end-users.
Keywords: Europe, UK, Banking, Securities, CCPs, OTC Derivatives, Central Clearing, Netting, Collateral Cost, Research, BoE
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