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    BoE Paper Examines Cost of Clearing Fragmentation Across Multiple CCPs

    May 31, 2019

    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 information to be provided by a third party seeking authorization to assess the compliance of securitizations with the STS criteria provided for in Securitization Regulation should enable a competent authority to evaluate whether and, to what extent, the applicant meets the conditions of Article 28(1) of the Securitization Regulation. An authorized third party will be able to provide STS assessment services across EU. The application for authorization should, therefore, comprehensively identify that third party, any group to which this third party belongs, and the scope of its activities. With regard to the STS assessment services to be provided, the application should include the envisaged scope of the services to be provided as well as their geographical scope, particularly the following:

    • To facilitate effective use of the authorization resources of a competent authority, each application for authorization should include a table clearly identifying each submitted document and its relevance to the conditions that must be met for authorization.
    • To enable the competent authority to assess whether the fees charged by the third party are non-discriminatory and are sufficient and appropriate to cover the costs for the provision of the STS assessment services, as required by Article 28(1)(a) of Securitization Regulation, the third party should provide comprehensive information on pricing policies, pricing criteria, fee structures, and fee schedules.
    • To enable the competent authority to assess whether the third party is able to ensure the integrity and independence of the STS assessment process, that third party should provide information on the structure of those internal controls. Furthermore, the third party should provide comprehensive information on the composition of the management body and on the qualifications and repute of each of its members.
    • To enable the competent authority to assess whether the third party has sufficient operational safeguards and internal processes to assess STS compliance, the third party should provide information on its procedures relating to the required qualification of its staff. The third party should also demonstrate that its STS assessment methodology is sensitive to the type of securitization and that specifies separate procedures and safeguards for asset-backed commercial paper (ABCP) transactions/programs and non-ABCP securitizations.

    The use of outsourcing arrangements and a reliance on the use of external experts can raise concerns about the robustness of operational safeguards and internal processes. The application should, therefore, contain specific information about the nature and scope of any such outsourcing arrangements or use of external experts as well as the third party's governance over those arrangements. Regulation (EU) 2019/885 is based on the draft regulatory technical standards submitted by ESMA to EC.

     

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    Effective Date: June 18, 2019

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  • 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.

     

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    Keywords: Europe, UK, Banking, Securities, CCPs, OTC Derivatives, Central Clearing, Netting, Collateral Cost, Research, BoE

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