The Risk Controllers E-Book

Peter Norman

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 1062

Veröffentlichungsjahr: 2011

Beschreibung

Clearing houses, or CCPs, were among the very few organisations to emerge from the global financial crisis with their standing enhanced. In the chaotic aftermath of the bankruptcy of Lehman Brothers, they successfully completed trades worth trillions of dollars in a multitude of financial instruments across listed and over-the-counter markets, and so helped avert financial Armageddon.

That success transformed the business of clearing. Governments and regulators around the world gave CCPs and the clearing services they provide a front-line role in protecting the global economy from future excesses of finance. CCPs, which mitigate risk in financial markets, responded by greatly expanding their activities, notably in markets for over-the-counter derivatives, and often in fierce competition with one another.

In The Risk Controllers, journalist and author Peter Norman describes how CCPs operate, how they handled the Lehman default, and the challenges they now face. Because central counterparty clearing is a complex business with a long history that continues to influence decisions and structures even in today’s fast changing world, The Risk Controllers explores the development of CCPs and clearing from the earliest times to the present.

It draws on the experiences of the people who helped to shape the business of clearing today. It sets the development of CCPs and clearing in the broader context of changes in society, politics and regulation. The book examines turning points, such as the 1987 stock market crash, that set clearing on a new path and the impact of long running trends, including the exponential growth of computer power and the ebb and flow of globalisation.

Written in non-technical language, The Risk Controllers provides a unique and accessible guide to CCPs and clearing. It is essential reading for clearing professionals, legislators and regulators whose job it is to take this vitally important business into the future.

“The recent crisis has, thankfully, renewed interest in the importance of central counterparties: how they can help preserve stability or, as Hong Kong showed in 1987, undermine stability if they are not super sound. Peter Norman’s book places the role of clearing houses in a historical context, and explains why the financial system’s plumbing matters so much. It should be read by anyone interested in building safer capital markets.”

Paul Tucker, Deputy Governor Financial Stability, Bank of England

Leseprobe

Contents

Cover

Praise

Title Page

Copyright

Dedication

Preface

Acknowledgements

Part I: Clearing up the Crisis

1: Unlikely Heroes

2: The Modern Central Counterparty Clearing House

2.1 THE CCP'S UNIQUE SELLING POINT

2.2 TRADING VENUES AND CLEARING MARKETS

2.3 MANAGING RISK

2.4 CLEARING DERIVATIVES AND SECURITIES

2.5 CCPS AS A BUSINESS

2.6 NETTING TRADES AND OPEN INTEREST

2.7 VERTICAL AND HORIZONTAL CLEARING SYSTEMS IN THE US

2.8 VERTICAL VERSUS HORIZONTAL IN EUROPE

2.9 RISK AND RESPONSIBILITY

2.10 CLEARING UP A CRISIS

3: The Biggest Bankruptcy

3.1 AN INAUSPICIOUS START

3.2 LCH.CLEARNET IN THE FRONT LINE

3.3 LBIE – A DIFFICULT DEFAULT

3.4 SWAPCLEAR IN FOCUS

3.5 THE PICTURE IN PARIS: LCH.CLEARNET SA

3.6 RESPONSES ELSEWHERE

3.7 IMMEDIATE LESSONS FROM THE DEFAULT

3.8 LCH.CLEARNET STANDS THE TEST

Part II: The Road to Central Counterparty Clearing

4: Early Clearing

4.1 THE FIRST TRADERS AND POST-TRADE PRACTICES

4.2 CLEARING IN THE DUTCH GOLDEN AGE

4.3 THE SPREAD OF CLEARING HOUSES

4.4 THE DOJIMA RICE MARKET

4.5 FORWARDS AND FUTURES

4.6 TRADING AND CLEARING COTTON IN LIVERPOOL

4.7 FUTURES AND CLEARING IN CHICAGO

4.8 ANTI-GAMBLING SENTIMENT IN THE US

5: Innovation in Europe

5.1 BREAKTHROUGH IN LE HAVRE

5.2 THE FUNCTIONING OF THE CAISSE

5.3 EUROPE FOLLOWS LE HAVRE'S LEAD

5.4 ANTI-GAMBLING SENTIMENT IN EUROPE

6: The London Produce Clearing House

6.1 CLEARING FOR PROFIT

6.2 ESTABLISHMENT OF LPCH

6.3 LPCH: SUGAR AND THE GERMAN CONNECTION

6.4 A DIVIDED MARKET AND A CLEARING COMPETITOR

6.5 LPCH AND THE FIRST WORLD WAR

6.6 LPCH: AN AWKWARD RECOVERY

6.7 FORCED INACTIVITY AND THE SALE OF LPCH

7: Complete Clearing in North America

7.1 THE MINNEAPOLIS CLEARING ASSOCIATION

7.2 MINNEAPOLIS: A NEGLECTED INNOVATOR

7.3 THE GRADUAL SPREAD OF COMPLETE CLEARING

7.4 A CCP FOR THE CBOT

7.5 THE BOARD OF TRADE CLEARING CORPORATION

7.6 PROSPERITY AND DEPRESSION

7.7 GLOBAL POSTSCRIPT: SEPARATING THE WEAK FROM THE STRONG

Part III: Formative Years

8: The Collapse of Bretton Woods and the Invention of Financial Futures

8.1 THE RETURN OF PEACETIME AND ECONOMIC GROWTH

8.2 LPCH RESUMES CLEARING

8.3 NEW ACTIVITIES AND THE COMING OF COMPUTERS

8.4 FLOATING CURRENCIES AND FINANCIAL FUTURES

8.5 OPTIONS, INTEREST RATE FUTURES AND CASH SETTLEMENT

8.6 THE INFLUENCE OF REGULATORS

8.7 HORIZONTAL INTEGRATION FOR US EQUITIES CLEARING

8.8 FINANCIAL FUTURES IN THE UK

8.9 CCP FAILURES

9: The 1987 Crash, Regulation and CCPs

9.1 THE 1987 CRASH

9.2 US RESPONSES

9.3 CROSS MARGINING, TIMS AND SPAN

9.4 NEAR DISASTER IN HONG KONG

9.5 THE COLLAPSE OF BARINGS

9.6 THE REACTION OF REGULATORS

10: Continental Europe – CCPs in the Slipstream of Exchanges

10.1 ACRONYMS IN ABUNDANCE

10.2 EUROPEAN UNION, EMU AND EUROPE'S SINGLE MARKET

10.3 THREE EXCHANGE LEADERS

10.4 CORPORATE MANOEUVRING IN FRANCE

10.5 EUREX AND CLEARNET

11: Users and Clearers

11.1 USER-GOVERNED CCPS IN THE UK AND US

11.2 THE UK: FROM ICCH TO LCH

10.3 NEW PRODUCTS: REPOCLEAR AND SWAPCLEAR

11.4 THE CREATION OF DTCC

11.5 THE OPTIONS CLEARING CORPORATION

Part IV: CCPs in a Decade of Boom and Bust

12: Shapers of Change

12.1 CHALLENGES OF THE NEW MILLENNIUM

12.2 USERS DEMAND LOWER COSTS

12.3 IPOS FOR FINANCIAL INFRASTRUCTURES

12.4 EUROPE'S DIVISIVE CONSOLIDATION OF POST-TRADE SERVICE PROVIDERS

12.5 THE NON-APPEARANCE OF TRANSATLANTIC CLEARING SOLUTIONS

12.6 REGULATORS TORN BETWEEN SAFETY AND COMPETITIVENESS OF FINANCIAL MARKETS

12.7 FINANCIAL INNOVATION

12.8 CONCENTRATION AMONG CLEARING MEMBERS

13: The Chicago Roller Coaster

13.1 COMMON CLEARING FOR SCREEN-BASED TRADERS

13.2 MARRY IN HASTE; REPENT AT LEISURE

13.3 CBOT AND BOTCC ON DIFFERENT TRAJECTORIES

13.4 THE ASCENT OF THE CME

13.5 AFTER THE CFTC'S DECISION

13.6 VERTICAL INTEGRATION AND OPEN INTEREST

14: Risks and Opportunities

14.1 THE NEED TO MITIGATE RISK

14.2 OPERATIONAL RISK AND 9/11

14.3 INTERNATIONAL STANDARDS FOR CCPS

14.4 CONFLICT AND INNOVATION IN ASIA

14.5 ENRON, ICE AND CLEARING OTC ENERGY DERIVATIVES

14.6 OTC PROBLEMS

14.7 A CCP FOR CREDIT DERIVATIVES?

15: Cross-border Clearing in Europe

15.1 CCPS FOR EQUITIES

15.2 CLEARNET: EUROPE'S FIRST CROSS-BORDER CCP

15.3 LCH AND CLEARNET CONSIDER MARRIAGE

15.4 THE QUEST FOR A SINGLE CENTRAL COUNTERPARTY

15.5 LCH AND CLEARNET FINALLY MERGE

16: Post-trade Policy in Europe

16.1 FRAGMENTED REGULATION: THE EXAMPLE OF LCH.CLEARNET

16.2 THE FIRST DRAFTS OF EU POST-TRADE POLICY

16.3 THE ESCB-CESR STANDARDS

16.4 THE EU COMMISSION MOVES TOWARDS LEGISLATION

16.5 McCREEVY PUSHES FOR AN INDUSTRY SOLUTION

16.6 COMPETITION AUTHORITIES AGAINST VERTICAL SILOS

16.7 THE ECLIPSE OF THE SINGLE CCP

16.8 INTEROPERABILITY ON THE MENU

16.9 THE CODE OF CONDUCT

16.10 PROBLEMS WITH THE CODE OF CONDUCT

17: LCH.Clearnet Under Threat

17.1 DAVID HARDY DEPARTS

17.2 TUPKER AND LIDDELL TAKE COMMAND

17.3 TURQUOISE AND EUROCCP

17.4 ICE, LIFFE, RAINBOW AND THE LSE

17.5 LCH.CLEARNET SEEKS SAFETY WITH OTHERS

17.6 VERTICAL ASCENT

17.7 TRANSATLANTIC PERSPECTIVES

Part V: New Paradigms: Clearing After the Crisis

18: Mitigating Risk in OTC Markets

18.1 TOO BIG AND TOO INTERCONNECTED TO FAIL

18.2 CLEARING AS HIGH POLITICS

18.3 ACTIVISM AT THE NEW YORK FED

18.4 MISTRUST ACROSS THE ATLANTIC AND INSIDE THE EU

18.5 WORKING TOGETHER

18.6 TWIN TRACKS TOWARDS LEGISLATION

18.7 THE PITTSBURGH CONSENSUS

18.8 SETTING BOUNDARIES

19: Clearing Swaps

19.1 NEW PRODUCTS, NEW CONTENDERS, NEW HORIZONS

19.2 CLEARING CREDIT DERIVATIVES

19.3 DTCC AND LCH.CLEARNET UNVEIL THEIR MERGER PLAN

19.4 THE LILY APPROACH

19.5 THE BATTLE FOR LCH.CLEARNET

19.6 HOSTILITIES SUBSIDE

19.7 RIVALS TO SWAPCLEAR

19.8 SECURITY FOR THE BUY-SIDE

20: Exchanging Places

20.1 COMPETITION, PROLIFERATION AND EXPANSION

20.2 FALLING FEES FOR CLEARING EUROPEAN EQUITIES

20.3 CLEARING ALGORITHMIC AND HIGH-SPEED TRADING

20.4 INTEROPERABILITY IN EUROPE: PROGRESS AND SETBACK

20.5 NYSE EURONEXT PLANS ITS OWN EUROPEAN CLEARING HOUSES

20.6 CHALLENGES TO THE CME

20.7 CLEARING AT THE LSE: SYMPTOMATIC FOR AN INDUSTRY IN FLUX

20.8 A DIFFERENT FUTURE FOR LCH.CLEARNET

21: The Way Forward

21.1 THE DODD-FRANK ACT

21.2 ‘EMIR’ – THE DRAFT EUROPEAN MARKETS INFRASTRUCTURE REGULATION

21.3 BASEL III AND CCPS

21.4 CONTEMPLATING CCP FAILURE

21.5 CCPS SPREAD AROUND THE WORLD

21.6 AN ASIAN CENTURY FOR CLEARING HOUSES?

22: Reflections and Conclusions

Appendix A: References and Bibliography

Appendix B: Glossary

Appendix C: Abbreviations of Company, Industry Group and Regulators’ Names

Index

Further praise for The Risk Controllers

“The fallout from the 2008 financial crisis is forcing the world of clearing and settlement out of its traditional back-office obscurity into the limelight. Peter Norman's book presents an invaluable view of the history, operations and strategic issues relevant to this world. At a time when market infrastructure is undergoing the most fundamental change in living memory, his book is an essential companion to anybody involved in helping to shape the new landscape.”

–Richard Berliand, former Head of Prime Services and Market Structure at J.P. Morgan

“The Risk Controllers is an invaluable historical and investigative work about one of the more arcane, yet critical parts of the financial industry. As a result of the financial crisis, Central Counterparty Clearing is now full square at the centre of the global financial repair agenda, especially for derivatives markets, which makes this book particularly timely and welcome. This book will be the reference work on this subject for years to come.”

–David Wright, Deputy Director General, Internal Market, European Commission (2007–2010)

“A must-read for all involved in the development, implementation and oversight of new clearing regulations following the recent financial crisis. Peter has presented a rich history of clearing in a concise and significant manner for those who must seize the successes of the past in putting today's new clearing regimen in place. All should thank Peter for creating this important work which is so relevant in today's world.”

–Dennis Dutterer, Retired CEO, President and Director of The Clearing Corporation; former General Counsel of the CFTC

“The Risk Controllers provides a welcome insight into the world of central clearing. A timely exercise as legislators around the world pin their hopes on CCPs to plug the deficiencies in risk management identified in the global derivative markets. By explaining the history, exposing the limitations and describing the myriad of vested interests involved in central clearing, Peter Norman has clearly outlined the possible pitfalls we must all now try to avoid. A very concise and engaging book on a complex topic.”

–Dr Kay Swinburne, Member of the European Parliament, ECR Coordinator for Economic and Monetary Affairs

This edition first published 2011

© 2011 Peter Norman

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ISBN 978-0-470-68632-4 (Hardback) ISBN 978-1-119-97655-4 (ebk) ISBN 978-1-119-97794-0 (ebk) ISBN 978-1-119-97795-7 (ebk)

To Janice and in memory of Frank Norman

Preface

This history and account of central counterparty clearing is my second book dealing with an important financial infrastructure and covers a business that has shot to prominence since the bankruptcy of Lehman Brothers.

The Risk Controllers was conceived before the cataclysmic events of September 2008. As with my previous book – Plumbers and Visionaries: Securities settlement and Europe's financial market – the present volume is the result of a three-way collaboration between Chris Tupker, the former chairman of LCH.Clearnet, John Wiley & Sons, Ltd and myself.

Like the previous book, the origins of The Risk Controllers can be traced back to a lunch – this time in March 2008 – when I met Chris Tupker to chew over our experiences that resulted in the publication of Plumbers and Visionaries a few months before.

He suggested that I prepare a synopsis for a companion volume that would deal with the little known and rather abstruse business of CCPs, which ensure that trades in derivatives and securities markets will be completed in cases where one of the parties to a trade defaults.

As with the previous book, Chris Tupker's ambition was to have a book that would explain the business of clearing and how it worked to a wider audience and how an important but little known part of the financial world had developed over time in the context of society, politics and regulation.

After some hesitation, prompted mainly by a non-specialist's concern that clearing involved some highly technical issues, I agreed. On balance, we both thought that writing The Risk Controllers would be a relatively easy task, given that it would build on insights gained writing the earlier book.

That was six months before the bankruptcy of Lehman Brothers, which turned the financial world upside down and propelled the business of clearing from the back office to the front pages.

The Lehman bankruptcy and its aftermath made the subject of clearing topical but added greatly to the complexity of this book. The result is a work that is much bigger than originally envisaged, with a case study of how clearing houses in general and LCH.Clearnet in particular handled the Lehman default in Chapter . Part V of the book deals with the political, regulatory and corporate developments since September 2008, which will shape the business of clearing for years to come. The book covers developments up to the middle of October 2010, with some late updates inserted in March 2011. It therefore takes into account the post-crisis legislative initiatives to reform the US, EU and global financial systems.

While paying due attention to the events of the past three years, the book has tried to stay true to its original goal of providing a description and history of clearing. This too has made for an ambitious project as the subtitle ‘Central Counterparty Clearing in Globalised Financial Markets’ implies. As the reader will discover, CCPs are complex businesses, deeply rooted in history and in several continents.

As far as I can tell, this is the first attempt in many years to write a general account and empirical history of clearing. Clearing houses attracted a good deal of attention during the two decades after they were introduced in Europe in the 1880s. Attention waned for much of the 20th century, however, as they shrank in importance with the global economy under the impact of two World Wars and the Great Depression. A considerable literature on CCPs and clearing has built up since the early 1980s, but this appears largely to consist of official reports and specialist studies of aspects of clearing rather than any general history.

Although I hope that this book will appeal to specialists, I especially hope it will bring the world of the CCP to a wider audience, including readers with a general interest in economics, finance and business and how these interact with politics and regulation.

The book itself cannot possibly claim to be the definitive account of CCPs and central counterparty clearing. Wars, technological advance and office relocations have conspired against the retention of the records necessary to produce such a work, if ever one were possible. CCPs, like many other IT-related businesses, have tended to show scant regard for their roots or history. In my experience, the first thing to disappear into a skip, if space is in short supply or an office is being moved, is the company archive.

Yet, I am convinced there is much more to be discovered about the history of clearing, in archives that may be half forgotten or are waiting to be catalogued. It is encouraging that some companies, such as ICE Futures in Canada, have donated historical material obtained through corporate acquisitions to university archives. If such acts, or indeed this book, encourage other companies to follow suit or researchers to take up the history of financial infrastructures, it will be all to the good.

This book has been made possible by the support of LCH.Clearnet Group, which provided financial backing without which the research would have been impossible. The story of the clearing houses that eventually merged to form LCH.Clearnet forms part of the narrative. But the book is not an official history of LCH.Clearnet or any other clearing house. My relationship with the LCH.Clearnet Group has been at arm's length throughout.

Books are never written without the assistance of many people and this is especially true of The Risk Controllers. The list of individuals and institutions who helped me research this book is long. They are mentioned, with thanks, in the following Acknowledgements.

However, there are some without whom this book could not have been produced. Special thanks go to Chris Tupker, whose patience, encouragement and guidance proved a great support at all times. I am also grateful to Rory Cunningham, who helped me understand, if not master, some of the technicalities of modern day clearing. Dennis Dutterer unselfishly shared documents from his own collection of papers covering the early history of the Board of Trade Clearing Corporation, read some of the early draft chapters and provided valuable insights into the development of clearing in the US. Michael March, Natasha de Terán, Rory Cunningham, Ed Watts, Andrea Schlaepfer, Peter McLaren, David Wright and Ben Norman took the time and the trouble to read parts of the text and made helpful comments. After all that input, it goes without saying that any errors in the pages that follow are mine as are the judgements.

Finally, there would be no The Risk Controllers without Janice, my wife, whose patience, good humour and support sustained me as I researched and wrote this book.

Acknowledgements

I am indebted to many people who helped me research and prepare this book. Some I have already thanked in the Preface. There are many more whom I met and who gave generously of their time and wisdom. Others responded helpfully to e-mailed queries, shared their thoughts over the telephone or swapped ideas on the margins of conferences and seminars. Some were happy to be quoted in the text. Others preferred to discuss matters on a background basis. Without their help The Risk Controllers would never have been written.

My thanks go to: Jacques Aigrain, Will Acworth, Valerie Bannert-Thurner, John Barneby, Robert Barnes, Jan Bart de Boer, Anthony Belchambers, Richard Berliand, Jim Binder, Michael Bodson, Thomas Book, Bill Brodsky, Phil Bruce, Maurice Buijsman, John Burke, Didier Cahen, Michael E Cahill, Diana Chan, Ignace Combes, Tom Costa, John Damgard, Godfried De Vidts, Diana Dijmarescu, Athanassios Diplas, Don Donahue, Oliver Drewes, Wayne Eagle, Peter Elstob, David Farrar, Rudolf Ferscha, Werner Frey, Piet Geljon, Phupinder Gill, Daniel Gisler, Victorien Goldscheider, Stuart Goldstein, Jeremy Grant, Carol Gregoir, Owen Gregory, Catherine Gully, Claire Halsall, François-Guy Hamonic, John Harding, David Hardy, Judith Hardt, Tina Hasenpusch, Daniel Heller, Christophe Hémon, Richard Heyman, Michael Hofmann, Thomas Huertas, Paul-André Jacot, Hans-Ole Jochumsen, Christopher Jones, Alexander Justham, Pen Kent, Cherelt Kroeze, Jacques de Larosière, Olivier Lefebvre, Iona Levine, Roger Liddell, Kelly Loeffler, Walter Lukken, Wayne Luthringshausen, Gina McFadden, Ian McGaw, John McPartland, David Marshall, Gérard de la Martinière, Susan Milligan, James Moser, Mario Nava, John Nordstrom, Patrick Pearson, Nils-Robert Persson, Denis Peters, Martin Pluves, Martin Power, Peter Praet, Alberto Pravettoni, Wal Reisch, Pierre-Dominique Renard, Scott Riley, Daniela Russo, Ulrike Schaede, Heiner Seidel, John Serocold, Martin Spolc, Robert Steigerwald, Marco Strimer, Paul Swann, Kim Taylor, Marc Truchet, Paul Tucker, Steven Van Cauwenberge, Paul Watkins, Martin Wheatley, Justin Wilson, Colin Woodley, Eddy Wymeersch and Marcus Zickwolff.

One of the challenges of this book was to keep up with unfolding events at the same time as researching the past. It helped greatly to attend some of the more important conferences that bring clearing professionals, regulators and policy makers into contact. I am especially grateful to the CSFI; Eurofi; FESE; the FIA; the Financial Markets Group of the London School of Economics; the FOA; Forum Europe; ICBI, Mondo Visione and the SFOA for making me welcome at their events.

To build a picture of clearing before modern times meant rediscovering the delights of digging around in libraries and archives. The British Library, the Library of Congress, the New York and Chicago Public Libraries yielded valuable background and source material. London's Guildhall Library, with its helpful staff, was an important source of information about LPCH.

I gained access to other information because several organisations kindly allowed me to study material in their possession. These included the Archives municipales du Havre; the Bank of England; Czarnikow in London; the CFTC and Federal Trade Commission in Washington DC; the Museum of American Finance, New York; The National Agricultural Library, Beltsville, Maryland; the Special Collections Department of the Richard J Daley Library of the University of Illinois at Chicago and the Stichting Vereniging voor de Effectenhandel (VvdE) of Amsterdam.

There were some collections and archives that I was unable to visit but which responded helpfully to e-mailed requests for assistance. I am especially grateful to Brian Hubner of the University of Manitoba Archives & Special Collections in Winnipeg; Alison Purgiel of the Minnesota Historical Society Library in St Paul, and Rita Maloney and Eric Grover of MGEX in Minneapolis. My thanks go also to David Boutros of the Western Historical Manuscript Collection-Kansas City and Heather Paxton in Kansas City, Missouri.

Helping inform this book have been insights and contacts gained over 40 years in journalism, many of them writing on economic and financial affairs, with 22 of those years based on the European mainland. This book has also benefited from work I did for Plumbers and Visionaries, my book on securities settlement in Europe, which was published in December 2007.

The Internet was also an essential tool for researching this book. Quite apart from making ‘on the record’ announcements of companies, regulators and policy makers instantly accessible, the web has made available a phenomenal and ever growing amount of historical and archive material. In researching this book two services were especially useful: the WorldCat online library catalogue service and the San Françisco-based Internet Archive.

Preparing the Risk Controllers necessitated learning some new skills: my thanks go to Vida Yirenkyi at LCH.Clearnet in London for giving me a crash course on how to create graphics using a computer. I am also grateful to Kate McAusland, who as assistant to Chris Tupker was always helpful.

Finally, my thanks go to John Wiley & Sons, Ltd the publisher of this work, and in particular to Aimee Dibbens, Caitlin Cornish, Pete Baker, Viv Wickham and Lori Boulton for their guidance and help through the gestation of The Risk Controllers, and also to Andy Finch, who as copyeditor helped clean up and prepare my text ready for typesetting.

Part I

Clearing up the Crisis

1

Unlikely Heroes

Crises create unlikely heroes. The bankruptcy of Lehman Brothers on 15 September 2008 was no exception.

When Lehman sought protection from its creditors in the US that day, a small number of specialist financial institutions sprang into action to keep the world's securities and derivatives exchanges at work.

First in Europe, and later around the globe, central counterparty clearing houses (known as CCPs) stepped in to rescue trillions of dollars worth of trades caught up in the Lehman collapse. Without their action, the global financial meltdown threatened by the failure of the 158 year old investment bank would have been an instant reality.

These little known organisations fulfilled their emergency role of successfully completing trades for which they had assumed responsibility. Therefore they ensured that the world's securities and derivatives exchanges could continue to function and handle trading volumes that leapt into the stratosphere as prices for shares, bonds and other exchange-traded instruments gyrated wildly in the crisis.

The collapse of Lehman Brothers changed the world in many ways. The petition for Chapter 11 protection, filed by Lehman Brothers Holdings Inc. with the US Bankruptcy Court for the Southern District of New York, turned a steadily escalating international financial crisis into a global economic cataclysm. The investment bank's failure put paid to any prospect of orderly management of the financial turmoil that started during the summer of 2007 as a result of growing losses in the subprime sector of the US housing market. The bankruptcy shattered confidence in market-based finance. The lending between banks that lubricated transactions in the global economy jammed as trust drained away. Money became scarce. Its cost soared.

The decision of the US authorities to let Lehman fall shattered a widespread belief that large institutions of importance to the global financial system were simply too big to fail. That the same authorities decided within 24 hours to prop up the crippled AIG insurance group only added to the convulsions. No-one was left with a clear idea of what would or would not be saved. The issue of ‘counterparty risk’ – whether it was safe or not to do business with another financial institution, no matter how great or low its standing might be – assumed an overwhelming importance.

In the following weeks, governments in the US, Britain and continental Europe were forced to prop up banking and financial systems with rescue packages costing billions of dollars, pounds and euros. Interest rates tumbled. Budget deficits soared. Many leading banks survived solely because taxpayers’ funds were committed to their recapitalisation. In a few frantic weeks mighty financial structures created over the previous three decades either crumbled away or sought to survive as subsidiaries of stronger rivals or wards of the state. The market-based financial systems that had spread from the US around the world since the early 1980s now hosted banks that were either partly or wholly state-owned.

Lehman's bankruptcy placed in jeopardy trillions of dollars worth of transactions conducted by and through the investment bank and its many subsidiaries. Assets were caught in limbo, spreading financial hardship, and in some cases collapse, to companies at the other end of these trades. As became clear when bankruptcy administrators on both sides of the Atlantic tried to make sense of the wreckage, assets worth many billions of dollars would be out of reach for creditors for months if not years.

But the story was very different for those trades transacted on derivatives and stock exchanges and even for a minority of the huge volume of specialised transactions negotiated among financial institutions bilaterally on the ‘over-the-counter’ (OTC) markets between buyers and sellers. These trades escaped the Lehman catastrophe for the simple reason that they were cleared by central counterparty clearing houses. The CCPs covered for losses after Lehman's default, having stepped in as the buyer to every seller and the seller to every buyer in the markets that they cleared.

Within a week of the Lehman bankruptcy, most outstanding open positions relating to these trades had been neutralised or ‘hedged’ so that they no longer threatened further losses to creditors or to add more chaos to the world financial system.

Within two weeks, most of Lehman's customer accounts were transferred to other investment companies.

By late October 2008, CCPs in most leading financial markets had reported success in managing the biggest default in financial history without cost to their member companies.

The performance of these unglamorous institutions permitted some rare outbursts of satisfaction in a business where sober understatement is the norm.

In New York, Don Donahue, the Chairman and Chief Executive of the Depository Trust and Clearing Corporation of the US, reported that DTCC was ‘able to ensure reliability and mitigate risk across the industry’ despite ‘unprecedented volatility and shaken confidence’ in the financial services sector.1

Terrence A. Duffy, Executive Chairman of the Chicago-based CME Group of derivatives exchanges, declared that ‘no futures customer lost a penny or suffered any interruption to its ability to trade’ when Lehman Brothers filed for bankruptcy. ‘The massive proprietary positions of Lehman were liquidated or sold, with no loss to the clearing house and no disruption of the market. This tells us that our system works in times of immense stress to the financial system,’ Duffy told a Senate committee.2

In London, where LCH.Clearnet Ltd, the UK operating subsidiary of the multinational LCH.Clearnet Group, declared Lehman in default shortly after the start of trading on 15 September 2008, Group Chairman Chris Tupker recalled how: ‘At the moment Lehman sought Chapter 11 protection, every exchange in London was clearing through us. No other CCP had the variety and size of positions on its books that we did. I shudder to think what might have happened to the marketplace if we had failed.’3

The ability of LCH.Clearnet and other clearing houses successfully to manage the Lehman default helped enable the City and other leading financial centres to survive one of the darkest chapters in the global economic crisis. Thanks to CCPs, the world's securities exchanges have continued to raise capital for enterprises while futures and options exchanges continue to provide investors, traders and entrepreneurs with the means to protect themselves against risk.

The events of September 2008 changed fundamentally the status of CCPs in financial markets and the priority they are accorded on the agenda of policy makers. After years spent in obscurity, central counterparty clearing houses emerged from the days of chaos among very few organisations in the global financial system with a good story to tell.

This book takes up the story of central counterparty clearing by examining in detail how CCPs functioned in the emergency that followed Lehman's bankruptcy petition.

Chapter 3 places special emphasis on the successful responses of the LCH.Clearnet Group despite serious, unexpected problems faced by its CCPs in London and Paris. The multinational CCP operator was the first big clearing house to declare Lehman companies in default on 15 September. It cleared for a wider range of markets and asset classes than any other CCP. It broke new ground in closing down very large open positions in the interest rate swap market, where over the previous 10 years SwapClear, its specialist clearing service, had built up unique experience in clearing these OTC instruments.

Having demonstrated the value of CCPs in a crisis, the book explores how central counterparty clearing houses grew out of techniques rooted in antiquity and developed from the late 19th century into the institutions on which many hopes are pinned today.

Part II of the book shows how clearing house pioneers in the globalising world of the late 19th and early 20th centuries adopted different systems of governance and ownership, strung along a spectrum from mutualised utility to for-profit, listed corporations, and faced challenges that would be familiar to some of today's CCP managers. Then, as now, technological change – notably in the field of communications – and political developments shaped their decisions.

Part III tells of the emergence of modern CCPs amid the turmoil of the late 20th century and their increased interaction with policy makers and regulators.

Part IV brings the story of CCP clearing to the point of Lehman's default in September 2008 as the optimism engendered by economic globalisation gave way to the global financial crisis.

Part V examines how clearing and CCPs have shot up the public policy agenda as a result of their successes in dealing with the Lehman default and some of the lessons learned from the crisis.

The final part of the book reviews the initiatives by industry and governments to use CCPs to bring transparency and mitigate risks in financial markets and so help ensure that the worst global economic crisis since the Great Depression of the 1930s is not repeated. These include a central role for CCPs in the markets for OTC derivatives, the financial instruments that caused massive losses at AIG, the US insurance group rescued by the US taxpayer immediately after the Lehman bankruptcy. Great hopes are being pinned on CCPs. The big question is whether too much is being expected of institutions that concentrate as well as mitigate risk.

The story of central counterparty clearing in globalised financial markets is a story of constant change, made difficult at times by the absence of a common vocabulary. The terminology of clearing has changed as the business has developed over the past century and a quarter. The terms ‘central counterparty clearing’ and ‘CCP’ are relatively recent, and only in common use since the early 1990s.

In examining CCPs and their history, this book covers institutions which existed before the phrase ‘central counterparty clearing’ and the abbreviation ‘CCP’ were invented and which nonetheless performed similar functions. It also provides a review of earlier forms of clearing to provide some context for the eventual emergence of CCPs. But it does not claim to be a comprehensive history of all forms of clearing.

CCP-type institutions first existed in 18th century Japan, where they were part of the infrastructure of the Dojima rice market of Osaka. However, today's CCPs trace their lineage back to clearing systems that guaranteed against counterparty risks in commodity futures trading in late 19th century Europe.

During the 1880s, in the historic trading cities of continental Europe and the UK, techniques foreshadowing central counterparty clearing appeared in support of traders who were developing futures and options to manage and exploit the vagaries of the seasons and the cycles of investment, production and trade in markets for agricultural commodities and raw materials.

Soon afterwards, new style clearing practices appeared in North America, where ‘complete clearing’ houses took on the role of buyer to every seller and seller to every buyer in the nation's commodity exchanges. After a slow start, partly reflecting anti-gambling sentiment, complete clearing became firmly established as the norm for US commodity exchanges in the years of rapid growth between the end of the First World War and the Great Depression.

The importance of central counterparty clearing has grown exponentially in the past 40 years. Human-made uncertainty arising from the shift to floating exchange rates in the early 1970s gave a huge boost to derivatives trading – and by extension to CCPs. The invention of financial futures that facilitated speculation and the management of risks inherent in currencies, securities and interest rates created markets that dwarf the commodities exchanges that CCPs were originally created to serve.

Ever greater computer power has supported the development of CCPs. An important influence was the Wall Street Crash of 1987, which highlighted the growing importance of clearing houses and the risks that attached to them and brought in its wake greater regulatory involvement with CCPs.

Also crucial has been the realisation, during the past two decades, that CCPs have a capacity to add value in the chain of transactions between the buyers and sellers of securities and futures contracts. This gave an impetus to the drive to demutualise exchanges and the infrastructures that support them.

Until recently, it was axiomatic that CCPs dealt only with standardised commodities or financial instruments. CCPs are still used mainly in support of transactions in bonds, shares and futures and options contracts that are listed and traded on regulated exchanges. As initiat- ives to create CCPs for credit instruments traded over-the-counter show, the role of central counterparty clearing in financial markets stands on the threshold of a new era.

But before exploring the role of CCPs in the past, present and future, the following chapter offers an overview of the modern CCP, how it works and the special features that define central counterparty clearing and its place in today's financial markets.

1. DTCC (29 October 2008), Addressing the DTCC Executive Forum 2008. DTCC provides clearing, settlement and other post-trade services for companies trading on US stock markets and other financial markets.

2. Testimony before the Senate Committee on Agriculture, Nutrition and Forestry, 14 October 2008.

3. Conversation with the author, 12 January 2009.

2

The Modern Central Counterparty Clearing House

2.1 THE CCP'S UNIQUE SELLING POINT

The near meltdown of the global financial system following the bankruptcy of Lehman Brothers refocused the attention of markets and policy makers on the original and unique purpose of CCPs.

Just as the forerunners of today's CCPs were set up in the 19th century to neutralise counterparty risk in commodity markets, the core responsibility of today's central counterparty clearing house is again to ensure that a security or derivatives trade between two of its users will not fail because the buyer or the seller are unable to fulfil their side of the bargain. By becoming the buyer to every seller and the seller to every buyer, the CCP assures completion of the trade if a trading partner defaults.

The trade might take place on an exchange, an alternative electronic trading platform or be bilaterally negotiated in an OTC trade. The legal substitution of the clearing house as the counterparty in two new trades, in which the seller sells to the clearing house and the buyer buys from the clearing house, is generally known as novation.

Thanks to advanced technology, modern CCPs clearing for exchanges novate and become counterparties to trades instantaneously at the time of their execution. Under traditional methods – still used for OTC trades – novated trades are registered on the CCP's books just after the trade and the details of the original bargain have been verified or matched. Novation takes place before the completion or settlement of trades, which in many cases is handled by a different institution.

Counterparty risk was relatively low among the concerns of financial markets in the decade and a half before Lehman's collapse. Most users in those years probably placed more value on the ability of CCPs greatly to minimise costs and maximise efficiency by netting the positions of counterparties to trades and to provide anonymity for their trades.

If users valued the guarantee function of a CCP it was probably because it also reduced their costs. Under internationally agreed bank capital rules, the substitution of a CCP, with its high credit rating, meant the original counterparties to a trade no longer had to hold capital in respect of their open positions.1

Before the Lehman weekend, CCPs appeared worthy at best: little known companies that combined some of the attributes of a bank, a post office and an insurer. In fact, after computers began to take over the processes of registration, novation and netting in the 1960s, the capacities of CCPs increased exponentially in scope as well as scale so that today, for example, the LCH.Clearnet Group clears more than 2 billion trades a year.