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LAGOS (Capital Markets in Africa) – Since the financial crisis, clearing houses – also known as central counterparties (CCPs) – have come to be seen as having a fundamental role in managing risk in financial markets. So far, Africa has lagged behind other regions in adopting CCPs. Do African markets need CCPs?
The answer to this question depends on understanding more about the ways in which CCPs contribute to risk management and how much of this is appropriate for African markets.
A CCP, as its name implies, sits at the centre of a financial market. After the trades are done, the CCP steps in between the buyer and the seller: it becomes the buyer for the seller and the seller for the buyer. The benefit of this arrangement is that the two parties to a trade are no longer exposed to each other, only to the CCP. The buyer does not have to worry whether the seller will still be around to deliver the asset and the seller does not have to worry whether the buyer will still be around to pay. Always provided of course that they have confidence that the CCP will always be able to meet its obligations.
CCPs ensure that they are able to meet their obligations by using sophisticated risk calculations to measure their exposures and by collecting collateral from the buyers and sellers. This means that if a party fails to meet its obligations, the CCP has enough resources to step in and make sure that the other party does not take a loss and that the market is able to continue without disruption. A critical role of the CCP, therefore, is to manage the default, even of a major market participant, so that it has the least possible impact on other market participants and on the operation of the market.
A CCP is not the only way to address this risk. Many African stock exchanges provide protection against the failure of a participant by requiring traders to pre-position securities or cash before trading and by requiring contributions to a guarantee fund. These arrangements, if they are well designed, can provide good protection when a market is in the early stage of development, but it is important to understand when they need to be replaced by more sophisticated arrangements, such as a CCP.
The requirement to pre-position securities or cash may be acceptable when turnover is low, but it can hold back the development of a more active, liquid market by restricting the activities of active traders. Pre-positioning rules are generally unpopular with international investors and can deter international participation. Most importantly, a simple guarantee fund can provide adequate protection in a securities market, when trades are settled within a few days after being traded: the time period when something can go wrong is quite limited. But this approach is not adequate when futures markets are introduced and the period between trading and settlement may be measured in months. The longer the period, the more potential there is for things to go wrong and for prices to move in the “wrong” direction. This requires the ability to calculate risk exposures and collect varying amounts of collateral – the core skills of a CCP.
While a CCP is optional in a spot commodities or cash securities market, it is essential in any kind of futures market.
Although managing counterparty risk is the core activity of CCPs, they are important in other ways, too. A CCP sits at the centre of a market as the buyer to every seller and seller to every buyer. This means it can provide a benefit by netting multiple trades into a single daily settlement: an active securities trader can make a single delivery to or from the CCP each day for each security rather than having to make multiple deliveries to or from many different counterparties. This reduces operational risk by limiting the number of trades that have to be managed and can help to reduce costs.
A CCP may also become necessary to support the type of market structure being adopted. As markets modernise, many of them are adopting electronic trading platforms with an anonymous order book: participants can see the orders in the book but cannot see who has placed them. This anonymity is important in generating liquidity, as traders can place orders without concern that they are giving away their positions. However, after a trade is done, the two parties need to know who to settle with and here is a dilemma: if the two parties learn each other’s identities, then the benefit of anonymity is quickly lost, but if they do not learn each other’s identities they do not know how to settle or who they are exposed to. A CCP can resolve this difficulty. After a trade is executed on an electronic trading platform, the CCP immediately steps in. Both parties know that they will settle with the CCP and anonymity is preserved. This support for pre-trade anonymity and the benefits of netting as trading volumes increase mean that the adoption of an electronic trading platform is almost always accompanied by the adoption of a CCP.
Let us sum up.
CCPs are one of a number of mechanisms for managing risk in financial markets. These can be thought of as a spectrum. Different mechanisms are appropriate at different stages as a market evolves, with a CCP becoming more important as the market matures.
What are the indicators that suggest a market needs to consider introducing a CCP?
A critical indicator is the development of a futures market. It is almost impossible to launch a successful futures market, whether for commodities or financial instruments, without using a CCP to manage the risks.
Even in cash or spot markets, a CCP brings benefits. The more the market is open to international investors and the more volume increases, the greater the benefit of introducing a CCP. And a CCP becomes essential to support a market structure based on an electronic trading platform with an anonymous order book.
To answer the question posed by the title of this article, relatively few markets in Africa outside South Africa meet these tests at the moment, but the rising level of international investor interest, the development of more sophisticated trading platforms and futures markets means that we can expect to see a growing number of CCPs being established across the continent in the years ahead.
This article is featured in the March 2017 edition of INTO AFRICA Magazine, Africa’s Lions: Trust in Fundamentals.
Hugh Simpson is the Managing Partner at Bourse Consult, has over 20 years’ experience in securities markets post-trade infrastructure, as CEO of the UK CSD CREST, as an expert adviser on capital markets and post-trade infrastructure and as a Non-Executive Director.
John Falk is Partner at Bourse Consult, has over 23 years’ experience in securities market infrastructure and market integration as a consultant with Bourse Consult and as Director Securities Market Infrastructures at SWIFT.