The Challenge at Clearing

The most visible part of financial markets is trading -- prices move in realtime reflecting the dynamic nature of information, all influencing weighty financial decisions. On the other hand, ``post trade'' is often treated as a transactional detail of lower consequence.

Ideally, post-trade operations would be trivial -- the moment a trade took place, the buyer and seller would immediately do delivery and payment. This would be a ``spot transaction'': on the spot, the buyer would pay funds and the seller would give good securities. At a shop, when we buy a shirt and pay for it, that is a true spot transaction.

On all financial markets, what instead takes place are forward transactions. In a forward transaction we make a purchase today, but the actual exchange of securities and funds takes place later. For example, a seller S will decide to sell a tonne of wheat to a buyer B at a stated price on 31 December 1999. Similarly, on the BSE, when a trade takes place on Monday, the seller brings the securities 10 days hence and the buyer brings the funds 11 days hence. Hence ``cash market'' trading on BSE involves forward contracts.

Credit Risk

All forward transactions contain counterparty risk. In the wheat example, neither B and S can be certain that the other will live up to the obligations of the contract. In the 1.6 years that stand between trade and delivery, prices would fluctuate. If wheat prices rise, S would lose by adhering to the contract (selling the wheat at a price much below the then--current spot price). The reverse takes place when wheat prices fall.

These dangers increase as time passes -- price fluctuations that can take place in a year are larger than what can happen in a month. Counterparty risk is greater for longer-dated forward contracts than for those with a shorter duration.

When price fluctuations take place, either party has an incentive to declare bankruptcy (either because it is genuinely impossible to absorb the loss, or because declaring bankruptcy is a more attractive -- albeit less ethical -- alternative). Hence contract performance is threatened by price fluctuations.

Failure on the part of one broker can blossom into a full-fledged payments crises through a domino effect. Here the failure of A breaks B (who was to get money from A), which in turn breaks C (who was to get money from B), etc. Several payments crises were witnessed in India; most recently, the M. S. Shoes crisis in 1995.

Counterparty risk cannot be eliminated by depending upon business ethics or legal enforcement alone. Even if only a small fraction of trades collapse through bankruptcies, it will disrupt the smooth functioning of the market. The very threat of such failure will be factored into the behaviour of the market through smaller open positions, reduced volumes and distorted prices.

Do nothing about it?

Some financial markets have evolved with no control over credit risk. This leads to two kinds of outcomes: the ``club market'' and the ``unsafe market''.

The club market withdraws itself to involve only a small club of participants who trust each other, therefore eliminating counterparty risk. This market effectively imposes entry barriers to widespread participation. Inter-bank markets are often of this character: banks only trade with banks. This structure hurts liquidity on the market by limiting the size of positions that can be adopted and the quality of information flow into the market. Even within the club, each participant sometimes imposes ``counterparty exposure limits'' on a case by case basis. Other custom procedures, like elevated prices, also exist to compensate large players for bearing credit risk owing to small players. Higher prices further hurt liquidity by generating different prices for different participants.

An unsafe market ignores counterparty risk completely. Such markets periodically collapse into payments crises when individual participants go bankrupt. Such a market mimics a club market in relying upon friendships and the persuasion of exchange staff in resolving a payments crisis, but without any well-formulated checks or limits on positions. The problem of credit risk between members are exacerbated as volumes grow.

Both these approaches generate inferior liquidity and market inefficiency. A modern financial market must do better.

The futures market

In 1874, the Chicago Board of Trade took a momentous step in the history of economics by introducing a new concept of guaranteeing all trades. At a legal level, the clearinghouse became the counterparty to all trades. Thus, when S sold and B bought, neither would have any legal standing with respect to each other: S would sell to the clearinghouse and the clearinghouse would sell to B. One immediate consequence of this is the elimination of the domino effect: as long as the clearinghouse is able to meet its obligations, market-wide payment crises are infeasible.

What enables a clearinghouse to become the counterparty for both legs of all transactions, thus betting on the creditworthiness of those involved? This is done using a two-part procedure of refundable deposits paid by participants:

  1. One is the mark-to-market (MTM) margin. At the end of each trading day, the notional loss experienced on a position is required to be paid up in full. These payments eliminate the increase of risk with time -- a new contract entered today is no different from one entered a month ago. The MTM margin serves to break a large loss accumulated over a large period into a series of small daily losses. At the daily MTM margin payment, a member faces two choices: to pay the one-day loss or to declare bankruptcy. The incentive to declare bankruptcy here is tiny when compared with a forward contract, where the full loss in a trade has to be paid on one day.
  2. To eliminate the risk of bankruptcy even at the one-day margin payment, the clearinghouse requires an upfront initial margin which is equal to the largest possible one-day loss. A broker is unlikely to skip a (small) daily MTM marrgin payment, since the clearinghouse would then confiscate the (larger) deposit.

These principles -- clearinghouse as counterparty, daily MTM margin, and the initial margin which is larger than the largest possible one-day loss -- are the distinguishing features of futures markets as opposed to forward markets.

This approach has worked remarkably well. The markets in Chicago have over a century of experience without a single breakdown, despite events like the October 1987 crash, where the market index dropped by 20% in one day. Similarly, while Mr. Leeson drove Barings into bankruptcy, the SIMEX clearinghouse continued unscathed.

Applications in India

From mid-1996 onwards, the one-week equity market on the NSE conformed to all three principles, making it a futures market. Other stock markets in the country are still forward markets featuring credit risk.

The badla institution involved forward positions without margins and without a clearinghouse as the counterparty. Our reasoning here suggests that this would generate difficulties in clearing, and this expectation is borne out by the history of payments crises in a world with badla.

The use of such futures--style functioning imposes considerable working capital requirements upon brokerage firms. With a depository, the logical next phase is to use T+5 rolling settlement, which will enable a spot market which functions safely with lower working capital requirements.

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