33 Reasons Why Central Clearing is Better Than Bilateral Clearing

Introduction

Central clearing and bilateral clearing are two mechanisms that facilitate the settlement of financial transactions. Here is a highly simplified table comparing the strengths and weaknesses of central clearing against bilateral clearing.

Improved Risk Management

1. Counterparty Risk Reduction

Central clearing minimizes counterparty risk. For example, during the 2008 financial crisis, central clearing parties (CCPs) played a crucial role in averting defaults.

2. Netting Benefits

Central clearing allows for multilateral netting, reducing overall exposure. This was evident when a single CCP managed to net down $100 billion of nominal transactions to just $1 billion.

3. Standardized Collateral Requirements

Collateral requirements are standardized in central clearing. A case in point is a major CCP that requires all participants to maintain a set collateral amount, reducing disparities.

4. Real-time Risk Monitoring

CCPs offer real-time risk monitoring. Firms that utilize CCPs often receive immediate alerts if they are nearing risk thresholds.

Operational Efficiency

5. Simplified Settlement

Central clearing simplifies the settlement process. Millions of trades can be consolidated into a much smaller number of settlement lines, reducing the funding and margin requirements for cleared products.

6. Economies of Scale

CCPs can leverage economies of scale. This was illustrated when transaction costs dropped by 20% after introducing a new CCP in a particular market.

7. Automation

Many CCPs have automated systems. For instance, one CCP introduced an automated matching system that reduced errors by 15%.

8. Streamlined Reporting

Central clearing often includes robust reporting tools. A European CCP, for instance, offers one-click compliance reporting, simplifying regulatory adherence.

Transparency and Compliance

9. Regulatory Oversight

CCPs are generally subject to strict regulatory oversight. For example, the Dodd-Frank Act in the U.S. mandates stringent requirements for CCPs. There are also global standards for Financial Markets Infrastructures. These are managed by the Bank of International Settlements (BIS) and participating members.

10. Public Price Discovery

Central clearing mechanisms often result in more transparent price discovery. For instance, a well-known exchange saw increased trading volumes after introducing a CCP, which improved price transparency.

11. Audit Trails

CCPs provide comprehensive audit trails. A CCP's audit trail facilitated a quicker resolution when a dispute arose between two parties.

12. Standardized Contracts

Standardized contracts simplify regulatory reporting. A global bank reported a 30% reduction in compliance costs after switching to a CCP offering standardized agreements.

Capital and Liquidity

13. Improved Capital Allocation

Central clearing allows for more effective capital allocation. A small hedge fund could better allocate its capital after switching to central clearing, thus improving its returns.

14. Lower Liquidity Risk

With netting and standardization, liquidity risks are generally lower. A study found that firms using CCPs had an average of 25% lower liquidity risk.

15. Collateral Efficiency

Assets can be pooled as collateral, leading to better asset utilization. One CCP's pooling feature allowed a fund to utilize previously idle assets as adequate collateral.

16. Reduced Capital Requirements

Due to risk mitigation, regulatory capital requirements may be lower. For example, several European banks reported lower capital charges after adopting central clearing.

Market Access and Flexibility

17. Increased Market Participation

Central clearing can encourage more participants. A newly established CCP in Asia saw a 40% increase in market participation within its first year.

18. Wider Range of Instruments

CCPs often handle a broad range of financial instruments. Equities, fixed income, swaps, options, futures and even cryptocurrency futures are cleared by CCPs.

19. Cross-Margining

CCPs may offer cross-margining benefits. A U.S.-based CCP's cross-margining feature allowed traders to offset positions in correlated assets, reducing margin requirements.

20. Anonymity

Central clearing can offer anonymity to traders. For example, more minor market participants reported that using a CCP allowed them to trade without revealing their size, thus removing counterparty bias.

Reliability and Safety

21. Financial Stability

CCPs contribute to financial system stability. During market turbulence, CCPs have been observed to act as shock absorbers.

22. Business Continuity

CCPs often have robust business continuity plans. When a natural disaster struck, one CCP's backup systems kicked in seamlessly, preventing any trading disruptions.

23. Disaster Recovery

Robust disaster recovery mechanisms are usually in place. For instance, a CCP successfully conducted a simulated disaster recovery exercise involving multiple stakeholders.

24. Clearing Member Oversight

CCPs often have measures to oversee the financial health of clearing members. One CCP detected a clearing member's capital shortfall early and took preventative action.

Innovation and Adaptability

25. Investment in Technology

CCPs invest in cutting-edge technology. A leading CCP recently adopted blockchain technology for more secure and transparent transactions.

26. Quick Adaptation to Market Changes

CCPs can rapidly adapt to regulatory and market changes. For instance, a CCP quickly revised its risk models in response to Brexit.

27. New Product Introduction

CCPs are often quicker in introducing new financial instruments. One example is a CCP, the first to offer clearing services for climate credit futures.

28. Fostering Competition

Central clearing fosters competition by levelling the playing field. This was evident when a new entrant could successfully compete with established players thanks to a CCP.

Social and Economic Benefits

29. Systemic Risk Mitigation

Central clearing helps in mitigating systemic risks. For example, the role of CCPs in the Eurozone crisis helped prevent broader financial collapse.

30. Market Integrity

Enhanced compliance and oversight contribute to market integrity. A study linked the introduction of CCPs to a measurable increase in market trust.

31. Financial Inclusion

By lowering barriers, central clearing can contribute to financial inclusion. For instance, a CCP in Africa enables smaller local banks to participate in international financial markets.

32. Lower Transaction Costs for End Users

Reduced costs can be passed on to consumers. A report showed that the overall cost of trading decreased by 15% in markets with active CCPs.

33. Job Creation

The infrastructure needed for CCPs can create jobs. For example, a new CCP in South America created 200 new jobs within its first six months.

Conclusion

Central clearing offers many advantages over bilateral clearing, from risk management and operational efficiency to market integrity and financial stability. As financial markets evolve, the role of central clearing as a superior mechanism continues to solidify.