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Last week I wrote about the elegant design of clearinghouses, looking at what it would take to blow one up. Today I want to go a bit deeper, reviewing the business & strategy behind clearinghouses. Here's how CHs are so critical to an exchange's competitive position:
Imagine two exchanges compete in the oil futures market. They list identical contracts, charge the same fees for trading & data, and have adequate liquidity. But Exchange A makes me put up $3,500 for margin while B requires $5,000. Exchange A will win the trade every time.pic.twitter.com/yOk2Cv6RTl
How can Exchange A require less capital for the same trade? Its clearinghouse had a more efficient margin model. The exchange can manage the same amount of risk for less upfront cost. This is huge. Margin models matter a ton to competing exchanges.
To calculate margin, CHs model a wide variety of worst case market scenarios & put an expected value on those scenarios. The combination of these expected values is what determines how much money is needed to cover a trader's position. Here's an example in CME's case:pic.twitter.com/MaLxmIr9SQ
A lot of different inputs go into a margin model & can have a big effect on a trader's all-in transaction cost. For example, Exchange A may have offered me better margin bc I already had $ posted with them for a natural gas trade. Cross-product margining saves me capital.
You should have picked up a word in that CME example - SPAN. SPAN stands for Standard Portfolio Analysis and was developed by CME in the 1980s to calc margin. Many clearinghouses still use SPAN today.
Just because the SPAN model has been around for 40 years doesn't mean it's old & stale. CHs tweak their margin models constantly in response to changing market & competitive conditions. CME is actively working on a SPAN upgrade as we speak:pic.twitter.com/67L7oQ81A6
Other exchanges use different margin models based on the nature of their assets. CBOE's clearinghouse (the OCC) uses the STANS Monte Carlo model. ICE's clearinghouses use IRM. LCH uses the PAIRS model.pic.twitter.com/mjdJevYmQR
More than exchange v exchange competition, clearinghouses drive secular trends for the industry as a whole. Regulators LOVE clearinghouses. After the GFC many markets were forced to go through clearinghouses, which gave their exchange owners effective monopolies in the process.
Europe's equity & options market is much more fragmented than the US largely because it has so many clearinghouses. The US has only 1 for equities - the DTCC - and one for options - the OCC. Combining margin into 1 or 2 clearinghouses is way more efficient.pic.twitter.com/AZ4eh8yYjZ
Younger exchanges are also investing heavily in clearing technology to save costs. For example, MarketAxess is working on clearing its own corporate bond trades to in-house clearing fees & cut expenses.
The net strategy of a clearinghouse is to find a model that protects the trust & strength of its markets while also requiring the least amount of capital from its users. The ones who can do this have a huge advantage over competition.
Here's my 1st clearinghouse thread for those who missed it:https://twitter.com/HideNotSlide/status/1425183481651466244?s=20 …
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