Should individuals be banned from acting as central counterparties?

European Securities and Markets Authority (ESMA) has looked into whether or not individuals should be allowed to act at central counterparties (CCP).

A CCP is a financial institution that takes on counterparty credit risk between parties to a transaction and provides clearing and settlement services for traders in foreign exchange, securities, options and derivative contracts.

The report was motivated by an incident that occurred in September 2018 when heavy rained caused huge fluctuations in regional power markets, with the Nordic hydroelectric-dependent region saw its prices dropped whilst German prices spiked along the rise of carbon prices.

For a Norwegian power market trader, this situation led to him amounting such huge losses that he was eventually unable to cover them. As a result, Nasdaq Clearing House AB’s member ended up forced to plug a €114m ($133m) hole in a contingency fund, Reuters reported at the time.

Nasdaq Clearing AB paid €7m and told its members to cough up the rest or risk following in the ill-fated trader’s tracks and risk being declared in default.

The trader who caused it all ended up risking personal bankruptcy as a result.

“I think it’s an extreme situation,” Catharina Hovemyr, CEO of Nasdawy European Commodities, told Reuters.

That might be, but it still gave ESMA cause to reach out to CCPs to see what could be done to prevent a similar situation from arising again.

In particularly, it looked into three things: whether individuals can be clearing members at EU CCPs, what membership criteria EU CCPs apply and how EU CCPs conduct their on-going monitoring of compliance with membership requirements.

In other words, what rules did CCPs have in place to ensure they were compliant with regulations?

ESMA surveyed 16 CCPs for a new report. None of them allowed private individuals to participate as clearing members, but four did not rule out that they could act as clearing members if they could satisfy all admission criteria.

When asked whether they believed private individuals should be banned altogether from becoming clearing members or if they should just rely on the existing legal framework with regards to admission criteria, they CCPs polled preferred the second option.

Having looked at the European Market Infrastructure Regulation (EMIR), it found that no rule excluding private individuals from being clearing members existed.

However, seven CCPs did allow non-financial financial counterparties to participate as clearing members. While that was the case, CCPs either tried to limit the risk by only offering non-financial counterparties specific memberships or required them to use the same membership model as financial counterparties, forcing them to comply with the same rules and obligations.

In regards to CCPs’ due diligence on their clearing partners, ESMA found that CCPs used internal credit classification, warning monitoring systems of their economic and financial situation, availability of reporting packages or connection to CCP dedicated risk system, mandatory due diligence questionnaire, regular engagement with clearing members and onsite visits.

Following the report, ESMA has updated its Q&A on the implementation of EMIR.

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