The cost of clearing fragmentation

Focus

This paper studies the costs associated with clearing fragmentation as central clearing of over-the-counter derivatives contracts becomes more common. Fragmentation arises when multiple central counterparties (CCPs) clear the same or similar derivatives contracts. We focus on the "CCP basis", which refers to the price distortions that arise between such contracts.

Contribution

Using proprietary data, we document and analyse an economically significant CCP basis for dollar swap contracts cleared at the Chicago Mercantile Exchange (CME) and the London Clearing House (LCH). We contribute to the ongoing policy debate about the fragmented clearing landscape by providing both a theoretical explanation and empirical evidence for the driving factors behind the CCP basis.  

Findings

We find that the average CCP basis for dollar swap contracts was around 2 basis points during our sample period. This is economically significant as it translates into a daily opportunity cost of around $80 million for end users.

The CCP basis allows dealers to recoup increased collateral costs when clearing is fragmented. In those cases, dealers, who provide liquidity globally, cannot net their offsetting trades across CCPs. This increases their collateral costs. They pass these costs on to end users through the CCP basis. That is, dealers quote a higher price at a CCP where buyers prevail, and a lower price when sellers prevail.

Our analysis shows that the CCP basis increases in the amount of dealers' posted collateral pledged with the CCP (ie the initial margin), dealers' credit spread and debt overhang costs, and the order-flow imbalance in one CCP. The basis decreases in the volume share of sophisticated traders with access to both CCPs who can therefore clear where prices are more advantageous.

Abstract

Fragmenting clearing across multiple central counterparties (CCPs) is costly. This is because dealers providing liquidity globally, cannot net trades cleared in different CCPs and this increases their collateral costs. These costs are then passed on to their clients through price distortions which take the form of a price differential (basis) when the same products are cleared in different CCPs. Using proprietary data, we document an economically significant CCP basis for U.S. dollar swap contracts cleared both at the Chicago Mercantile Exchange (CME) and the LCH in London and provide evidence consistent with a collateral cost explanation of this basis.

JEL codes: G10, G12, G14

Keywords: central clearing, CCP basis, collateral, fragmentation