Quad-Party Clearing - a Winner's Curse?

Quad-Party Clearing – a buy-side focused clearing model – was widely perceived as an innovative solution for the clearing obligation under EMIR (European Market Infrastructure Regulation). The benefits for buy-side firms include efficiency, cost and risk reduction.

However there’s a growing concern that these are outweighed by cost and risk factors of market infrastructure providers and sell-side institutions. For example, many experts anticipate a collateral crunch as a consequence of clearing obligation and risk mitigation techniques under EMIR, and liquidity requirements under Basel III. As a result there’s a need for innovative collateralization processes and innovative clearing solutions that address the requirements of all participants.

The Quad-Party Clearing model would enable participants to optimize collateral usage and so satisfy margin requirements, reduce credit risk and improve asset protection through segregation and portability.

Minimizing transaction costs

Critically, the Quad-Party Clearing model means that buy-side collateral allocated to the Central Counterparty (CCP) remains in the buy-side client’s custodian network and thus bypasses the clearing member’s account. By eliminating a step in the chain, the buy-side can minimize transaction costs thanks to internal transfers at the custodian—and benefit from a significant reduction in settlement and transit risk.

This approach also shines a spotlight on the needs of the buy-side which would mark a change from ‘central clearing’ to ‘client clearing’. Eventually, it would enable the buy-side to benefit from the imposed regulatory changes for the first time.

In turn, CCPs would benefit from direct access to a new clientele - the buy-side - while custodians could increase their buy-side client services. In short, there are a number of benefits that Quad-Party Clearing brings to several market participants— so what’s the catch?

From theory to practice

Technically, this solution seems to be quite difficult to implement. As a result, costs might outweigh benefits. As it also entails cooperation between Central Securities Depository (CSD), CCPs, custodians and clearing brokers, this might result in a cannibalization of one’s competitive advantage. In addition, it could also intensify competition and market consolidation, as custodians incorporate CSDs and CCPs compete for clearing volume.

Compounding matters further, article 47.3 EMIR represents a prominent legal hurdle for this model, with its demand for initial margins or default fund contributions to be held by securities settlement systems (usually operated by CSDs) that ensure full protection of those financial instruments. However there should be ways to configure a compliant model depending on the account setup and legal structure. Nevertheless, clearing brokers could shy away as they would have less influence and control. This, in turn, implies higher risks compared with the prevailing double-title transfer model. Ancillary services such as collateral transformation would also be much harder to integrate in the process.

But in spite of these issues, it is merely a matter of time before new collateral models start appearing, driven by client demand. What kind of models do you expect to see in the future?