by Steve Letzle
Walter Lukken, the CEO of New York Portfolio Clearing (NYPC), the start-up U.S. derivatives clearinghouse owned equally by DTCC and NYSE Euronext, recently sat down with @dtcc to provide an update on this innovative joint venture.
When it launches on March 21, NYPC is expected to reduce risk and deliver capital efficiencies to its members in the fixed income markets by providing a single margin calculation across fixed income trades cleared at DTCC's Fixed Income Clearing Corporation (FICC) and futures traded on NYSE Liffe U.S. This groundbreaking capability is called "one-pot" margining.
What is NYPC's basic value proposition?
The main idea for NYPC is to provide one-pot margining in the fixed income markets, which will help mitigate risk in the market while delivering capital efficiency to the clearing members of NYPC and FICC, at a time when capital is in great demand. The ability to see a firm's entire portfolio – both cash and futures positions – and the associated risk in one spot is a win-win both for the regulators and for the marketplace.
What is NYPC's status in terms of regulatory approval?
NYPC has spent the last 18 months in discussions with regulators, providing them with the information and testing necessary to show that this initiative will benefit the markets without adding risk to the system. Our primary regulator is the Commodity Futures Trading Commission [CFTC], which approved our registration as a U.S. Derivatives Clearing Organization on January 31, 2011. On February 28, the Securities and Exchange Commission also approved FICC's rule change to allow it to engage in one-pot margining with NYPC. [See article, page 6.] On March 2, the CFTC approved a similar order for cross-margining for NYPC. These final approvals will enable us to launch the clearinghouse on March 21, 2011.
What type of testing did NYPC conduct to validate its risk model?
Coming out of the financial crisis, the regulators were understandably cautious about an initiative that could require less margin for certain firms that are hedged in these markets. We had to demonstrate how our risk model could maintain the highest level of risk management at a clearinghouse, while at the same time delivering capital efficiencies.
In order to do that, we conducted rigorous testing with a variety of real and hypothetical portfolios to demonstrate to the regulators that we will meet or exceed the highest global standards in risk mitigation.
NYPC has an innovative concept of margining across asset classes. Which instruments will be eligible for the single pot?
Initially, these will be Eurodollar futures contracts and U.S. Treasury futures contracts listed on NYSE Liffe U.S., including the 2-year, 5-year and 10-year U.S. Treasury Note futures and U.S. Treasury bond futures.
FICC will continue to clear the cash positions it now clears: U.S. government securities and agencies, as well as the repo transactions for which FICC serves as central counterparty. All these products will be in the one-pot margining arrangement when NYPC launches.
So NYPC will margin these products in a single pot for risk purposes, but the cash and futures products will clear and settle separately?
Correct. The bridge between these clearinghouses occurs in the margin calculation and risk management. Once operational, there will be one margin calculation for a firm's entire portfolio, inclusive of cash and futures. Then, based on that calculation and using FICC's value-at-risk methodology, we will assign the margin calculation amounts to both the FICC side, as well as to the NYPC side. There will still be legal and regulatory differences between the clearinghouses, but for the first time, the risk management of these instruments will be integrated and unified. FICC will perform the margin calculations for NYPC, working closely with our chief risk officer to make sure this process is completely coordinated and integrated.
At launch, one-pot margining of cash and futures positions will only be available for the proprietary accounts of common members of NYPC and FICC.
Where is NYPC operationally? Has everything been tested and run?
We're in the final stages of testing. We spent February conducting final dress rehearsals with firms, and making sure the connectivity is there. We will be ready to go for our March 21 launch.
Can you tell us where NYPC stands in terms of customers?
We expect to have somewhere in the vicinity of 10 to 12 clearing firms on the first day of operations, including all the major firms you would expect to be there on day one. So, we're thrilled about that.
For firms that want to wait and see, we'll move quickly to get them in the door in a Phase II implementation. And we are highly motivated to bring additional firms on board in the next couple of months. My job as CEO of NYPC is to bring as much volume into the clearinghouse as possible.
Do you anticipate that other exchanges will use NYPC?
Yes. It's important to remember that NYPC is an open-access clearinghouse, meaning any exchange that meets certain objective criteria and wants to plug into NYPC and its one-pot arrangement with FICC can do so. We want to encourage other exchanges to join and to bring them on board as soon as it is operationally feasible for them to do so.
How would NYPC margin one exchange's contract against another exchange's contract?
They are not fungible in the sense that you won't be able to buy a contract on one exchange and close it out on another exchange. But the one-pot arrangement would treat these contracts equally for risk management and margining purposes.
Why are you letting other clearinghouses connect to NYPC?
NYPC is committed to giving the market flexibility and choice. We want to offer multiple options for accessing our system. While an exchange plugging into NYPC may be the simplest arrangement, some exchanges may want to maintain the relationship with their current clearinghouse, so they will want that clearinghouse to have the primary relationship with NYPC.
There are a variety of ways to structure these types of arrangements. For instance, we could allow one clearinghouse to become a super clearing member of the other clearinghouse, what we call a limited-purpose participant. This model has been used in the past by other clearinghouses. Right now, we have a general game plan for how this would look, but it will take additional discussions between the two clearinghouses to come up with the exact mechanisms for how such a relationship would work.
NYPC has opened membership to firms that just do futures trading. What are the benefits to these members?
A big benefit for these firms is FICC's locked-in trade delivery system, which will integrate with and utilize the cash delivery process of FICC. Firms that have futures contracts and want to make or take delivery will be able to deliver through FICC's system without the costs and inefficiencies associated with the current market structure. I think firms that are trading futures only will recognize this benefit immediately.
What can you tell us about NYPC fees?
Without getting into the specifics, we have a very basic, three-word philosophy surrounding fees: simple, transparent and competitive. Given the complexity of today's fee schedules in the futures industry, we wanted to keep it simple. It's hard to hold someone accountable if you can't figure out how much you are paying for their services. So the first key is simplicity. The second is transparency. A lot of market participants find fees in the marketplace to be complex and opaque, so let's make them plain and easy to understand. And the third is competitive. Certainly, our fees are going to be competitive out of the box.
How will NYPC handle a member default or liquidation?
If a firm defaults, we will have a uniform liquidation agent serving both NYPC and FICC that will take the entirety of the portfolio, including cash and futures positions. The agent's first responsibility will be to either hedge the portfolio – to make sure it's protected against further price movement – or to liquidate it. The benefit of NYPC and the futures positions it holds is that it serves as a built-in natural hedge for the portfolio's liquidation. The liquidation will be managed in a highly coordinated, unified manner, which will contribute to a greater transparency and understanding of the defaulting firm's portfolio. This will strengthen our ability to hedge or liquidate its positions rationally and quickly, which will, in turn, enable us to mitigate the overall risk more comprehensively.
Do you envision extending the cash and futures single-pot-margining methodology beyond U.S. borders?
At some point, but we want to walk before we run. Domestically, we want to make sure the machine works before we add other challenging factors such as cross-border jurisdictional issues and the additional legal and regulatory frameworks that come with operating internationally. @