Ratings

Commodity and stock exchanges are organized marketplaces where buyers and sellers of listed financial instruments can efficiently execute trades. Exchanges provide liquidity to the market in their role of accurately and expeditiously collecting and disseminating transaction information. They report trades and the terms of trade to the associated clearinghouse for clearance and settlement.

Clearance is the process of determining accountability for the exchange of financial instruments and money between clearing members on opposite sides of the market. The clearinghouse, or in some cases the exchange, conducts a process called trade comparison in which it reviews each trade to ensure that the buyer and seller, along with the terms of trade (that is, quantity, price, and delivery) match. The clearinghouse can reject trades that do not match or otherwise meet its specifications. Rejected trades are returned to the clearing members for additional information, resolution, or cancellation. By only accepting perfectly matched trades, the clearinghouse removes position risk from each transaction. Once it accepts a matched trade, the clearinghouse can act as either agent, principal, or guarantor for settlement.

Settlement is the final step in a trade, whereby funds and financial instruments are exchanged between the two parties through the clearinghouse. In the U.S., a clearinghouse's contractual arrangement for clearance and settlement is solely with its clearing members. By way of contrast, Marche à Terme International de France (MATIF) offers a two-tier guarantee. French futures regulation requires that MATIF offer a performance guarantee that covers not only clearing members in the event of a counterparty default, but also extends to their direct clients.

If the clearinghouse acts as principal, it becomes the substituted counterparty for each trade. It becomes the buyer for every seller and the seller for every buyer in a process called novation. In this capacity, the clearinghouse can provide multilateral netting, which enhances operational and market efficiencies and reduces systemic risks. With multilateral netting, the clearinghouse groups all transactions involving identical instruments or contracts. The buys and sells are offset with one another, resulting in one long or short position for each clearing member account at the end of the day.

Until settlement is complete, the clearinghouse is exposed to credit risk; that is, the risk that a party to an uncompleted transaction defaults. Only when a party fails to perform does the clearinghouse then become exposed to market risk. An important tenet in reducing settlement risk is a procedure known as delivery versus payment. DVP is the simultaneous exchange of financial instruments (the delivery) and funds (the payment). If one party to a trade fails to deliver (or pay), the clearinghouse withholds any payment (or delivery) owed to the defaulting party. In a true DVP environment, funds and financial instruments must meet in the same place, at the same time, and under control of a single entity. Furthermore, the receipt of payment must be ensured and there must be finality of settlement at the end of the exchange process. The Group of Thirty, in its report Clearance and Settlement Systems in the World's Securities Markets, recommends that "DVP be employed as the method for settling securities transactions."

As with all financial enterprises, the long-term viability of an exchange or clearinghouse depends on the supply and demand of its listed products. Thus, the rating process begins with an assessment of the listed products; their importance to the financial markets or the functioning of the real economy; and the liquidity (that is, the breadth and depth) of the markets. Standard & Poor's considers the diversity of listed products and examines trading volumes over a 10-year period—both in the aggregate and individually—to determine if there are any concentration issues.

Some exchanges are highly specialized, listing contracts in only one or a few closely related instruments. Others offer a broad diversity of products. For example, the Chicago Mercantile Exchange (CME) lists agriculture (livestock), financial (stock indices and fixed income), and foreign exchange futures and options on futures. The three-month Eurodollar contract, however, dominates trading volume on the CME.

Exchanges and clearinghouses are unique financial institutions that typically enjoy special privileges in their home country and are protected by high barriers to entry. Nevertheless, they face varying degrees of competition. In assessing competitive factors, Standard & Poor's examines market share statistics and trends in trading volumes and (in the case of commodity futures) open interest among rival exchanges. Seat prices are also used by Standard & Poor's to confirm the underlying trends in the value of business conducted on the exchange.

Some exchanges and clearinghouses do benefit from monopoly protection, while others compete intensely on the basis of price, product offerings, and services. Options Clearing Corporation (OCC) is the sole clearinghouse in the U.S. for listed equity options. This monopoly position gives the OCC some leverage over its membership. Alternatively, five exchanges in North America vie for wheat traders. The smaller of these five exchanges attract traders on the basis of price (that is, lower cost access to the pits; smaller contract sizes).

Competition among exchanges and clearinghouses extends beyond national borders. The New York Mercantile Exchange (NYMEX) is the sole commodity futures exchange for petroleum contracts in the U.S., but it competes in the global markets against established exchanges in London and the Far East. Increasingly, futures and options exchanges and clearinghouses must compete with the over-the-counter (OTC) market, which can offer highly customized as opposed to standardized contracts.

The long-term vitality of an exchange or clearinghouse depends upon its ability to adapt to changing market conditions. Some exchanges are highly innovative in bringing new instruments to the market. NYMEX, which for its first 100 years was an agriculture exchange, successfully evolved during the late 1970s-early 1980s to specialize in energy contracts. There is no guarantee that any new product will be accepted in the marketplace. The product life cycles of listed financial instruments differ. Some have very long lives and trade in highly liquid markets. Others never catch on after they are introduced.

In rating a traditional (that is, open-outcry floor trading) exchange, Standard & Poor's weighs whether the institution suffers a competitive disadvantage vis-à-vis after-hour trading, highly automated proprietary trading systems, or other technological developments. Increasingly, screen-based trading systems are making serious in-roads to traditional open-outcry trading systems. With trade execution becoming a commodity business, the cost of executing a trade on an electronic trading system is but a fraction of the cost of a floor trade. Standard & Poor's believes that electronic trading eventually will win the day. Rather than face immediate mass extinction, however, trading floors, particularly those in the U.S., are likely to evolve. Notwithstanding certain economic advantages of screen-based trading systems, Standard & Poor's believes open outcry exchanges can still obtain very high credit ratings.

The ownership of an exchange or clearinghouse can take many different forms, which may have rating implications. Standard & Poor's is interested in the financial resources and the incentives of the owners to support the exchange or clearinghouse in times of need. In the U.S., exchanges are owned by their members, the diversity and financial soundness of which are factored into the rating process. Alternatively, clearinghouses in the U.S. come in a variety of ownership structures.

Clearinghouses that are associated with one exchange are typically structured as either a division or a subsidiary. However, there is one notable exception in the U.S. Board of Trade Clearing Corporation (BOTCC) is an independent clearinghouse that is owned by its clearing members, not the Chicago Board of Trade (CBOT). This ownership structure, to some degree, addresses the potential conflict of interest that arises between the exchange's focus on marketing and growth, and the affiliated clearinghouse's concerns for safety and soundness. The default of a clearinghouse, whether structured as a division, a subsidiary or an independent entity, could, in Standard & Poor's opinion, threaten the viability and, thus, the creditworthiness of the associated exchange. Conversely, a default by the exchange could jeopardize the orderly and timely wind down of the associated clearinghouse's clearing and settlement obligations.

Clearinghouses can also have multiple owners. The OCC is owned by the five separate and competing equity options exchanges. In Europe, Cedel Bank S.A. is owned by 99 financial institutions, none of which has more than a 5% stake. OM Gruppen, the parent of derivative exchanges and clearinghouses in Stockholm and London, is a public company whose shares are listed on the Stockholm stock exchange.

In assessing corporate governance of an exchange or clearinghouse, Standard & Poor's considers management experience and tenure, as well as its attitude and control of risk. Standard & Poor's weighs the independence and authority of the compliance department to ensure that exchange rules are enforced and that rule violators are appropriately disciplined. As part of the rating process, Standard & Poor's reviews actual cases of disciplinary actions. The surveillance department needs the systems and personnel to monitor and analyze trading patterns and member positions to detect possible abuses or risks to the exchange. Standard & Poor's also reviews the compliance department's audit trails, as well as its trade exception policies and authorizations.

At future and options exchanges, house limits should not allow for any undue concentrations in trading activities. As part of its due diligence, Standard & Poor's examines exchange position limits and activity reports to determine if one or a few members dominate trading activities or have outsized positions.

Because of their central role in the financial markets, exchanges and clearinghouses are subject to regulatory scrutiny and varying degrees of explicit or implicit support. The government may provide implicit support by promoting policies that foster the development of open capital markets and enacting laws that create a favorable operating environment for exchanges and clearinghouses. More explicit support may come in the form of outright guarantees or official liquidity facilities. In the U.S., commercial banks provide backup lines for some securities and commodities clearinghouses. While the Federal Reserve may provide liquidity during a crisis situation to prevent a systemic meltdown, any such possibility is not factored into Standard & Poor's ratings.

An important factor in Standard & Poor's rating consideration is the body of national bankruptcy laws that may place exchanges and clearinghouses in a preferential position in the event of a member's default. Clearinghouses must be able to quickly seize collateral and liquidate a defaulting member's position in order to protect themselves from possible adverse price movements.

Regulatory authorities may play a direct role in the affairs of exchanges and clearinghouses. Standard & Poor's looks favorably on the role of the regulators to the extent they provide a backstop by setting or, as is done in the U.S., approving minimal financial and operating standards and rules of conduct for officially recognized exchanges and clearinghouses. U.S. regulators occasionally audit these institutions for enforcement of their own rules and discipline those that violate rules or otherwise do not meet official standards. The regulators also police market participants to deter them from disrupting the marketplace or otherwise putting the exchanges and clearinghouses at undue risk.

Clearing membership. A clearinghouse's first line of defense against loss is the creditworthiness of its clearing members and, ultimately, the broader membership base. This is because the clearinghouse, in order to protect its own resources, attempts to place as much risk as possible on its clearing members who are responsible for their own trades and must stand behind the accounts they carry Standard & Poor's favors clearinghouses that have a large, diverse clearing membership base exhibiting a strong financial profile or a high Standard & Poor's credit rating. Within limits, a clearinghouse can compensate for a smaller number of clearing members by requiring them to maintain extremely strong credit standards.

The OCC has 140 clearing members, predominately U.S. registered broker/dealers, with a combined capitalization (equity plus subordinated debt) of about $76 billion. Yet even with a diverse membership base, the OCC has a concentration of clearing volumes within a certain group of related clearing members. Large securities and commodities firms sometimes try to limit their exposure to loss at a clearinghouse by becoming a clearing member through a minimally capitalized affiliate. In such cases, Standard & Poor's does not automatically assume that the securities or commodities firm stands ready to support its affiliate, the clearing member. If the trading activities at a particular exchange are not of strategic importance, the firm or its parent, in a time of crisis, could conceivably let its affiliate default on its obligation to the clearinghouse rather than jeopardize the firm's own financial health.

Clearinghouses take a variety of precautionary measures to ensure that clearing members will not default on their obligations. High admission standards are the beginning. Standard & Poor's takes into consideration a clearinghouse's requirements for admitting new clearing members. An applicant must demonstrate to the membership committee that its financial strength, operational capacities, and management competence meet the organization's standards.

Standard & Poor's further considers the compliance department's policies regarding clearing member position limits and its ability to monitor and enforce such limits. The compliance department surveils the financial health of its clearing members, requiring them to submit financial reports on a timely basis. Clearing members must also demonstrate their ability to monitor the ongoing creditworthiness of their customers.

Clearing members that are undergoing financial stress or conducting unusual trading activities should be flagged by the compliance department and placed on a watchlist, where they may be required to post additional margin or restrict trading activities. Standard & Poor's evaluates the financial health of the clearinghouse's membership by examining the size and trends of the watchlist, as well as the history of disciplinary actions and clearing member defaults. In cases of default, Standard & Poor's compares a clearinghouse's written procedures with actual experience.

Margin requirements. Because clearing members can and do default, clearinghouses need additional financial resources to fulfill their clearing and settlement obligations with nondefaulting members in a timely manner.

A critical component of a clearinghouse's risk management is its margin or collateral requirements. The margin is, in essence, a performance bond posted by clearing members. Should a clearing member default, the clearinghouse can quickly liquidate any open positions using the posted margin to cover any price shortfall. Ideally, clearinghouses prefer margin requirements that offer the highest degree of protection against possible price movements. Yet competitive factors and pressure from membership prevent clearinghouses from going to extremes in establishing margin levels.

Standard & Poor's examines the size and trend of the aggregate margin collected (in relation to the value of open interest), as well as the calculation methodology, collection, and character of the margin.

Clearinghouses employ a variety of methodologies for calculating margin requirements for its clearing members. Some use simple proprietary models, while others use highly sophisticated models based on option pricing theory. Two popular models used by many futures and options clearinghouses worldwide include the Standard Portfolio Analysis of Risk (SPAN) developed by the CME and the Theoretical Intermarket Margins System (TIMS) developed by the OCC.

Standard & Poor's evaluates the reasonableness of quantitative models and how they are used by the clearinghouse management. Questions that need to be answered in assessing model risk and analyzing margin adequacy include:

• What assumptions (e.g., coverage levels) and historical price observations go into the model?
• What degree of protection does the model provide?
• How much price volatility (two, three, or more standard deviations) does the margin cover?
• How reliable is the model?
• How well does it perform during periods of market turbulence?
• Is margin calculated on a gross basis or net basis?
• To what extent do offsetting or hedged positions reduce margin requirements?
• Does the clearinghouse run the model through stress tests?

As part of the due diligence process, Standard & Poor's tests margin adequacy in covering the clearinghouse's exposure to large members during extreme market movements.

The best modeling techniques are of little value if they are not properly implemented by the clearinghouse. Standard & Poor's looks for margin exceptions, their frequency and size, as well as minimum and maximum margin requirements in relation to the model's theoretical requirements. Standard & Poor's also looks at the ability of the clearinghouse to demand extra or super margin from higher-risk members (such as those with large positions or those that are on the watchlist) or in cases of market emergencies. Standard & Poor's looks favorably on those clearinghouses with a streamlined decision-making process so that they can quickly adjust margin levels to rapidly changing market conditions. Commodity futures clearinghouses may demand extra margin during the spot month because prices tend to be more volatile as contracts approach expiration.

Margin character refers to the acceptable forms of collateral that clearing members can post. Here, liquidity is paramount. The clearinghouse should have policies limiting inferior (that is, less liquid) forms of collateral and haircutting securities that are posted as collateral. Standard & Poor's examines the aggregate margin mix, preferring cash and highly liquid securities to letters of credit (LOCs). The principal problem with LOCs is that they leave the clearinghouse exposed to the potential default of the issuing bank. For this reason, Standard & Poor's assesses the creditworthiness and concentrations among the LOC-issuing banks. Another problem is that there can be delays in initiating the drawdown of the LOC following the default of a clearing member, leaving the clearinghouse temporarily exposed to market risk.

Standard & Poor's takes into consideration the frequency of margin calls. Margin requirements are typically calculated overnight, based on the closing prices of the day just ended. Clearing members are then required to deposit collateral before the start of the trading day. Commodity futures clearinghouses in the U.S., however, have margin calls twice a day. Standard & Poor's looks more favorably on intraday margin calls that are "collect only" (that is, the clearinghouse collects margin from the member) than on those that are "pay and collect." Margin should be deposited in sound financial institutions, where it is readily available at all times. Standard & Poor's assesses the creditworthiness and concentrations of the depositories approved by the clearinghouse. In cases of margin shortfall, there should be standard procedures for quickly reducing the exposure that a clearing member represents to the clearinghouse.

Standard & Poor's requests clearinghouses to provide reports on the daily pays and collects during periods of market turbulence. For example, the OCC was tested by the October 1987 stock market meltdown. According to the SEC report on the October 1987 market break, the OCC did not collect all margin in a timely manner due to credit-related delays at certain settlement banks. The Barings debacle also illustrates that collecting margin is sometimes easier said than done during periods of market uncertainty. On the day following the Barings insolvency filing, SIMEX notified the other clearing members to post additional margin. According to press reports, however, some members balked because they feared any additional margin payments would be used to cover Barings' losses. These members withheld payment until after the Monetary Authority of Singapore announced that margin payments would not be used for Barings, but solely to cover a paying firm's own positions.

In the U.S., clearing members of commodity futures exchanges must segregate firm from customer margin. From the customer's point of view, margin segregation is important for protecting its assets. From the clearinghouse's perspective, margin segregation enhances its reputation in the world's markets and aids in monitoring customer and firm position limits. Furthermore, margin segregation allows the clearinghouse to quickly transfer customer positions in the event of clearing member default.

Beyond their own margining requirements, clearing members must collect margin from their customers. Customer margin requirements may be set by the clearinghouse, the associated exchange, or by the clearing members themselves. Customer margin requirements should be at least equal to, and preferably greater than, the clearing member's margin requirements.

Additional financial resources. In lieu of, or in addition to, margin requirements, clearinghouses may have other sources of readily available cash to help them meet their clearing obligations in the event of a member default. Such resources may include a parent or government guaranty or a surety bond. For example, OM Stockholm AB and its London affiliate have an unlimited guarantee from their parent company, OM Gruppen AB. Another resource is liquid assets on the clearinghouse's balance sheet. These amounts tend to be small, although one notable exception is the BOTCC, which has over $150 million of short-term U.S. Treasury securities on the balance sheet. The BOTCC can raise additional funds from its clearing members/owners by requiring them to purchase additional shares of the clearinghouse.

More prevalent is a separate clearing fund (sometimes called a guaranty fund or surety fund) to which clearing members must contribute. As with margin, Standard & Poor's studies the size and trend of the aggregate clearing fund (relative to exposure and volatility), as well as the calculation, character, and collection of clearing fund contributions. Standard & Poor's compares the clearing fund to the largest overnight or intraday margin call and stress tests the adequacy of the clearing fund by assuming the simultaneous failure of the two or three largest "collects." In case of a clearing member default and a shortfall in its margin account, the clearinghouse should be able to quickly tap into the clearing fund, first using the defaulting member's own contribution and then, if necessary, other members' contributions. For rating purposes, there is an advantage for clearinghouses that can tap the clearing fund for reasons other than a member default. For example, a clearinghouse might need to tap the fund to help meet its debt service requirements.

Standard & Poor's looks more favorably on those clearinghouses that have broad powers to assess its members to replenish the clearing fund. Assessment formulas vary and tend to be limited. At one extreme, Mercado de Valores de Buenos Aires (Merval) has no powers of assessment. By way of contrast, the CME has unlimited powers of assessment in what it calls "good to the last drop." This means each clearing member is jointly and severally responsible for the obligations of every other clearing member. Standard & Poor's believes that the mutualization of risk gives clearing members a strong incentive to police fellow members, because their own capital is at risk.

For such powers of assessment to be effective, there should be restrictions on members' ability to exit the clearinghouse. For example, the OCC has broad powers of assessment. But after one special assessment in an amount up to the amount of the clearing fund, clearing members can close out their positions and withdraw. Since OCC has a monopoly on listed U.S. equity options, members have a strong incentive to meet their assessments.

Last, clearinghouses may have backup lines of credit provided by unaffiliated banks or the government. Even if it is a separate and distinct legal entity (as opposed to a division), a clearinghouse may be able to tap the resources of the associated exchange that has a vested interest in the clearinghouse's survival. Standard & Poor's considers these financial resources as necessary final backstops, but accords them only minor weighting in the rating process.

Financial performance. Whether run as a for-profit or as a not-for-profit enterprise, exchanges and clearinghouses must be able to generate sufficient earnings over the long run. As with all financial institutions, Standard & Poor's examines the trends and components of core revenue and the fixed/variable cost structure. Yet because of the cooperative nature of clearinghouses and exchanges, traditional measures of profitability, such as the return on assets, are not very meaningful. These institutions operate for the benefit of the members, who are both customers and owners at the same time. Management sets fees and service charges not to maximize profit, but rather, to support the essential services that members require. Particular attention is paid to an exchange's or clearinghouse's ability to raise fees (or reduce rebates, if any) in times of need given the context of both competitive pressures and membership influences. Standard & Poor's also weighs the power of the exchange to assess the broad membership. To be effective, such powers should not require a membership vote, but rather, a decision of the board of directors for reasons it deems necessary.

Operating leverage at an exchange or clearinghouse is substantial because revenues are largely composed of transaction fees that are a function of trading volumes, while expenses, at least over the near term, are mostly fixed. Standard & Poor's stress tests exchanges and clearinghouses for their ability to withstand significant drops in trading volume and still cover their heavy fixed cost base.

Standard & Poor's assesses capital adequacy by measuring the size and trends of the equity foundation relative to market exposure, not the assets on the balance sheet. This approach is akin to Standard & Poor's methodology for rating asset managers, whereby the ratio of equity to assets under management, rather than equity to assets on the balance sheet, is a more meaningful measure of capital adequacy. If the exchange has taken on debt or other financial obligations, such as a long-term lease, Standard & Poor's analyzes financial leverage and forecasts cash flow generation under a variety of scenarios in relation to debt service requirements. Again, common measures of financial leverage, such as the debt-to-capital ratio, may not be meaningful. Alternatively, Standard & Poor's considers the ratio of debt to aggregate seat price (that is, most recent sale price times the number of full members), which acts as a proxy for market capitalization. Similarly, historical earnings or EBITDA interest coverage multiples do not fully capture an exchange's capacity to service debt without considering its co-operative structure and financial flexibility.

As part of its due diligence process, Standard & Poor's takes into consideration not only on-balance sheet liabilities, but also contingent liabilities, such as pending lawsuits or regulatory actions.

Operations. To meet the demands of members and the trading community at large, exchanges and clearinghouses must have exceptional computer systems and back office capabilities. Each day they must process a multitude of transactions and track trading activities for compliance purposes. An exchange's or clearinghouse's reputation hinges on its ability to compare, clear, and settle both sides of a trade accurately and on a timely basis. Standard & Poor's, as part of its due diligence, reviews the back office operational capabilities of an exchange or clearinghouse, whether conducted in-house, outsourced, or shared through common industry utilities. Among the items that need to be reviewed are the computing system's capacity and redundancies, as well as security of both the data base and physical facilities. Exchanges and clearinghouses must have formal disaster recovery plans covering file backups, off-site processing, and alternative power sources. These plans should be tested via periodic fire drills.

Exchanges and clearinghouses are competitive enterprises that must continuously enhance their services to benefit traders. One way is by introducing new products to be traded. Standard & Poor's reviews the research and development function and its track record in bringing new products to market. Exchanges and clearinghouses may also provide ancillary businesses indirectly related to their primary functions. For example, Cedel extends short-term credit to its members so they can complete their transactions. The Caja de Valores, beyond its primary responsibility of safekeeping Argentine government bonds and corporate securities, also acts as registrar for over 100 listed corporations and provides data processing services to Merval and the Bolsa. Standard & Poor's, as part of its rating analysis, determines whether any ancillary businesses or affiliates add to or detract from the underlying creditworthiness of an exchange or clearinghouse.