February 2006 Market Clearing in the Energy Industry 3-11 © Copyright 2006, CCRO. All rights reserved. characteristics, both of these models also share many salient similarities, including confidence by the market that obligations will be met due to the risk management techniques employed, adequate capitalization, and the backstops in place to guard against default. In fact, many of the attributes that give rise to the success of these models can be found in other successful clearinghouse models in operation in the US today. (Please see Appendix B for evidence of the extent of clearing in the US.) As noted, one of the key attributes of a clearing solution is its structure: single tiered or two tiered. The single tier model can be contrasted to the two-tier model employed by future exchanges such as the NYMEX. In the two-tier model the clearing member (in the case of NYMEX, the futures commission merchant, or FCM) extends trade guarantees, margin and other credit extensions to its customers, i.e., counterparties to trades. The clearing member (i.e., the FCM) then brings transactions to be cleared to the clearinghouse and these transactions are cleared and settled on its books. The clearing member posts collateral to the clearinghouse to cover risk on the transactions and the clearinghouse monitors the credit standing of the clearing member, as well as ensuring the clearing member complies with the clearinghouse’s rules. Importantly, the clearinghouse extends its trade guarantee to the clearing member, not the clearing member’s customer. The customer has no direct credit relationship with the clearinghouse. Figure 2-2 shows the structural differences in the single and two-tier models. FIGURE 2-2: ILLUSTRATION OF SINGLE-TIER AND TWO-TIER MODELS Clearing through a mechanism employing a single-tier model differs from clearing through a two-tier model. In a single tier model, the clearinghouse is exposed to counterparties with a wide range of credit quality. In an effort to treat all clearing participants equally, single-tier clearing houses may adopt a single set of margin and reserve rules that can be costly to highly Clearinghouse Type Credit Exposure Default Hierarchy Single-Tier Two-Tier Structure Clearinghouse Participant Clearinghouse Participant Clearinghouse provides participant with trade guarantee but becomes exposed to heterogeneously rated participants Clearinghouse provides trade guarantee to FCM but becomes exposed to homogenously rated counterparties (FCMs) FCMs provide trade guarantees but are exposed to heterogeneously rated counterparties (participants) Participants take market positions generating credit exposure at the clearinghouse Participants take market positions generating credit exposure at the FCM If a participant defaults, the FCM makes good by liquidating the participant’s collateral If an FCM defaults, the clearinghouse makes good on the losses by liquidating an FCM’s collateral, reserves and through assessment of FCMs Credit risk is mutualized onto the balance sheets of participants. If a participant defaults, the clearinghouse makes good on the losses by liquidating collateral and reserves or through assessments on participants. Futures Commission Merchant (FCM) Participants exposed to a (low) potential FCM default Participants exposed to a low) potential clearinghouse default