Why does a CCP matter

 

Note: This post was originally published on LinkedIn in Oct 2023

Why does a CCP matter?
When everything else was going wrong during the 2008 financial crisis, some things were still going right. The Lehman default triggered a collapse of confidence in financial markets. But what was going right? On Friday the 12th of September, LCH (the Central Counter Party Clearing House) had called Lehman for the required margin to cover the market risk of their positions. This cover was sufficient to cover the events as they unfolded when Lehman filed for bankruptcy on the 15th of September.

The result of this, was that all the trading counterparties to Lehman saw their positions (and in many cases hedges) honoured. Chalk up one for Financial Market Infrastructure (FMI).

What is an Intermediated Model?
As a child, my big brother taught me how to play poker (not very well). I soon learnt that if I lost, I could cry, run away, and not honour my debts. Welcome to the peer-to-peer transaction model. Much later in life I observed in Vegas the need for trusted intermediaries. The dealer at the casino ensures each counterparty places their chips on the table.  As the game progresses, you continue to pay to play. If your counterparty has a bad game and chooses to run away, no problem. The chips are down and the trusted intermediary will honour your winnings. We all know this model. And like it. This is business to consumer (B2C).

But how do we scale this model for financial services? Membership of these wholesale clubs requires additional checks e.g. regulatory licenses. This is the B2B model. And this is the critical role our CCP partner plays in the GFO-X market model: acting as a trusted counterparty, having the confidence in the abilities and capitalisation of all their Members (who in turn back our market Participants).

What can we learn from this?
2023 was a bit of a shakeout year for the crypto markets. Fraud, conflicts of interest, etc. All the age-old illegal and unethical practices that traditional finance markets are unfortunately no stranger to. Things that we’ve seen before in TradFi, just under different guises. What it highlights is the importance of decoupling the transaction value chain into its components of Trading (price discovery), Clearing (risk mitigation) and Settlement (fiat payment rails). These have been hard lessons learned by TradFi markets, and the crypto market must learn from these mistakes, lest another FTX occurs.

The importance of partners.
GFO-X has chosen an intermediated model, with LCH as our CCP so our Participants have both certainty of contract performance and recourse in the event of default. This is underpinned by a legal and regulatory framework. Choosing LCH as our CCP was not a decision taken lightly. It is about delivering a trusted framework, in good times and bad, for our users.

And as for the photo credit? That’s AI for you. Thanks Leonardo.AI (It’s not really Brett, ‘The Lehman guy’ in the iconic photos).