What it means
When two firms trade a bond, there is a gap between agreeing the deal and exchanging the bond for cash. A clearing house closes that gap by becoming the buyer to every seller and the seller to every buyer, a role known as central counterparty.
This process, called novation, replaces many separate exposures with a single exposure to the clearing house. FICC operates through two divisions.
The Government Securities Division handles US Treasury bills, notes and bonds, along with repurchase agreements (short-term loans secured by securities). The Mortgage-Backed Securities Division handles trades in pass-through securities backed by pools of home loans.
A major benefit is netting, which means offsetting a firm's buying and selling positions so that only the net amount is settled. If a dealer buys $500,000,000 of a Treasury issue from one counterparty and sells $480,000,000 of the same issue to another, only $20,000,000 needs to move.
This reduces the cash and securities needed to settle the trades each day. Members must contribute to a clearing fund, which acts as a financial cushion if a member fails.
The size of each contribution depends on the risk of that member's positions, and the clearing house can call for more when markets are volatile. Strong risk management is vital because a failure at a central counterparty could spread stress across the whole financial system.
Regulators have encouraged wider central clearing of Treasury and repo trades to improve the resilience and transparency of these markets. For a non-specialist, FICC is the unseen infrastructure that makes the world's biggest bond market work every day.
Risk management at the clearing house includes daily mark-to-market (revaluing positions at current prices) and the collection of margin to cover price moves. If a member cannot meet its obligations, FICC can use that member's collateral and clearing fund contribution, then call on remaining members if needed.
This layered protection is why regulators treat the clearing house as critical infrastructure.
In practice
Real-world examples.
Example
A bond dealer buys and sells Treasury notes throughout the day with dozens of counterparties. At the close of the day the clearing house nets the trades, and the dealer settles one net position, not dozens of separate ones, which cuts the number of payments its operations team must process.
Example
A mortgage lender sells a pool of newly made loans as a mortgage-backed security to an investor. The trade is submitted for clearing, so the lender does not carry the risk that the investor fails to pay and can recycle its cash into new mortgages quickly.
Example
A hedge fund borrows cash against Treasury securities in the repo market. Cleared repo through a central counterparty can lower its balance sheet usage compared with trades settled bilaterally, which frees capacity for further borrowing.
Formula
Calculation
The benefit of netting can be expressed as a ratio:
Netting efficiency = 1 - (Net settlement amount / Gross trade value)
A dealer buys $500,000,000 and sells $480,000,000 of the same Treasury issue on one day. The gross value of the trades is $500,000,000 + $480,000,000 = $980,000,000, while the net settlement is $500,000,000 - $480,000,000 = $20,000,000. Netting efficiency is 1 - ($20,000,000 / $980,000,000) = 1 - 0.0204 = about 98%, so roughly 98% of the gross flows never need to be settled.Case study
Seen in the real world.
Greystone Securities is an illustrative, fictional mid-sized dealer that settled most of its Treasury trades bilaterally with its counterparties. Its treasurer found that settlement balance sheet charges were limiting how much trading the firm could do each quarter.
After reviewing the costs, the firm applied for access to central clearing through a sponsored arrangement with a larger member. Trades that were previously settled separately were netted, and the firm's gross exposures fell sharply.
In this illustrative story the treasurer also had to budget for margin and clearing fund contributions. The net result was more trading capacity and lower operational risk, with a higher but predictable liquidity requirement. Management judged that a known daily margin call was easier to plan for than the hidden risk of a counterparty failing to deliver.
Watch out
Common mistakes.
- Confusing FICC with the DTCC itself, when FICC is one clearing subsidiary within the larger group.
- Assuming central clearing removes all risk, when it concentrates risk in the clearing house, which must be well capitalised.
- Ignoring margin and clearing fund requirements when pricing the benefit of netting, so that the cash cost of access is underestimated.
Questions
People also ask.
What does FICC clear?
Mostly US Treasury securities, repurchase agreements and mortgage-backed securities.
What is a central counterparty?
A clearing house that steps between buyer and seller so that each trades with the clearing house, not with each other.
Can small firms use FICC directly?
Direct membership has strict financial requirements, including minimum capital and operational standards, so smaller firms usually access it through a larger member via a sponsored arrangement.
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