Interoperability is a simple concept: it requires competitors to cooperate in order to provide choice to consumers, while still competing on quality and price.

There are many examples of interoperability in everyday life. Everyone who carries an ATM card is a beneficiary of interoperability. Without interoperability among banks, consumers would only be able to withdraw cash at an ATM installed by their own bank. The same with mobile phones – without interoperability among telephone networks, consumers would only be able to call someone using the same network.

How the CCPs manage their exposure to each other’s default is at the heart of an interoperability agreement. The agreement typically also includes operational, connectivity, change management, and business continuity provisions, and any other item which requires coordination when CCPs jointly clear for the same trading venue.

Risks associated with interoperability arise from several areas:

• Some major components of a CCP's risk management measures are typically not applied to interoperating CCPs, who do not become participants of the other CCP. The measures not applicable may include minimum capital requirements and obligation to participate in loss sharing. Although they do not become participants, the nature of the exposure interoperating CCPs face is similar to that vis-a-vis participants: the inability of the other party to honour its obligations when due. This could happen if, for example, a CCP suffered massive losses from participant defaults and exhausted its available financial resources, which is a possibility in extremely stressful market conditions.
• One CCP’s default could cause financial distress to the other interoperating CCPs, if the remaining CCPs incur significant losses in closing out the obligations of the defaulter.
• Differences in a CCP’s rights and obligations towards their own participants versus interoperating CCPs could create additional exposure to a CCP. Such differences must be identified and appropriately managed.
• Lack of transparency in bilaterally negotiated and confidential inter-CCP risk management arrangements could result in additional but invisible risks. Four CCPs interoperating require six bilateral risk management agreements, only three of which will be visible to each CCP as a signatory.

The regulators of the CCPs currently working on interoperability issued in February 2010 a list of requirements that the CCPs must fulfil in order to adequately manage these additional risks. The requirements include additional collateral in the system to cover the additional risks, and assurance that if a CCP defaulted any collateral it has received from the remaining CCPs is not trapped in its estate. Furthermore, the inter-CCP risk management arrangements must be scalable to increased business volumes, additional trading venues and additional CCPs joining the interoperating network.

The regulators’ requirements are very helpful to progress interoperability and have encouraged CCPs to work collectively on a uniform and transparent risk management approach.

Under the Code of Conduct for Clearing and Settlement, there are three possible types of relationships between CCPs: standard access, customised access, and interoperability. These describe different levels of legal, technical and operational arrangements between CCPs, and not the cooperative versus competitive nature of an inter-CCP relationship. [The Code of Conduct is a voluntary code signed by trading, clearing and settlement market infrastructures in the EU in 2006 with the aim to promote competition.]

Full interoperability which delivers free choice to trading firms means that, if they wish, they could consolidate clearing with a CCP of their choice to achieve economies of scale and efficiency gains. Firms which concentrate with one CCP the clearing of trades executed on multiple venues benefit from:

• Risk management expertise and robustness of their preferred CCP, ensuring that they do have the protection they think they have;
• One CCP relationship to manage, saving time on service monitoring and management;
• One CCP connection to manage, with lower back office costs and operational risks.
• Lower clearing fees, by concentrating business with one provider to qualify for the highest volume discounts;
• Lower settlement costs and operational risks, by reducing to one single settlement per stock per day, regardless of the number of trades or the number of venues on which it has traded;
• Lower funding costs and liquidity needs, both from lower margin requirements through netting and risk offsets within all open obligations, and from one single net settlement per security per day.

For a firm to have free choice, the venues on which it trades need to appoint its preferred CCP, and any other CCP that also clears for those venues needs to interoperate with the firm’s preferred CCP.

Some firms may still want to use multiple CCPs, and interoperability does not prevent that.

In Europe, trading venues select different CCPs based on their own valid economic interests. Users are obliged to use different CCPs appointed by the venues, adding to costs and risks of post-trade activities.

Full interoperability in Europe will create a virtual single CCP environment with low frictional costs. Full interoperability means firms can choose a preferred CCP, if they wish, to clear all their trades regardless of where they trade, even though there are many CCPs in Europe.

Partial or patchy interoperability will result in firms still being required to connect to multiple CCPs that have been pre-selected by trading venues and their incumbent CCP(s).

Although competitive clearing is still elusive and the latest requirements by regulators to make interoperability safe mean additional costs to firms, many firms active in cross-border trading still want interoperability to be implemented. For these firms, interoperability brings the benefits associated with competition and is therefore worthwhile.

Many market participants believe that if they were given the ability to freely choose which CCP to use, the industry would consolidate. Currently there are 8 CCPs in the 17 European markets in which EuroCCP operates; soon there will be 9 (Norway) or even 11 (Greece and Spain). While no one can agree what is the right number of CCPs for Europe, most market participants agree that the current proliferation leads to higher costs and risks due to operational complexity and inefficient use of collateral. Full interoperability allows competition on a level playing field and many market participants believe it would provide the necessary transitory phase to pave the way for CCP consolidation.

One of the reasons interoperability seems difficult is that it has to be implemented by trading venues and CCPs, and there is no consensus among them that interoperability is beneficial to their business.

Regulators of CCPs currently active in interoperability discussions have made it clear that there is no absolute regulatory barrier to interoperability.

The CCPs need to work together to reach agreement on the details of their interoperable risk management models and obtain approval from their respective regulators, who will jointly review the models and agreements to ensure that they meet regulatory objectives.

Participants will expect transparency on any changes to the CCPs’ risk management models and their impact (e.g. on the exposure of their participants), so it would be desirable if these were clearly communicated by each CCP to its participants, including consultation on rule changes where necessary.

Trading venues that are determined to offer trading firms effective competitive clearing should likewise ensure their incumbent CCPs move quickly to deliver on interoperability.

Users need to ensure trading venues open up their trade feeds to all interoperating CCPs. Without this, free choice is not possible since it would still be the trading venues that decide what choice is available to users. Users then need to ensure CCPs move quickly to deliver on interoperability.