For companies and households, the combination of rampant inflation, the threat of energy shortages, foreign exchange volatility, and sharply rising borrowing costs are proving a perfect storm. Banks, which welcome the rise in policy rates that boost interest margins, remain cautiously optimistic about not facing an onslaught of credit stress among their borrowers. Faced with weak market sentiment and falling valuations, capital raising has become a torpid affair--undermining revenues for investment banks and listing revenues for securities exchanges. But the FMI sector is generally doing well and, first among them, derivatives exchanges and clearinghouses (central counterparties or CCPs).

The pre-pandemic years, marked by low volatility and low or zero policy rates, delivered cheap money, rising equity markets, and strong capital raising. That was good for securities markets, but poor for rates, credit, and foreign exchange derivatives in particular. For sure, many FMI players still rode secular growth trends--the shift from active to passive investment, the insatiable demand for data and analytics, the regulatory push of over-the-counter (OTC) transactions toward exchange-traded markets--but softening economic growth depressed cyclical derivatives revenues. Since 2020, the markets and with them FMIs have negotiated an upswell in volatility, culminating in 2022 in a reversion in economic growth prospects, a sharp rebound in policy rates, and price swings in equity, fixed income, and commodities. Secular growth opportunities remain available, but they have been joined by a huge boost to cyclical revenues. The rated sector's big beasts--CME Group Inc. (CME), Intercontinental Exchange Inc. (ICE), Deutsche Boerse (DB), LCH, and Options Clearing Corp. (OCC)--have done well this year, and will likely continue to do so.

Yet central bankers are worried. These market conditions reflect a sharp cyclical reversion as well as geopolitical events and follow the substantial shift in the tectonic plates of finance since the financial crisis. Monetary policy tightening is proving rapid, widespread, and uncoordinated. Reforms after the financial crisis improved market transparency, but banks do not and cannot intermediate markets as they used to. Parts of mainstream finance moved into the shadows. Predictable volatility is an opportunity for many market actors, but severe nickel price volatility, U.S. treasury market illiquidity, U.K. gilt market gyrations, and roiled European power markets undermine confidence and expose latent vulnerabilities. Market liquidity can now be deep and yet ephemeral, and sharp price movements lead to big margin calls and liquidity stress for the cash poor, even if they are balance sheet solvent.

Since the financial crisis, CCPs became the critical nodes of finance--the system risk controllers. Central clearing has so far worked well, not least because CCPs' clearing members (principally banks) are themselves more resilient. CCPs also significantly enhanced their risk management in the past decade, including taking care to ensure that margin calls are, within reason, antiprocyclical (that is, not amplifying market swings). CCPs now face increased latent risk but also benefit from increased risk mitigation. Faced with financial stability risks, regulators and policymakers seek to temper extreme market stress pragmatically, with a desire to avoid dilution of the protection offered to, and by, CCPs.

Rising earnings are supportive of our view about the FMI sector, and particularly for companies that seek to balance leverage and debt servicing capacity with their broader strategic ambitions, where M&A often plays an important role. However, the sector is already highly rated so there is little ratings upside. Indeed, our assessment of FMI groups is more sensitive to the effectiveness of their risk management. CCPs are critical nodes in the value chain exploited by many FMIs. The tides are turning, but we remain confident that FMIs will navigate them successfully.

Since 2020, derivatives volumes have bounced back, but it's not been plain sailing

The pre-pandemic years of benign market conditions were not normal. Cheap money and low volatility left rates and foreign exchange trading franchises in the doldrums, but buoyed FMI revenue from capital raising and equity trading. Secular trends of rising retail activity in equity markets, electronification of markets, and indexation proved a powerful boost. CCPs benefited from secular growth in central clearing and related treasury income as well. Highly cash generative, leading FMIs accelerated debt-financed acquisitions in adjacent faster-growing lines of business.

Derivatives exchanges' cyclical fortunes changed in 2020 as volatility spiked (see chart 1). This volatility caught out Ronin Capital LLC, but CME Clearing and the Fixed Income Clearing Corporation (FICC) comfortably managed the closing out of its trading positions. Related hedge fund Parplus Partners left prime brokers ABN AMRO nursing significant losses. As economies roared back into growth in 2021, so did the equity bull markets. Volatility receded but remained persistent. European gas prices, and therefore linked power prices, reacted sharply in December 2021 to weak supply in the face of strong demand. Margin calls spiked but were met. However, there was no repeat of the 2018 default, when power market basis risk caught out Norwegian trader Einar Aas, revealed risk management gaps at Nasdaq Clearing AB, and left its clearing members with €100 million of losses. In the U.S., plummeting prices in technology stocks took down Archegos Capital Management in March 2021. As an isolated incident costing $8 billion in losses to its prime brokers, this was expensive but ultimately not ruinous, and CCPs remained one step removed from this failure.

Chart 1

But this was nothing compared with a 2022 that has proven tumultuous for markets. Cyclical credit conditions snapped back as central banks responded to renewed inflation, and the consequences of geopolitics spilled out--whether from the supply-side constraints arising from the Russia-Ukraine war, China's persistent lockdowns, or fears of a global recession. Tighter money and evaporating confidence depressed equity markets and so stymied capital raising and weakened cash market activity, but futures volumes held up and options volumes have raced ahead (see chart 2). Rates, foreign exchange, and commodities derivatives volumes have generally seen a huge boost, as has repurchase agreement (repo) clearing. It's a sign of the times, as well as its expansive strategy, that LSE Group's capital market division now makes only 20% of its revenues from equities, behind even foreign exchange, and this is a fraction of total group income. Rising commodity prices also helped to drive up open interest, though energy prices have fallen back in recent weeks (see chart 3). The strengthening trend of the U.S. dollar has accelerated since March 2022 (see chart 4). CCP initial margins and default funds spiked (see chart 5), and with it treasury income. In March, wild price movements in nickel caught out major Chinese producer Tsingshan, and also its prime brokers and the London Metal Exchange (LME), as it suspended the market and cancelled trades--and it now faces multiple lawsuits from unhappy members. Retail activity switched to options, and CME expanded its retail push with its "micro" contracts - by breaking down larger, popular commodity derivatives contracts to attract retail investors and speculators.

Chart 3

Chart 4

Chart 5

The energy and gilt market volatility episodes highlight that cash is king

While the causes were different, the Tsingshan nickel episode offers a strong parallel with the stress on European power utilities. When nonfinancial corporates match long physical positions with short financial markets positions, this might hedge future returns and so long-term capital solvency, but the liquidity stress from short-term market moves can be crippling as they do not sit on substantial rainy-day liquidity buffers.

The parallel extends to the recent U.K. gilt market crisis. Pension funds using liability-driven investment (LDI) closely matched the profile of their assets and liabilities and, when gilt yields spiked, they became more solvent as the value of their liabilities fell by more than the value of their assets. But, again, these funds don't carry large cash buffers, and so were forced to sell assets when faced with huge margin calls, leading to a downward price spiral. The Bank of England's intervention in the gilt market alleviated some of the underlying pricing pressure and, therefore, margin pressure on the pension funds and avoided any wider fallout for their counterparts and the repo market. LDI strategies are also used by other European pension funds, though EU regulators authorities see less potential vulnerability among these funds.

The liquidity stress largely arises from clear-sighted policy choices made after the financial crisis--a deliberate decision to improve market transparency and mitigate and reduce credit risk among sizable market players (whether financial institutions or nonfinancials) via collateral requirements. In a very high volatility environment, such requirements transform credit risk into liquidity risk. The question policymakers now ask themselves is whether this increased liquidity demand is too high or else incorrectly distributed among the key actors (end-clients, banks acting as clearing members, and CCPs themselves).

CCPs have faced a limited test so far, but markets still have plenty to digest

In many respects, the market's resilience to stress is comforting and has vindicated reforms that brought greater transparency and a larger role for CCPs. There was no large counterparty default, but regulatory stress-testing exercises, notably those conducted by ESMA (European Securities and Markets Authority) in 2021 and reported in mid-2022, provide confidence that the European CCPs should be up to the task (see box).

However, the reassurance only goes so far. Following Russia's invasion of Ukraine, the price movements in asset classes like wheat, power, or gas were above those used in ESMA's stress test. CCPs have also seen rising margin backtesting exceptions that have resulted in some significant shortfalls in absolute terms and reduced performance against their targeted minimum standards (see table 1). Positively, this seems to reflect extraordinary price volatility, not that the models aren't working as well as intended, and the shortfalls would almost always have been well-covered by the fallback protection from default funds. Initial margin requirements have now adjusted to this period of high volatility, so backtesting exceptions might now reduce, but further bouts of high volatility could still leave default funds exposed if a sizable clearing member fails.

Table 1

Exchanges and CCPs have at times fared well in these periods when the perception of counterparty risk was high and trust low, and so the comfort of facing a CCP was prized. However, despite the gradual expansion of the regulatory clearing obligation beyond the major banks, some funds and corporates still have a choice about whether they use central clearing for their meaningful derivatives exposures. And as initial margin has become more expensive in liquidity terms, the incentive to avoid it by trading through the OTC market also became stronger--even though a move to bilateral trading increases their counterparty risk. That said, for some of these players, the margin relief from avoiding the cleared environment could be fleeting. The annual updates to SIMM (ISDA's standard methodology for calculating initial margin for uncleared trades) will now encompass the sharp price volatility of 2022 and so also imply a margin hike for firms that have to use it.

This and last year saw several significant market events: a combination of liquidity stress on otherwise solvent firms, interspersed with the failure of risky firms that become insolvent. But in many of these cases it needed intervention--by central banks (in the case of U.K. gilt yields), European governments (for power utilities), and the LME and prime brokers (for Tsingshan nickel)--to avoid significant defaults that could have spurred even steeper market volatility and a far stiffer challenge for CCPs. This is comforting because authorities are alert to the risk and willing to act, but it is also discomforting that these interventions were needed.

While these FMIs' revenues are likely to continue to fare well, the last weeks of 2022 and 2023 are likely to remain rocky for financial markets. Money policy tightening is far from finished. Central banks' net bond buying stopped, but quantitative tightening (net sales of bonds) is barely underway in the U.S., and will start eventually in the EU. In Europe, banks will need to repay a substantial part of their pandemic-era TLTRO drawings by mid-2023--they have the funds to do it, but they will likely run down their liquidity buffers. At the same time, the lack of central bank coordination of policy rate rises has left the Japanese yen exposed. Equity markets could fall further if confidence evaporates. With central banks moving out of bond buying and European governments needing to shore up their economies amid weaker GDP prospects, corporate and government bond yields could surge further. And October's U.K. gilt market stress showed that it's not only commodity markets that are exposed to event risk. While 2022 might prove to be the year of the greatest step-up in calls on initial and variation margins, the liquidity earmarked across the industry for potential margin calls is unlikely to dissipate rapidly.

Policymakers, regulators, and the market are well aware of this confluence of monetary policy tightening and heightened contingent liquidity needs and that it could promote dysfunctional markets. They are also acutely aware that the major banks' ability to intermediate financial markets is not what it was. True, other market-makers have now partially stepped into that role, but confidence about market depth might prove illusory if there's no one willing to bid in volume when prices start falling.

Irrespective of market conditions, CCPs should remain resilient

Despite this gloom, there are good reasons to expect that CCPs and the broader financial system are likely to remain resilient. Through a combination of tougher regulation and own initiative, rated CCPs have continuously improved their resilience and sophistication in the past decade. CCP risk managers understand the febrile environment and have good visibility about the positions being built by market actors. They remain on a high state of alert, and willing to intervene against weak players or those with concentrated positions. Major banks are the most important CCP clearing members and represent the first line of defense between CCPs and underlying clients, and they remain strong. The extraordinary price spikes of 2022 are now in CCP margin models, where antiprocyclicality measures will ensure that these episodes have a lasting influence on initial margins, even if markets settle down for a while. After years of liquidity almost being taken for granted, the huge variation and initial margin calls of 2022 will have alerted all market participants about the importance of reinforcing their contingency planning.

The near misses in recent years are learning opportunities to shore up points of weakness. After Archegos, prime brokers will be better prepared to understand the risks their clients bring, and hopefully also willing to uphold the limits of their risk-return appetite. The LME nickel episode highlighted the need for CCPs to surveil the entire market (not just the exchange-traded part) and the value of circuit breakers to effect a market halt in moments of extreme price moves. These mechanisms are theoretically the preoccupation of exchanges as they seek to maintain orderly markets, but they can also protect CCPs. The Nasdaq Clearing episode in 2018 led to renewed focus on the demerits of some nonfinancial players as direct clearing members and how CCPs model the closeout risk associated with highly concentrated positions (for example, in terms of average daily volume traded). The 2020 freeze in the U.S. treasury market, arguably the most important financial market globally, prompted the U.S. Federal Reserve to explore ways to increase the role of central clearing (see box 2). Similarly, various episodes have prompted regulators to probe the nonbank financial institution sector for vulnerabilities, particularly where they are leveraged or undertake maturity transformation.

Finally, while policymakers in Europe look at ways to ease the liquidity hit to European power companies and high prices to end-consumers, they appear wary of reversing previous strengthening in requirements on CCPs. The most notable proposal so far is the proposal from ESMA to allow CCPs to temporarily accept unbacked bank letters of credit as margin collateral from direct clearing members in the utility sector. This appears aimed particularly at alleviating pressure in the Nordic power market. Policymakers also tread carefully around trying to implement price caps in the wholesale market, knowing that it could destroy price formation and lead to unintended consequences. And what about the role of central banks as lenders of last resort--the ultimate source of fallback liquidity? Discount window access is likely to remain the preserve of credit institutions and a handful of CCPs (notably in Europe), but central banks are thinking more broadly about how to mitigate potential risks to the transmission of monetary policy. To boost collateral availability in the market, the Fed launched its overnight repurchase facility, and the Swiss National Bank started to issue treasury bills. Other central banks may well follow.

Ratings implication: neutral at best

To summarize, the base case we outline above is a relatively benign one for rated FMIs: A generally supportive revenue environment and post-trade risks that remain well-controlled. Faring least well are FMIs still heavily centered on the cash equities list-trade-clear-settle silo. Those active in credit, rates, foreign exchange, and commodities would benefit from generally strong tailwinds, even if activity and open interest doesn't attain the highs of 2022. Diversification strategies will continue to show their value. If markets are more volatile than we expect, this could boost revenue but also test CCPs if there is a material member default.

We remain confident that CCPs will navigate potentially stormy conditions successfully. However, there is little ratings upside here, not least given the already lofty rating levels in the sector, and our assessment of FMI groups is sensitive to the effectiveness of their risk management. CCPs are critical nodes in the financial system, but also in the value chain exploited by many FMIs. Therefore, ratings could come under pressure if we see risk management mishaps or a material weakening in the credit quality of CCPs' members or their broader package of financial safeguards.

Related Research

• This Week In Credit: Look Beyond Recent Market Elation, Nov. 14, 2022
• ESG Credit Indicator Report Card: Financial Market Infrastructure, May 20, 2022
• Global FMI Sector Outlook 2022: Growth Initiatives Will Be Key To Increasing Earnings, Jan. 13, 2022
• Strategic Shifts Are Changing Both The FMI Industry And The Way We Analyze It, Nov. 29, 2021
• Clearinghouses Continue To Up Their Risk Management Game, Jan. 29, 2020