29 Apr 2011
Current consensus from legislators and regulators is that
strategic use of CCPs will help address both firm-specific risk,
such as counterparty credit risk (CCR) as well as systemic risk
factors for the entire financial system.
This is evidenced in the Dodd-Frank Wall Street Reform and
Consumer Protection Act, entitled "Wall Street Transparency and
Accountability," which was passed into US law in July 2010 (with an
effective date of July 2011), and the European Commission's final
proposal for European regulation published on 15th September
2010, known as the European Market Infrastructure Regulation
(EMIR), which mandates the clearing of OTC derivatives through CCPs
by the end of 2012.
While significant uncertainty remains around what the final
implemented regulations will contain, the use of CCPs may be viewed
as a "new paradigm" to mitigate CCR for OTC derivatives contracts.
However, there are still concerns from market participants
associated with this new regulatory environment.
Main functions of CCPs
The financial crisis has highlighted that many institutions
failed to manage counterparty risk on derivatives contracts. In
reaction to this risk management failure, the regulators have
hastened to use CCPs and clearing houses for derivatives, to
unravel "the complexity" of counterparty risk. For example, the use
of exchanges to trade equity options, i.e. exchange traded
derivatives (ETDs), has proven to be efficient in mitigating risk.
ETDs allow market participants to trade with the confidence that
contracts will be settled in full.
Default
risk
The Risk of non-performance of a counterparty
Settlement risk
The risk of a counterparty failing to meet contractual
obligations at settlement.
Pre-Settlement
risk
The Risk of a counterparty failing to meet contractual
obligations before settlement
Replacement
risk
The Risk that a contract holder will know that the counterparty
will be unable to meet the terms of a contract, creating the need
for a replacement contract.
CCPs help facilitate the clearing; settlement and risk
management processes in financial markets. When trades are
centrally cleared, the clearing house acts as a central
counterparty, effectively guaranteeing each side of the trade.
If one counterparty of the contract defaults, the CCP will make
sure that the corresponding counterparty to the trade does not
suffer losses. This is achieved by requiring each counterparty to
post an initial margin (IM) and an ongoing variation margin (VM).
The IM provides a level of default protection and is based on the
volatility of the cleared instruments. The clearing house also
collects/pays VM (mark-to-market margin) on a daily basis, based on
the valuation of the derivatives contract at end-of-day prices
There will be many advantages
CCP clearing is expected to create more robust management of
counterparty risk, increased transparency, reduced operational risk
(by standardising, centralising and creating automated trade
processing through a single entity), as well as a number of other
associated benefits for the OTC derivatives market as a
whole.
CCP clearing advantages
- Remove trade‐by‐trade counterparty risk by acting as the
central hub and facilitator of every trade;
- Protect against default through margin requirements and a
default fund created from member contributions;
- Reduce operational risk by standardising, centralising and
creating automated trade processing through a single entity;
- Reduce capital requirements;
- Facilitate multilateral netting helping to reduce average
exposure; create positions that are marked‐to‐market;
- Rerate a real‐time P&L that is continuously updated
However CCPs must have robust risk management processes…
The CCP's risk management framework will need to define the
processes of evaluating and calculating; counterparty exposure to
outstanding obligations, the management of collateral being
provided by clients, the determination of collateral haircuts, the
definition of default procedures and maintenance of any additional
buffers.
Source of Risks
Counterparty:
Risk of a loss of an unrealised profit or a loss resulting from
a counterparty default.
Liquidity
Risk that payment or securities are not delivered in time
Settlement
Settling securities or payments
Custody
Risk of losing collateral and/or own assets held with a
custodian
Operational
risk
Risk of inadequacy or failure of internal processes. Could
affect the ability to monitor other risk
Legal
Risk that contractual provisions are not enforceable. Usage of
collateral and enforceability of default-procedures
In order to manage its own risk, the CCP will need, in our view,
to perform risk management processes at several levels:
- Calculation of daily or intra-day price movements, plus initial
and variation, per product for each counterparty;
- Application of stress test scenarios to ensure adequate
protection for the organisation against shortfalls;
- Determination of counterparty creditworthiness;
- Evaluation of cross-margining benefits across products and/or
markets;
- Finally, a "crystal clear" default procedure will need to be
defined to ensure shortfalls are promptly detected and damage kept
to a minimum.
By moving counterparty risk out of the banks and concentrating
it in a supervised central counterparty, mandated clearing of
derivatives will centralise information about new and existing
contracts, as well as simplify market monitoring. However as
central clearing will only be possible for eligible products, the
use of a trade repository will also be required for non-cleared OTC
transactions.
In our view, CCPs will help to address several financial
stability concerns such as the lowering of systemic risk and
counterparty risk and create increased transparency. However, the
introduction of a CCP, although necessary, is not in itself
sufficient for ensuring the achievement of the required
objectives.
Anticipating regulatory change is not a trivial exercise
The regulatory reforms in the pipeline will change the industry
landscape; we expect US, EU and Asian regulators to be consistent
in their approach, otherwise key differences in the regulatory
framework and its implementations could create regulatory arbitrage
opportunities and introduce, rather than mitigate systemic risk.
For example, if Asian regulators are more lenient than their peers,
the trading activity of some US and EU banks could be "pushed out"
to Singapore or Hong-Kong.
As yet there are no common standards for how a CCP should work.
Issues such as the allowable grades of collateral, the nature of
standardised trading products, and the responsibility of members
for maintaining the solvency and oversight of the CCP have yet to
be resolved. Currently, the UK Financial Services Authority (FSA)
is lobbying for a European directive that will standardise the CCP
model, but there is no guarantee this will match the US Futures
Commissions Merchant (FCM) model.
Though a significant amount of uncertainty still remains around
what the final implementation of the regulations will contain, the
use of CCPs may be perceived as a "new paradigm" to mitigate CCR
for OTC derivatives contracts. However, in our view there are
currently deep concerns amongst market participants in both the US
and Europe, given that these regulatory reforms are still only
"work in progress". Despite a strong desire to take a
proactive stance, the lack of a definitive decision-making process
in a timely manner on the part of these regulators, has forced many
participants to take a "wait and see" approach.
It cannot be emphasised enough, that market participants will
need to: reinforce their risk management culture, improve their
trade capture and processing, implement new collateral management
programmes, and set up dynamic credit risk monitoring with
counterparty watch list systems. Finally, all firms should analyse
their current derivatives trading models to determine if new or
revamped systems are required to help them comply with the new
imperatives.
The regulated use of CCPs is not a zero-sum game. The consistent
implementation of regulations across all jurisdictions, combined
with improved risk management processes for Clearing Members will,
in our view, result in a significant net positive benefit for
all.
Rule Financial
Since 1997 Rule Financial specialists have been working
alongside their counterparts at the world's leading banks and
trading houses, helping to improve productivity, manage risk, lower
costs, and deliver competitive advantage.
Our expertise in the management of change and risk, project
delivery, compliance and understanding of complex technology has
helped to build long-term relationships with clients based upon a
solid track record of success.
Rule Financial services a range of global customers from offices
in London, New York, Barcelona and Łódź (Poland).
