Our business specialists cover all aspects of the forthcoming reforms, evolution of the OTC derivatives market and the impacts of using a central counterparty (CCP).
We have gathered the opinions of a cross-section of our specialists, who view the implications and impacts across the entire OTC derivatives landscape.
The role that organisations play on the OTC derivatives landscape will be altered significantly depending on how they adapt to the new regulations, be they a global clearing broker, clearing member, non-clearing broker, prime broker, investment manager, custodian, or third party administrator.
Our specialists consider some of the wider benefits and business opportunities associated with OTC clearing, as well as the implications of the reforms on IT systems, risk management and regulatory compliance. They were asked;
What does the clearing of OTC derivatives via a central counterparty (CCP) mean to you?
G20 summit, Pittsburgh, September 2009
"All standardised over the counter (OTC) derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by the end of 2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements."
OTC clearing regulations: "Work in progress"
Historically, each financial crisis comes with its own lessons to learn. The credit crisis has stimulated and continues to stimulate unprecedented debates between regulators, policymakers, politicians, financial institutions and the public, to redesign, improve and refine the architecture of the global financial system. Whereas previous reforms in risk management for financial institutions emphasised the microprudential regulation of individual banks, the new agreements focus on systemic risk.
In September 2009 at the G20 in Pittsburgh the leaders agreed that: "All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms where appropriate, and be cleared through central counterparties (CCPs) by end-2012 at the latest". This has led policymakers to propose laws to ensure that in future most standard OTC derivatives are centrally cleared. For instance, in July 2010 The Dodd-Frank Wall Street Reform and Consumer Protection Act1 was signed into US law, and in September 2010 the European Commission adopted the European Markets Infrastructure Regulation (EMIR)2 to address issues relating to OTC derivatives, central counterparties and trade repositories.
Globally, these reforms have been welcomed by market participants, but the reaction has been cautious, as many of the key details have yet to be finalised. For example, the US Treasury completed an industry-wide consultation exercise in November 2010, on whether Foreign-Exchange Swaps and Forwards should be exempt from the mandatory clearing requirement under the Dodd-Frank Act. Conversely, in Europe, EMIR doesn't refer to specific asset classes, but has put in place two different approaches (bottom-up and top-down) to select which contract types should be cleared through CCPs.
Currently there is a high degree of uncertainty as many elements of the regulations still need to be clarified; while a strict deadline for compliance has already been established. It is now essential that these imperatives are implemented accurately with strong risk management practices, otherwise systemic risk in the market could actually increase.
"The difficulty lies not so much in developing new ideas, as in escaping from the old ones"
John Maynard Keynes (1935)
- Dodd-Frank Wall Street Reform and Consumer Protection Act (HR 4173)
- Proposed text released to Parliament and Council by the European Commission on September 15, 2010.
- Politicians and regulators in the US and Europe are in favour of the multiple CCP approach, with market participants deciding which platforms will succeed for each asset class. This approach may be less efficient, but if implemented robustly, should mitigate systemic risk.
The technologies required for OTC clearing
The regulatory changes driving the introduction of OTC clearing through a central counterparty (CCP) are the next step in an evolution and maturity of the derivatives asset classes. From a technical architecture point of view the vanilla and exotics worlds have been diverging for some time with the introduction of Grid computing for pricing and valuation, moving from night time reuse of computing power to essential dedicated Grids for real-time processing. The world of exotic derivatives is very different from the vanilla one moving to the centrally cleared model.
So what technology should support centrally cleared OTCs?
The simple conclusion is to change the systems that process them today, and add the capability to support:
- 'Trade Pricing Request for Quote', and 'Price Streaming to Swap Execution' facilities and electronic communication networks (ECN)s
- Risk management requirements
- Clearing House connectivity for trade give-up and margin processing
- Process daily margin management with clients
- Cross product collateral management and optimisation
- Settlement and reconciliation changes
- New sub-ledger accounting rules and entities
- New client and regulatory reporting requirements
When you review the list, there is quite a lot of change to a derivatives architecture that is evolving in a different direction. There may also be more that one derivatives architecture to change, for Fixed Income, Equities, FX etc. With this in mind, a number of immediate questions spring to mind:
What role does the organisation play in the OTC clearing landscape?
This is important, since the role that is played will have a significant effect on how the organisation adapts to the new regulations - be they a Global clearing broker, Clearing member, Non clearing broker, Prime broker, Investment manager, custodian or third party administrator.
What options are available?
Could other architecture be enhanced to accommodate the change (the Futures or ETD platform, the Cash Securities platform or the Prime Services Platform)? What criteria would you use to decide?
What are the required service qualities?
This will vary significantly depending on the daily volumes, size of portfolio and the diversity of the clearing house.
For our clients, we are developing and testing alternative strategic options for OTC clearing. This approach allows us to determine the most cost effective ways of achieving compliance, whilst ensuring the capability to take advantage of future opportunities presented by OTC clearing.
"Understanding the technical landscape for the clearing of OTC derivatives, where each participant sits, and the challenges they face, is no mean feat for any market participant, given the aggressive timescales"
The US view: The 'core' of the core SEC principles
The recently released US Securities & Exchange Commission (SEC) proposal on OTC clearing of Security-Based Swaps set forth 14 'Core Principles' that would require all new security-based SEFs to comply with significant operational and prudential directives by 2012.
These principles can be separated loosely into two groups: one touching upon important operating concepts - what I would call the 'core' of the core principles: those most likely to impact and potentially force a re-engineering of participants approach to conducting business as they rollout SB SEFs, and the other, principles that set an overall strategic tone for the reforms.
Among these 'core', each will require a material investment by participants in re-tooled technology platforms, significantly re-engineered business processes/workflows, enhanced valuation and collateral management techniques, improved reporting capability, and establishment of compliance practices, the equivalent of which the industry has not seen previously.
Implementing this will create anxiety, mis-steps, and confusion. The situation will be exacerbated by cross jurisdictional regulatory frameworks, tight timelines and the complexity of moving to a new rules-based regime.
However, the impact of the operational changes will tend to be mitigated by an apparent body of opinion within the regulators (at least within the SEC, as expressed in the 'strategic' core principles) that a deft hand must be taken or risk further damage to US markets. Such damage could negate progress made by participants in repairing balance sheets, and possibly subvert the overall US economic recovery in the process.
Regulators should be aware that the mandate requires a fine line between promoting US market safety, transparency, and competitiveness, and ensuring that burdens of domestic regulation do not reduce the liquidity of US markets in the broader global context. This will be challenging, as non-US regulators are also re-writing derivatives clearing rules within other major regional jurisdictions.
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