At Rule Financial we understand the drivers for the OTC Clearing mandate, and are already helping our investment banking and clearing house clients update their business practices, enabling them to benefit from the new legislation.
What has changed?
The recent financial crisis, with the failure of major broker dealers Bear Stearns and Lehman Brothers, plus the near failure of insurance giant AIG, has triggered a reconsideration of the supervision and regulation of the OTC derivatives market. The credit default swaps (CDS) market (part of the OTC derivatives market) took centre stage in the financial difficulties as the counterparty risk involved in this largely bilaterally cleared market began to materialise. These risks most specifically were in areas such as non transparency, inherent counterparty risk, and the danger of contagion.
Since 2009 there has been growing interest among international regulators, hedgers, investors, dealers, clearing members, clearing houses and exchanges in the development of a CCP or central clearing house (CCH) for CDS and other OTC derivatives.
The introduction of a CCH introduces a body that assumes the credit risk liability of all trades that are submitted to it by its members. Introducing a CCH to which trades are submitted is expected to:
- Reduce systemic risk
- Increase transparency
- Reduce counterparty risk
- Increase efficiencies in operational processes through accurate integration of trading, risk and operations
- Support a robust default management process to manage the default of any clearing member.
Soundly run and regulated OTC derivatives CCPs are intended to reduce counterparty risk among dealers and minimise the systemic risk associated with counterparty failures. Despite the initial benefits in moving to wider central clearing of OTC derivatives, this change will hide considerable challenges that the industry is still facing. Given the global nature of the OTC derivatives market, there is a clear need for international coordination to establish minimum international risk management standards to avoid regulatory arbitrage.
Our key findings
Rule Financial has performed an analysis of the developments in the OTC derivatives market, and our key findings are as follows.
Expansion of the OTC derivatives market
The market size has expanded dramatically in recent years, and is now significantly larger than that of exchange-traded derivatives. According to the International Swaps and Derivatives Association (ISDA), the total value of outstanding OTC derivatives contracts at the end of the first half of 2010 exceeded $582 trillion.
One of the key differences between these markets is that while exchange-traded derivatives are fully transparent in terms of positions, prices, exposures, and counterparty risk reduction, OTC derivatives are largely unregulated with respect to the disclosure of information, and information available to market participants and supervisors is limited
Risk Management for OTC derivatives
The OTC market has historically dealt with counterparty risk through a variety of methods; ranging from simple counterparty credit limits, to collateral or margin, margin "calls", and bilateral netting agreements. However, the financial crisis highlighted many weaknesses in the bilateral OTC derivatives market, such as non-transparency, inherent counterparty risks, and the danger of systemic risk.
The use of CCP clearing
CCP clearing (clearing, execution, collateral management, valuation and servicing) is an immediate way of addressing the limitations, creating more robust management of counterparty risk, increased transparency and a reduction in a variety of other associated risks for the OTC derivatives market. CCP clearing will: 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; and create a real-time P&L that is continuously updated
OTC derivatives regulation
Worldwide regulators increasingly favour a move towards cleared contracts. Pressures to move away from bilateral OTC trades are based on the current markets opaqueness, which exacerbates and contributes to systemic risk. Central clearing has been shown to increase transparency and reduce a variety of risks for OTC derivatives markets. Legislation is therefore underway to mandate the central clearing of all suitable products.
Areas covered by the new regulations:
- Regulatory responsibility for derivatives markets
- Scope of derivatives covered
- Registration and regulation of market participants
- Registration and regulation of CCPs
- Clearing and trading requirements
- Clearing organisation ownership rules
- Trade repositories
- Capital and margin requirements for dealers and end-users
- Bank "Push Out" of derivatives into a separate subsidiary
- Segregation of collateral requirements
- Position limits
There are a number of challenges associated with establishing this new paradigm in the OTC derivatives market, including: the costs associated with developing and maintaining a large number of dynamic exchange feeds, the operational risk costs, reconciling the collateral calls and margins, creating a clear link between product control and finance, implementing default management, provision of balance sheet reporting, creating new reconciliation requirements, providing full transparency around collateral, updating and extending system integration, margining and reporting.
The benefits of CCP clearing
These benefits will include: the avoidance of contagion, the removal of the 'unwind' phenomenon and the mitigation of bilateral default risk. The overall benefits of CCPs must be made clear, so that institutions will not circumvent clearing legislation by turning their vanilla OTC capability into a non-regulated 'exotic' by merely adding a financially benign leg to the trade.
Our conclusions
The regulatory pressure to move to a centralised clearing of OTC derivatives is being encouraged by a number of key considerations such as the need for transparency, liquidity and lower counterparty risk. Counterparty credit risk is now far more important than it was prior to the collapse of Lehman Brothers, and we see a definite need to address the lack of transparency that pervades OTC derivatives markets.
Future regulatory developments need to ensure that the banking system is made more resilient. However the use of CCPs alone is not enough to ensure that the OTC derivatives markets operate accurately and remain resilient. It is important to complement the introduction of CCPs with improvements in trading and settlement infrastructure.
With respect to the implementation of the new OTC derivatives regulations: "Harmonisation and Consistency" across the different jurisdictions around the world is a key condition (particularly in light of the US Dodd-Frank Bill and EU regulations covering OTC derivatives, central counterparties and trade repositories) to avoid participants exploiting weaknesses of the new reforms.
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