27 Apr 2012, Mark Pengelly, Nick Sawyer, Risk magazine
Dealers are getting used to the slow drip of national over-the-counter derivatives regulations, but the publication of Singapore’s proposed rules in February triggered a level of enthusiasm that is perhaps at odds with the size of its local currency derivatives market. The reason? Simply, because the Monetary Authority of Singapore decided not to propose that trades be cleared locally, and instead opted to give market participants a choice in their clearing arrangements. That stands in stark contrast to other markets, including Australia, Canada, Hong Kong and Japan, which are all considering – or have already decided – to impose location requirements on certain domestic derivatives trades.
The motives are obvious – regulators want their domestic banks to access clearing services directly, and are keen to retain oversight of local currency derivatives trades. But there are downsides, say dealers: it could lead to the fragmentation of liquidity and break-up of netting sets, which would eliminate efficiencies and lead to higher costs for end-users. In the worst case, it may be all but impossible to transact cross-border trades given competing and contradictory clearing requirements in some markets.
“The real issue people would find particularly troubling is if you have a US bank doing a Japanese yen-denominated trade with a European bank, and you could have regulators in all three jurisdictions demanding you have to clear that trade through a local central counterparty (CCP). Then you would have a really untenable situation where you couldn’t do that trade,” says Bob Pickel, chief executive of the International Swaps and Derivatives Association in New York.
It shouldn’t come to that – but there are plenty of examples of inconsistencies in the various OTC regulations. In some cases, they relate to the instruments that must be cleared; in others, to the entities that would qualify for an exemption to the mandatory clearing requirement. Even where the various national rules agree, they are unlikely to be implemented at the same time in every market.
“Ideally, what the industry would like is for all of the various jurisdictions to have the same rules and implement all the rules on the same day, at the same time – but we don’t enjoy the luxury of that ideal world,” says Stephen O’Connor, New York-based chairman of Isda and global head of OTC client clearing at Morgan Stanley.
The timings in the US and Europe are a case in point. The Dodd-Frank Act was passed into law in July 2010, and regulators have been working to draw up detailed rule-makings covering everything from swap dealer registration to the segregation of client collateral. While implementation has been delayed once already, dealers expect the mandatory clearing requirement to come into force – at least to some extent – this year. In Europe, however, the final version of the European Market Infrastructure Regulation (Emir) was only agreed by the European Commission, European Parliament and the Council of the European Union in February. The European Securities and Markets Authority was initially required to draw up a series of technical guidelines by the end of June – a deadline that was extended to September. But many market participants think it unlikely the rules will be fully implemented by the end of 2012 – the date set by the Group of 20 nations in September 2009.
“Looking at Europe and the US, it appears the US is going to go first and there’s a timing difference there,” says O’Connor.
Another potential issue is where trades that meet the mandatory clearing obligation will actually clear. Under the Dodd-Frank Act, clearing houses need to register with the Commodity Futures Trading Commission (CFTC) as a registered derivatives clearing organisation (DCO), requiring them to meet standards set by the regulator. The CFTC can exempt a clearing house from having to register, as long as it meets comparable rules in its own jurisdiction. However, many participants think it is unlikely the CFTC will provide an exemption for every CCP that springs up – meaning many foreign clearing houses will need to register in order to clear trades for counterparties subject to the Dodd-Frank Act.
“As it currently stands, a CCP would be a bilateral counterparty if it is not recognised as a DCO. If it trades with a US swap dealer as a bilateral counterparty, the US swap dealer would have to demand margin from the CCP. Clearly, that’s not the way CCPs work,” says Keith Noyes, Asia-Pacific regional director at Isda in Hong Kong.
This could be a particular problem in Japan, one of the largest local currency derivatives markets. The Japan Securities Clearing Corporation (JSCC), a Tokyo-based CCP, started clearing Japanese index credit default swap (CDS) trades in July 2011, and plans to start clearing yen interest rate swaps in October this year, but is not currently registered as a DCO. Conversely, any foreign CCP that wants to offer clearing services for domestic firms needs to be approved by the Japanese Financial Services Agency (JFSA). While the regulator has suggested it will authorise foreign CCPs to carry out clearing business, it has yet to do so.
This may not present too many difficulties for trades between two local counterparties. The current thinking is that Japan’s mandatory clearing obligation, due to come into effect in November, will only apply to domestic dealers in the first phase. Those firms will be required to clear Japanese CDS contracts through a domestic CCP, and yen interest rate swaps through a domestic or authorised foreign CCP – although, in reality, choice is limited to the JSCC at the moment.
Much less clear is the treatment for cross-border trades – those involving a domestic counterparty and a foreign bank. The JFSA has stated it will tackle this after the first phase, but dealers are concerned about the lack of clarity. As it currently stands, a Japanese bank would only be able to clear yen interest rate swaps through the JSCC. The overseas bank, however, may be required to clear elsewhere – either due to a domestic clearing requirement, or because the JSCC is not recognised by the bank’s regulator as an authorised clearing house. In other words, Japanese dealers may not be able to trade with foreign banks in certain circumstances. Given the fact that cross-border transactions account for around 50% of the volume in yen interest rate swaps, this could have a major impact on liquidity, dealers claim.
“The volume of trades between domestic and overseas firms is not small – it is larger than for domestic versus domestic trades. That gives Japanese banks access to liquidity. So, if domestic versus overseas transactions cannot clear through a Japanese CCP, we cannot trade,” says Yutaka Nakajima, senior managing director and head of trading for fixed income in Japan at Nomura Securities in Tokyo, and an Isda board member.
There is time for this to be sorted out. In fact, London-based clearing house LCH.Clearnet was working with the JSCC in a joint venture to develop a yen interest rate swap clearing service, but the initiative was abandoned last September, when it became clear the JFSA would only require mandatory clearing for domestic dealers in the first phase – a decision that meant the cost of the venture outweighed the opportunity, according to LCH.Clearnet (Risk December 2011, page 8). Dealers say the JFSA understands the issues, and hope it will be amenable to future applications from clearers like LCH.Clearnet.
Either way, dealers have been calling for greater clarity on the issue. “A local Isda working group strongly argued that the regulations in each country have to be consistent, clear and transparent in terms of cross-border transactions,” says Yasuhiro Shibata, joint head of the fixed-income group at Mizuho Securities in Japan, and an Isda board member. “Regarding the clearing obligations, it will be physically impossible to clear in multiple locations. The issue is really crucial in Japan, because roughly half of the major players in yen swaps and Japanese CDSs are non-Japanese. That means very close to half of the derivatives transactions traded here are booked somewhere outside the country.”
These kinds of issues appear in other markets – particularly in Asia, where a number of domestic clearers have either already launched or are likely to emerge. In some cases, these domestic CCPs may be helped by location requirements in national OTC regulations. For instance, the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) published a consultation paper last October that proposed a mandatory obligation to clear “certain products that are considered systemically important to the Hong Kong market” via local CCPs. Similar proposals have been tabled in Australia and are also being considered in Canada.
“Asia has always had different countries going their own way, so there have always been different market rules for derivatives in each jurisdiction. What we would like to see is the different countries moving towards a single solution, but realistically that’s not going to happen in the short term,” says Isda’s Noyes.
As with Japan, this creates a practical problem of where cross-border trades should clear. If the Hong Kong regulators, for instance, opt to make it obligatory to clear Hong Kong dollar swaps domestically, it could create problems for any trade between a Hong Kong bank and the Hong Kong branch of a US dealer. The Hong Kong dollar swap would be required to clear at a local clearing house, but the US firm would likely have to comply with Dodd-Frank, which requires the trade to be cleared through an approved DCO. If the local clearer isn’t registered, the US firm would not be able to enter into the trade.
Aside from the practical considerations, there are economic implications. Global dealers may need to link up with multiple CCPs in order to meet the needs of their clients, increasing the amount spent on membership fees and infrastructure costs. They would also need to contribute to the default fund of each CCP they join – and hold capital against that, as required by Basel III. The issue attracting most attention, however, is the break-up in netting sets. Portfolios would end up being split across the various CCPs, increasing the likelihood of directional exposures and leading to higher initial and variation margin requirements, participants say.
Ultimately, the various clearing houses may not attract enough flow to make the economics stack up, dealers claim. “If a CCP doesn’t have critical mass, both in terms of members and in terms of flows, there is a liquidity risk premium. If you are a clearing member and you cannot balance any big flow with other members, that is going to cause you problems and an additional cost in terms of posting initial and variation margin, given the directional risk created,” says Guillaume Amblard, London-based global head of fixed-income trading at BNP Paribas, and an Isda board member.
Does this mean there is no room for domestic CCPs? No, argues Takeshi Hirano, director of strategic planning and OTC derivatives clearing services at the JSCC in Tokyo. He contends there is scope for several clearers, perhaps one in each region or time zone, and says a single, global CCP would pose a huge systemic threat to the financial system.
“I know about the issue of fragmentation, and people would be upset if there were hundreds of CCPs in the world. But what about three or five or seven? What is the appropriate number of CCPs? Certainly, a single global CCP is not a realistic solution,” he says.
It is not just a question of where the trades will clear, however – market participants say the various OTC regulations contain a number of inconsistencies and contradictions. The Hong Kong rules, for instance, will likely only apply to certain types of interest rate swaps and non-deliverable forwards in the first phase – a much narrower scope than Dodd-Frank and Emir.
There are other, more technical differences. The HKMA/SFC consultation paper proposes a clearing threshold: no entity needs to clear unless its average month-end positions for the preceding six months breach a certain notional value per product class. While both Dodd-Frank and Emir contain certain exemptions from the rules, and Emir outlines a similar threshold concept for corporate end-users, the language in each set of rules is different.
Inconsistencies like these are highlighted in a February 29 report published by a taskforce on OTC derivatives regulation, formed by the Madrid-based International Organization of Securities Commissions (Iosco). The key finding was that regulators need to work more closely to ensure global consistency. “It is vital that authorities communicate with one another to better identify areas where there may be gaps or inconsistencies between the two clearing obligations to which a counterparty finds itself subject,” it reads.
One suggested solution – at least to the issue of location requirements and multiple domestic CCPs – is interoperability. By creating a network of interlinking clearing houses, a counterparty could clear through a small domestic CCP, but still benefit from offsets it has elsewhere, reducing the margin burden. This concept is noted as an area for further study in a June 2011 consultation paper by the Australian Council of Financial Regulators, and the JFSA is also keen on the idea. In fact, the JSCC’s discussions with LCH.Clearnet had originally centred on developing interoperability between the two platforms.
This is by no means simple to implement in OTC markets, though. For one thing, the different margin methodologies and default fund requirements applied by individual CCPs would make it difficult to calculate exposures. Even if an exposure could be estimated, there is no framework in place for the exchange of collateral between clearing houses.
“Interoperability has had limited success in cash equities – and OTC derivatives clearing is much more complex than cash equity clearing,” says Kim Taylor, Chicago-based president of CME Group’s clearing division.
Nonetheless, the JSCC’s Hirano thinks interoperability is potentially viable but, with the November 2012 deadline for mandatory clearing in Japan fast approaching, the clearer had to take the decision to go it alone. “I do not think it is impossible if both parties spend time and resources to solve it. Unfortunately, mandatory clearing will start in Japan from November 2012, so we had to decide on a deadline in order to be ready for November,” he says.
Another approach might simply be for regulators to co-ordinate more closely on cross-border issues – a point made by the Iosco report. Market participants agree this may be the best solution. “Obviously, all of us would like to see a more harmonised approach across jurisdictions, because that would provide companies like us with a more consistent legal and regulatory environment in which to operate. From our perspective, we want regulations that are mutually compatible, because we have clients in the US and elsewhere around the globe,” says Supurna Vedbrat, co-head of the market structure and electronic trading team at BlackRock in New York.
This closer co-operation should include giving “due consideration to allowing the use of third-country CCPs to meet mandatory clearing obligations”, says the Iosco report. Supervisors should also strive for transparency in clearing requirements, keeping market participants and other stakeholders informed, it says. In fact, the report even suggests the idea of setting up an online portal for the purposes of keeping supervisors and stakeholders up to speed on clearing rules.
Market participants are optimistic that global supervisors will head towards a system of mutual recognition. Nakajima at Nomura Securities believes this is the simplest way to move forward. “Under the current law, if a Japanese player wants to use a CCP, this CCP has to get a licence in Japan. To get a licence, it has to apply and the JFSA has to check it. If each regulator can recognise other CCPs, that would be easier,” he says.