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.