OTC derivatives clearing: no turning back

Global regulators have been cajoling banks to clear more derivatives for years, but the response has not always been the one they expected. The turmoil that swept the derivatives markets early last year showed it’s in lenders’ own interest to have an extra layer of protection.

While investors and companies got hit hard by bouts of Covid-driven volatility, one corner of the market remained unscathed in 2020: central counterparties (CCPs).

Despite a few mishaps here and there, no defaults were declared at any major CCPs, nor were their default funds tapped to cover losses from failed members.

By funnelling more trades through central clearing, lenders are able to remove an element of risk from the system. And while it’s hard to say to what extent Covid acted as a catalyst for a shift to CCPs, or whether it merely accelerated a secular trend, the latest publicly available figures are encouraging.

Data collated by the European Banking Authority shows cleared trades grew as a share of systemic eurozone banks’ over-the-counter derivatives portfolios throughout 2020.

The bloc’s eight top banks held €102.1 trillion ($120 trillion) of OTC derivatives notionals at the end of last year, 60.5% of which were cleared. This compares with €55.4 trillion, or 56.1%, a year prior.

It was the highest aggregate rate of cleared trades for the group since comparable disclosures began in 2013, and the largest absolute figure since 2014.

Post-financial crisis, clearing mandates forced banks to funnel trades linked to certain asset classes through central counterparties. In 2017, European dealers also had to comply with non-cleared margin rules, which made clearing more attractive from a cost and operational standpoint for many more trades.

This helps explain the rapid build-up of cleared portfolios across most of the eurozone’s top dealers over the past four years.

More recently, EU banks have started repositioning themselves ahead of the fifth and sixth implementation phases of non-cleared margin rules, originally scheduled for September 2020 but postponed in the wake of the Covid-19 outbreak. As the new deadline approaches, it makes sense for dealers to encourage counterparties where possible to shift to using cleared products and avoid the compliance headaches associated with the new rules.

Furthermore, some buy-side firms have jump-started the trend. In OTC markets most firms do not have to post initial margin in FX derivatives trades, and physically settled FX swaps are exempt from variation margin posting in most jurisdictions too.

Take Eaton Vance, for example. The Boston-based mutual fund manager made the conscious decision to voluntarily clear the lion’s share of its FX derivatives, arguing the pros of a wider circle of counterparties outweigh the cons of margining.

All in all, those advocating clearing is the way forward can rest easy, knowing the trend is set and is seemingly irreversible. For the rest, it’s time to catch up.