Central clearing a tricky fix for over-the-counter derivatives
Within the overall review of the causes of the global financial turmoil, the failures of AIG and Lehman Brothers cast over-the-counter (OTC) derivatives, incorrectly, as Public Enemy No. 2 (after securitised US subprime debt) for their perceived lack of transparency and lack of prudential regulation. As a result, the G-20 has stipulated that all standardised OTC derivatives should be cleared through central clearing counterparties (CCPs) by the end of 2012.
The US is in the final stages of passing legislation giving effect to this Group of 20 resolution and the European Commission has just ended a consultation on this topic, as a precursor to future European legislation.
CCPs are essentially intermediaries. They step into standard bilateral derivatives contracts and become the buyer to every seller, and vice versa, through back-to-back contracts that exactly offset each other. Therefore, the credit risk of the CCP is substituted for the credit risk of the buyer/seller.
CCPs rely on a panel of, usually, around eight or 10 clearing members to clear the contracts, consisting typically of the biggest dealers in these contracts. They require the clearing members to provide initial (fixed) margin and variation (top-up) margin for each contract they are clearing. In addition, the clearing members are required to contribute to a default fund. In the event of a failure of a clearing member, that member’s obligations would typically be covered firstly by the initial and variation margin posted by it, followed by that member’s contributions to the default fund, then any reserves set aside by the CCP to cover such defaults, and lastly the remainder of the default fund provided by other clearing members.
So, the question should be asked: If the clearing of OTC derivatives through CCPs is made mandatory for the majority of OTC derivatives traded globally, are we not thereby creating some of the largest too-big-to-fail institutions ever seen? The perceived rationale is that, by putting all the risk into a smaller number of clearing institutions, not allowing them to conduct any other business than clearing, subjecting them to prudential regulation and ensuring that details of the cleared trades are available to regulators, this makes the business of managing systemic risk much easier.
If the clearing of OTC derivatives through CCPs is made mandatory for the majority of OTC derivatives traded globally, are we not thereby creating some of the largest too-big-to-fail institutions ever seen?
However, pushing derivatives through central clearing carries with it a number of problems. Firstly, clearing will only be offered by the central clearing houses for contracts that are in a sufficiently standardised form, but the more standardised the form of contract, the less likely it is to act as a perfect hedge for the party using it as such.
Innovation in risk management techniques cannot continue without a certain level of bespoke derivatives being transacted, but in Europe the changes proposed to the Capital Requirements Directive (CRD4) would make non-standardised derivatives more expensive to transact, by virtue of a higher level of capital charges being applied to such instruments in the hands of credit institutions.
The second major problem with CCPs is margin (or collateral). Because CCPs really will be too big to fail, they will be required by regulators to be very conservative in the levels of initial and variation margin they require, as this is the first and most important line of defence in a clearing member failure situation. This, therefore, will involve the tying up of more capital from end-users and a consequent decrease of liquidity in the financial system.
In contrast to collateral arrangements typically agreed for OTC derivatives not cleared through a CCP, the margin requirements of CCPs will not differentiate between relative creditworthiness of end-users of the derivatives, and requirements will be set on the basis of the lowest-rated users, which will inevitably lead to higher-rated entities having to provide more collateral than previously.
In addition, as some OTC derivatives will remain outside the CCPs, the netting and set-off arrangements that can be achieved through master agreements covering the full range of OTC products will not apply to contracts cleared through the CCPs. This will lead to less effective risk management within institutions when viewed across the full range of OTC derivatives transacted by those institutions.
So, the most important questions are the extent to which OTC derivatives should be pushed through central clearing, and then what regulations CCPs should be subject to, to protect the financial system.
The European Commission recently published a consultation, which has just closed for comments, focussing on the reduction of counterparty risk relating to OTC derivatives and increasing transparency in such instruments. In particular, it aims to finalise its views in respect of four specific issues: (a) the clearing and risk mitigation of OTC derivatives; (b) the requirements for central clearing counterparties; (c) interoperability between CCPs; and (d) reporting obligations and requirements for trade repositories.
As to the question of which OTC derivatives will be required to be cleared, the Commission proposes both a bottom-up and a top-down approach to determining whether a clearing obligation applies to a contract.
The bottom-up approach consists of a CCP making a proposal to clear certain contracts and submitting an application for approval to the relevant competent authority, who in turn will inform the newly created European Securities and Markets Authority (Esma) if it proposes to accept the application. Esma will then decide whether a clearing obligation should apply to those contracts.
However, the Commission wants to make sure the clearing industry will not be able to determine, by its own selection or non-selection of certain contracts, what should or shouldn’t be subject to a clearing obligation.
Therefore, it also proposes using a top-down approach, whereby Esma, together with the European Systemic Risk Board (ESRB), determines which (currently uncleared) OTC derivatives contracts should be subject to the clearing obligation.
One of the most controversial issues of compulsory centralised clearing yet to be resolved is the extent to which non-financial institutions using OTC derivatives for their hedging or investment objectives will be affected by the proposed new regime.
The Commission has stated its belief that non-financial firms had become a part of the web of mutual dependence created by OTC derivatives contracts, and therefore such firms should also bear some of the cost of strengthening the market infrastructure for OTC derivatives.
The balance proposed for non-financial firms is that, once the positions taken by such a firm exceed an ‘information threshold’ (amount yet to be determined) the firm will be under an obligation to notify the relevant competent authority that its positions have exceeded that threshold. When the firm’s positions exceed a higher ‘clearing threshold’ (amount yet to be determined) the firm will become subject to the clearing obligation for all their relevant OTC derivatives.
Corporate treasurers have vociferously aired their concerns in relation to the proposed new requirements. Essentially, they are worried that these measures will increase their costs of hedging and therefore lead to more risks remaining unhedged (thereby exposing corporates to greater risks). So the levels at which the information threshold and clearing threshold will be set is of paramount importance to corporate end-users.
Next, the Commission has started to turn its focus to the safeguards needed to ensure CCPs do not fail, given their systemic importance. The following areas are under its consideration:
- The need for a clear organisational structure, including the need for a CCP to have an internal risk committee, independent of the CCP’s management, whose duties might include advising the CCP on risk management issues such as changes to its risk model, default procedures and the clearing of new types of derivatives;
- The need for a CCP to have adequate policies and procedures, including principles to govern conflicts of interest between it and its clearing members or their clients, and principles restricting or prohibiting outsourcing to third parties, and also including segregation (from itself and other clearing members) of the assets and positions of any clearing member; and
- Prudential requirements for CCPs, such as obligations: (a) to maintain a certain amount (as yet undetermined) of permanently available capital; (b) to assess exposures to clearing members and other CCPs; (c) to demand and collect margin to reduce credit exposure to clearing members; (d) to maintain a default fund to cover losses occasioned by the failure of a clearing member (such fund to be funded by all of its clearing members); (e) to maintain resources (such as other funds provided by clearing members, insurance, other loss-sharing arrangements, parental guarantees or a CCP’s own funds) sufficient to cover losses that exceed margin levels and the default fund; (f) to accept only highly liquid margin, and to invest its own funds only in highly liquid investments; and (g) to have procedures in place to contain losses arising from clearing member defaults.
In addition to central clearing requirements, the Commission acknowledges the importance of trade repositories in the monitoring of systemic risk in the financial system. Legislation will certainly ensure the relevant authorities in the EU, such as the ESRB, will have unfettered access to the information kept by such repositories, but it remains unclear as to what information will be required to be reported to them – particularly whether it should only be financial counterparties who are obliged to report information or trades, or non-financial firms as well.
Given the global nature of the derivatives market, the Commission acknowledges it would not be practicable to require EU counterparties to use only EU-based CCPs for clearing OTC contracts. However, non-EU CCPs would have to comply with certain conditions, including authorisation by competent authorities in their jurisdiction and being subject to comparable supervision and regulations in that jurisdiction. This would therefore mean the Commission would have to develop guidelines to establish the equivalence of such regulations to those in the EU.
Similarly, the Commission recognises that, if the reporting obligations of derivatives counterparties were allowed to be satisfied by reporting to non-EU repositories, there would need to be safeguards in place to ensure the continued access to information in those non-EU repositories for the competent EU authorities.
This could necessitate non-EU repositories either establishing EU subsidiaries to be approved for carrying out a repository role, or alternatively having to establish the equivalence of its supervisory and regulatory regime, as for CCPs.
In terms of equivalence of non-EU regimes, the passage in the US of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the DFA) is of great interest in the EU.
Similarly to the EU requirements for central clearing, the DFA requires that a derivative must be cleared if the applicable regulator determines it is required to be cleared and a clearing organisation accepts it for clearing. Such determination may be in respect of a single derivative or any group, category, type or class of derivatives.
If the clearing requirement applies to a derivative, the DFA provides an exception to that requirement if one of the parties to the derivative is a non-financial institution, is using derivatives to hedge or mitigate commercial risk, and notifies the applicable regulator as to how it generally meets its financial obligations under derivatives that are not centrally cleared. However, unlike the current proposals in the EU, the DFA requires the applicable regulators to impose initial and variation margin requirements on derivatives dealers and major participants in the derivatives markets for OTC derivatives that are not centrally cleared. Whether those margin requirements would also apply to non-financial end-users is unclear and has been the subject of much debate in the US.
Derivatives entered into prior to the application of the clearing requirement under the DFA will be exempt from the central clearing requirements if they are reported to a trade repository or the applicable regulator in a timely manner.
Unlike the proposals in the EU, the DFA also provides that a derivative that is subject to the clearing requirement must be executed on an exchange or a derivatives execution facility, if such an exchange or facility accepts such a derivative contract for trading.
The DFA also lays down rules as to the establishment and operation of CCPs that are broadly similar to the Commission’s proposals in Europe.
The European Commission plans to put forward its legislative proposals in September, and swap dealers and end-users alike will no doubt be looking at these closely to see if there are any potential regulatory arbitrage opportunities, based on these proposals, and the determinations on both sides of the Atlantic as to which derivatives are subject to a clearing obligation. However, central clearing, and the cost of it, is certainly set to become a consideration for the vast majority of global derivatives users.
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