The derivatives market was the venue in which the financial crisis played out. Regardless of whether this relationship was causal, world political leaders, notably in the context of the G20, decided early on to institute wide-reaching market reform to increase transparency, reduce risk and help improve financial stability. In particular, the over-the-counter (OTC) market was felt to be especially opaque. A clear policy was adopted of encouraging the migration of standardized OTC derivative contracts to regulated exchanges or central counterparties (CCPs):
All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the Financial Stability Board and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.1
Central clearing has a number of benefits:
- Since the clearer mediates between two principal parties and underwrites the deal in the event of a default, it contributes to security. In effect, counterparty risk is transferred to the clearing house which can manage risk through pooling, mutualization and margin.
- Since prices for listed derivatives are generally available to all market participants, it increases transparency and promotes the effectiveness of the price discovery mechanism.
- It introduces the market benefits of centralized and potentially enhanced liquidity, increased efficiency and market access to a larger base of participants.
- The clearing house can use margin to manage the risk of excessive leverage.
In the US, Title VII of the Dodd-Frank Act, also known as the Wall Street Reform and Consumer Protection Act of 2010 introduces new regulation of OTC derivatives and imposes the requirement that a range of swaps should be cleared through exchanges using CCPs. In Europe, the Commission is proposing to amend the European Market Infrastructure Regulation (EMIR) and introduce Markets in Financial Instruments Regulation (MiFIR) to regulate OTC derivatives, CCPs and trade repositories. This would also create a new framework for supervising clearing houses across the EU.
The derivatives sector itself sees the long-term benefits in moving to CCPs and is supporting the transition. In certain cases, parties to derivative trades will necessarily have specialized requirements which cannot be met by widely-traded products. Some bespoke products will continue to be traded OTC.
However, in many more cases, participants’ legitimate hedging requirements can be met by standardized products. Standardization and the move to CCPs are thus complementary. However, an efficient market cannot be created overnight. It takes time and investment in systems and processes to build the necessary network of connections between CCPs to enable them to communicate. One of the principles of the move to clearing is that counterparties can choose between competing CCPs, a principle known as interoperability.
CCPs create links to each other so that a user of a first CCP can execute and clear trades with a counterparty that has chosen a second CCP. But this complicates the systems challenges.
Despite these challenges, over the last 2 or 3 years, good progress has been made – in the credit-default swap (CDS) market in particular. The International Swaps and Derivatives Association (ISDA) notes:
The size of the CDS market has been reduced by more than 75 percent through a combination of clearing and compression; more than US$15 trillion has been centrally cleared while portfolio compression has eliminated more than US$70 trillion. Over 40 percent of the interest rate swaps market is now centrally cleared. Another US$106 trillion of interest rate swaps has been eliminated due to portfolio compression.2
Progress with commodity swaps, though, has been somewhat slower.
A key issue is that none of these changes comes without costs, both to dealers and to their clients. These fall into two broad areas: direct costs which feed through into individual prices (e.g. commissions, capital cost, technology cost) and indirect costs which may follow from a restructuring of the market (e.g. spreads and impact on liquidity). In many cases, dealers are still wrestling with the implications of both.
Given the nature of derivatives, margins for standardized products tend to be low. As a result, any deviation in the cost structure can have significant impacts on economic benefits. Not only will prices to clients rise. But volumes will fall and dealers may decide to withdraw from offering certain contracts, reducing choice, reducing liquidity and further increasing costs for clients. The wider economic impacts could be subtle but widespread. The derivatives market exists so that participants from multinational companies to public authorities to pension funds can manage and control their risks. To the extent that this market is disrupted, both costs and risks can increase as a result of measures originally designed to promote the opposite.
Risk and liability will be redistributed in complex ways. Large exposures will be transferred to CCPs. However, the capacity of a CCP to absorb risk is determined by the equity capital injected by its members, the margin it collects and the practice of marking positions to market. Existing derivatives CCPs generally collect an initial margin from their members to cover potential future exposure in the event that a clearing member defaults.
This initial margin, which is a form of collateral, is typically delivered either in cash or in the form of securities that have high credit quality and can easily be sold. CCPs will need the former OTC derivatives to be actively marked to market along with the collateral. Since OTC derivatives are currently mostly marked to model, the assumptions and the input market data will have to be very accurate and consistent as well as audited at regular intervals. In addition, credit and market risk will become merged at the CCP. This will be a new concept to most participants.
As always, change provides the chance to rationalize and to invest to increase efficiency. Faced with the need to build new communications systems, companies are exploiting the chance to create new technical infrastructures. Large multinational banks are positioning themselves to pick up derivatives business as other providers exit the market and/or seek to become CCPs themselves. Clients should see a more rational and orderly market in due course.
Central clearing is not a panacea. As we have seen it increase transparency and can reduce risk. But it will increase costs and may have unwelcome side effects at least in the foreseeable future. One major regulatory concern is that CCPs themselves could become systemically important institutions. In March 2012, Bill Dudley, President of the Federal Reserve Bank of New York, said, “Inessence, global CCPs will be systemically important. Thus for the system to be safer it is not sufficient to ensure that trades are standardized and that they are mandated to be cleared through CCPs, but also it is necessary that CCPs be bulletproof.”3
Dudley also highlighted the potential risks arising from the proliferation of national CCPs, reflecting concerns also expressed by the International Swaps and Derivatives Association (ISDA). While interoperability will reduce the dangers of fragmentation, the technical challenges of implementing new systems which were noted above mean that effective interoperability remains some way off. In addition, a number of national regulators are arguing for a structure of multiple locally-incorporated CCPs to serve local clients, which would further compromise the benefits of moving to central clearing.
Clearly, there are still major challenges to be overcome if the underlying objectives are to be met.
Director: Capital Markets and Alternative, Investments
KPMG in the US
Tel: ++1 212 954 1988
KPMG in the UK
Tel: ++44 20 7896 4293
Partner, Audit, New York Financial Services
KPMG in the US
Tel: ++1 212 872 3133
1. G20 statement, Pittsburgh, September 2009
3. Quoted Financial Times 22 March 2012