Clearing at the Crossroads

Author Name: 
Matthew Harrison


Recent regulatory and market developments have thrust clearing houses into the limelight. In this brave new world, traditional clearing practice will need to change.

Within the exchange world, the clearing function has tended to be seen as unglamorously back office. However, that is changing. A welter of regulatory, business and market developments are pushing clearing to the fore. 

The Group of Twenty nations (G20)’s call after the 2008 financial crisis for all standardised OTC derivatives to be centrally cleared gave a boost to central counterparty (CCP) clearing. The crisis also threw up incidents which tested CCPs’ strength. Higher standards proposed by the Bank for International Settlements (BIS)’s Committee on Payment and Settlement Systems and the International Organisation of Securities Commissions (CPSS/IOSCO) will require CCPs to tighten their risk management. And among exchanges themselves there has been growing realisation of the business potential of clearing. 

This article discusses how these and other developments are impacting the CCP clearing function and how CCPs may need to adapt. 

Clearing OTC derivatives

Perhaps the biggest development is the G20 mandate for OTC derivatives to be centrally cleared. OTC derivatives are bilateral privately-negotiated contracts the value of which is based on an underlying asset such as a commodity, security, interest rate or index. Exchange-traded derivatives are standardised in terms of contract specifications, and are cleared in a CCP; OTC derivatives are customised to the needs of the counterparty and are mostly cleared bilaterally between the players concerned. 

The OTC and exchange-traded markets are interrelated. New products tend to develop first in the OTC market and move to the exchange market as they become more commoditised and liquid. OTC derivatives players often use exchange-traded derivatives to hedge their exposures. And OTC derivatives can also be centrally cleared via a CCP.

The G20 mandate

Concerned over the role of OTC derivatives in such incidents as the collapse of AIG, the G20 has called for OTC derivatives to be moved en bloc onto centralised platforms.

“All standardised 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… Non-centrally cleared contracts should be subject to higher capital requirements.”[1]

This is an ambitious goal. However, in fairness to the G20, a substantial proportion of the dealer-to-dealer OTC derivatives market was already being centrally cleared on a voluntary basis. By mid- 2010, 47% of interest rate swaps (IRS), 22% of multi-name credit default swaps (CDS), and over 20% of OTC commodity derivatives were being centrally cleared[2], principally through LCH.Clearnet Limited and ICE Clear. Since then, further progress has been made, particularly in respect of CDS. But moving the entire standardised market to CCP clearing remains challenging.

Legislative implementation

Policy-makers are moving to implement the G20 declaration in local legislation. The US Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) of July 2010, provides among other things for the registration and regulation of swap dealers and swap execution facilities (SEFs), and for central clearing of OTC derivatives. Many swaps have to be cleared and exchange-traded, although swaps with end-users are exempt.

In September 2010, the EU Commission published the proposed European Market Infrastructure Regulation (EMIR). All financial counterparties’ eligible OTC derivatives contracts with another financial counterparty are to be centrally cleared, and all (cleared and uncleared) transactions are to be reported to a trade repository or regulator. Non-financial counterparties must clear and report transactions only if a threshold is exceeded. CCPs must have open and transparent admission criteria, and accept eligible contracts regardless of execution venue; they are subject to governance and procedural requirements, eg CCPs must be able to port positions from one participant to another. National insolvency laws are to be disapplied.

Other jurisdictions such as Japan, Australia, Hong Kong, are consulting on potential regulation. However, global progress towards mandatory central clearing has been slower than hoped. As of October 2011, the Financial Stability Board (FSB) states that, “only the United States has enacted legislation and is actively working on the detail of the implementing regulations. While the European Union… has set out the direction of its regulatory framework, it does not anticipate having legislation in place before 2013. Most other jurisdictions have not yet made basic decisions about regulatory measures, including whether any regulatory action will be taken.” [3]

Operational challenges

The transition to central clearing is challenging not only for regulators but also for CCPs. Although the final objectives of exchange-traded and OTC clearing are the same, there are many differences of process and approach. OTC transactions are by their nature more customised to the user’s needs, albeit that the International Swaps and Derivatives Association (ISDA) has introduced a degree of standardisation in OTC documentation and procedures and market practice tends to converge around key tenors and transaction sizes. While the exchange-traded market tends to be a ‘captive’ market (although Europe is seeing increasing inter-clearer competition and/or interoperability requirements, particularly in the cash market), CCPs entering the OTC clearing market face more competition. And while the exchange-traded market is usually dispersed among many broker-dealers, certain OTC derivatives asset classes are highly concentrated among a few major banks, the so-called Group of Fourteen (G14)[4]. Accordingly the OTC clearing house faces a near-oligopoly, and must make proactive efforts to win over its client base and tailor its pricing and services, while likely having to accept lower returns. Given, in particular, the active participation expected of members in handling a default, the clearing house may need to admit members into its risk and default committees. Nonetheless, the introduction of CCP clearing may help broaden access to and perhaps ‘democratise’ the OTC derivatives market.

Geographical challenges

While the OTC derivatives market is global, clearing houses are local, grounded in local regulation and insolvency law. If regulators feel that IRS in their respective local currency[5], or CDS concerning their respective local institutions[6] are systemically important they may require such contracts to be cleared at home so that collateral and default fund contributions will be protected by local insolvency law and they as regulators can oversee the default process. While this improves default management, it also raises the prospect that the global OTC market may become localised. Localised markets may be less liquid and less able to serve end users such as large multinational corporations – albeit that the equity markets while localised do manage to serve large corporations. 

Interoperability among CCPs could be a way to overcome the disadvantages of mandatory local clearing. However, introducing an additional CCP into the transaction chain requires additional collateral to offset the bilateral risk between the CCPs. The CCPs may have different risk management standards and their respective jurisdictions different insolvency laws.  Too zealous a pursuit of interoperability might add to systemic risk.

[1]     Leaders’ Statement, G20, Pittsburgh Summit, section 13.

[2]     Implementing OTC Derivatives Market Reforms, Financial Stability Board (FSB), 25 October 2010.

[3]     OTC Derivatives Market Reforms – Progress report on Implementation, FSB, 11 October 2011, pages 1 to 2.

[4]    To be renamed ‘G16’ – G14 dealer group adds two members,, 1 December 2011.

[5]     Australian regulators are proposing that Australian dollar interest rate contracts are cleared in Australia (Central Clearing of OTC Derivatives in Australia, Council of Financial Regulators, June 2011).

[6]     Japanese regulators are imposing local clearing on credit default contracts, OTC Derivatives in Japan – Clearing and Related Developments, Clifford Chance Client Briefing, April 2011.

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About Matthew Harrison

A UK-trained accountant, now essentially a policy researcher and internal consultant. Has been with Hong Kong Exchanges and Clearing (and prior to that the Stock Exchange of Hong Kong) since 1993, mostly in research, planning and development roles. Conducts studies and surveys of Hong Kong, Mainland China and global exchange and regulatory development.