The future of OTC trading/clearing and the impact of regulations. John Wilson

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John Wilson

The future of OTC trading/clearing and

the impact of regulations



Drivers for OTC market evolution

The Future of Trading and Clearing

Risk implications of the reforms


Drivers for OTC market evolution


Financial Crisis

• Financial Crisis in 2008/9 highlighted structural weaknesses including

– Absence of regulatory transparency on positions or activity in OTC markets

– Lack of collateralisation in some notable instances – Inter-connectedness of financial institutions

• Policy makers have also claimed

– Dealers were making unreasonable profits from opaque markets OTC – OTC derivative prices and capital charges did not fairly reflect their

social cost

– “Casino banking” is a material threat to retail banking arms

– Markets were distorted by the proprietary trading arms of banks – Actions of financial speculators caused harm to the real economy – Counterparty risks present systemic risks to the financial system


Regulatory landscape

• G20 Group Meeting in Pittsburgh in Sep 2009

“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. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements”

• Regulatory framework agenda to meet these objectives

– US Dodd–Frank Wall Street Reform and Consumer Protection Act [“DFA”]

– EU European Market Infrastructure Regulation [“EMIR”] & MIFID2 – Basel III [EU implementation - CRD IV]

– Japan has enacted legislation requiring clearing by end 2012 – Singapore to mandate clearing but not “Exchange” trading

– Other regions/countries developing their regulatory proposals including Hong Kong, Australia & Canada


Capital requirements

• Policy makers are determined to increase the cost of using OTC derivatives

• RWA levels incentivise cleared over bilateral exposures, notwithstanding some products cannot be cleared

• Capital costs for clearing members will increasingly prompt re-evaluation of business case and cause a polarisation of the clearing market

– Default fund

– Market risk charge on accounts failing to pay margin same day – Capital linked to initial margin

• New capital charges reduce bank capacity and widen spreads, but encourage new entrants unfettered by capital charges

• Banks will be motivated to unwind existing stocks as part of deleveraging efforts


Trading & Clearing obligations

• Mandatory clearing will apply to

– Trades between financial institutions,

• EU has granted exemption to Pension Funds trading with EU counterparties for up to 6 years and to intra-group trades within EU

– Corporate groups in EU which exceed usage thresholds – Third country sovereigns

• Key factors in an instrument being capable of being cleared

– Standardisation [product, legal, process]

– Liquidity

– Risk management/modelling

• A mandatory clearing obligation will normally create a mandatory trading obligation (with the exception of block trades in the US)


Instrument scope for clearing

• Regulations have yet to prescribe specific instruments

• Clearing exemption in the US for FX Swaps and FX Forward, EU position yet to be determined

• Expect the following instruments to be cleared

– Plain vanilla IRS, Inflation swaps, Cross Currency Swaps, Swaptions – Index CDS [index tranche less likely]

– Some single name CDS [high-grade, rather than high yield]

– FX Options* [CCP must guarantee settlement of gross amounts to all parties]

– Non-deliverable FX forwards – OTC Equity options

– Commodities


The Future of Trading and Clearing


Trade universe

Bilateral &

Not cleared SEF &

Not Cleared

Bilateral &

voluntarily cleared SEF &


Product can’t be cleared; or No

requirement to clear;

or Party exercises their exemption from

clearing and SEF Party exercises

exemption from clearing but chooses to use SEF

Product requirement to clear & use SEF; or Party disregards their exemption from clearing to both use SEF and clear

Product can be cleared but not mandatory to use clearing or a SEF; or Party voluntarily clears but trades bilaterally

The relative dimensions of the quadrants will vary by asset class and product, as well as by turnover v tickets

Bilateral &

mandatory cleared

Product obliged to clear but either no SEF or not mandatory to use a SEF e.g. block trade



• Few products will be suitable for clearing and hence for exchange-trading

• Clearing is a credit leveller – all counterparties face the CCP and not each other shortly after execution and enable pre & post trade anonymity

• Pre & post trade transparency like equity & futures markets, but expected to impact liquidity and discourage firms from making markets in size

• Growth in traded notional and transaction volumes, with electronic trading also widening market participation

• Fragmentation of liquidity across myriad of venues and across CCPs, with multiple market models operating in parallel including voice

• Regional trading & clearing arrangements due to regulatory barriers

• Capital costs of bilateral trades drives down volumes for non-cleared trades

• Significant change in the business model and organisation structure for Dealers, notably agency sales and smart aggregation/routing tools



• There will initially be many CCPs competing around the globe, but regulations will hamper global CCPs

• Few CCPs will achieve critical mass, prompting consolidation but progress will be slow and inter-operability will take many years to come to fruition

• CCPs will compete on

– Cost

– Lowest initial margins, offset by larger default funds – Widest range of eligible collateral and liquidity facilities – Segregation facilities

– Cross product offsets for margin purposes e.g. listed v otc

• Huge tension with members over default funds, due to likely capital costs

• Convergence of CCP risk models through regulation and member pressure

• Onboarding the industry represents a massive challenge, whilst capacity constraints may initially exist


Implications of the reforms

Risk implications


Funding Operational

The regulatory reforms will have risk

implications in

many respects. Three such areas are


Implications of the reforms

Risk implications


Funding Operational


Counterparty exposures

Category Default treatment Collateral treatment (A) -

Historic trades

Offset with (C) No initial margin regulatory requirement, only mark-to- market on the basis of existing Credit Support Annex terms. Netting of variation margin

requirement with (C)

(B) - Cleared trades

Remain as a separate netting set per CCP and per product. Credit exposure treatment between end user and clearer depends on agreements

Would attract initial margin requirement from the CCP and have a cash variation margin requirement, purely on cleared trades, with separate netting sets per CCP and product

(C) – New non- cleared trades

Offset with (A) Would attract initial margin requirement. Netting of variation margin

requirement with (A)

New rules on netting sets are likely to exacerbate

counterparty exposures and hamper exposure

management eg in/out swaps


CCPs – The Financial “Nuclear Power” Station



CCP Default - Too big to Fail?

Paul Tucker, deputy governor of the Bank of England and Head of FSB group on CCPs, said the issue needed

attention because clearing houses had become centres of systemic risk in their own right, with potentially huge

consequences in the event of failure.

Speaking at a European Commission conference in Belgium recently, he said:

"There is a big gap in the regimes for central counterparties (CCPs).”

"What happens if they go bust? I can tell you the simple answer:

mayhem. As bad as, conceivably worse than, the failure of large and complex banks."


Default of the CCP

• There have been examples of CCP failure - HK Futures Exchange 1987, Caisse de Liquidation 1974, the Kuala Lumpur Commodities CCP 1983

• Main causes of a CCP failure

– Default of members that exhausts its’ “capital”

– Lack of liquidity to settle VM following a default – Investment losses

• Ramifications

– Crystalisation of systemic risk and crash of market confidence – All members and clients affected, positions immobilised

– Collateral may be subject to loss depending upon segregation arrangements – Potential losses as unsecured creditors

– Inability to use cleared products if alternate CCPs unavailable – Potential liabilities to clients if offering clearing

• Mitigating measures?

– Reduce positions

– Segregation, but its’ effectiveness is questionable

– Careful selection of CCPs balanced against where liquidity resides


Implications of the reforms

Risk implications


Funding Operational


Collateral “wars”

• Clearing will absorb significant high grade collateral ≈ $2.5tn

• CCPs will compete on eligible collateral scope, but perversely the “loosest”

CCP will receive “rubbish” akin to ECB operation

• Higher collateral requirements on non-cleared trades than cleared trades

– US is seeking to impose initial margin for all firms within a US group – EU will similarly adopt initial margin requirements

– Could absorb a further $3tn of collateral

• Governments will seek to influence collateral policy

• More firms will be obliged to participate/borrow in repo and stock lending markets to meet their collateral needs

• Liquidity requirements will also mean banks have to hoard liquid assets

• Increased demands for collateral may create a squeeze on certain assets

• Firms will need to devote considerable effort to optimising their collateral use with recognition of collateral as a tradable “asset class”

• Custodians will benefit greatly from increased demand for collateral and new requirements to provide independent segregation


Implications of the reforms

Risk implications


Funding Operational


Operational risk

• Comprehending and complying with the magnitude of the regulatory reforms will challenge all organisations

• New requirements on trading, clearing, segregation and increased use of collateral will be onerous to manage/absorb

• System and process re-configuration, coupled with notable static data revision, will entail considerable regression and development testing

• Implementation lead-times once rules are finalised are relatively short i.e. few months in many cases

• Cross border barriers will require significant re-configuration of organisations and their activities e.g. booking models

• Extra-territorial reach of regulations will catch many 3rd country firms out who will be unaware of being ensnared





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