Complexity and lack of visibility in the over-the-counter (OTC) derivatives market was a major contributor to the financial crisis. Institutions struggled to understand their exposure to trading counterparties, while regulators failed to identify the systemic risks inherent in OTC trading. The aftermath has been a wave of regulation in the financial markets aimed at better managing risk and increasing transparency.
Despite uncertainty over the final form and timing of legislation across the globe, it is clear that substantial change is afoot in the clearing market. With regulators looking to mandate central clearing for many standardised derivative products, and open up competition in the clearing market with interoperability standards, some of Europe’s largest clearing houses are taking the lead, having recently announced plans to offer co-ordinated four-way clearing to their members by 1 January 2012.
Of all the regulatory changes, the European Market Infrastructure Regulation (EMIR) will have the most significant impact on Europe’s clearing market. Designed to regulate post-trade processing of derivatives by enforcing the use of central counterparties (CCPs), EMIR applies across a wide range of asset classes. It also regulates the operation and governance of CCPs, introduces mandatory reporting requirements and presents significant operational challenges for financial institutions in terms of implementation within the required timescales (currently February 2012). At the same time, the introduction of Basel III and CRD IV in Europe substantially increases capital requirements for OTC derivatives in a bid to move trading to exchanges and CCPs. The increased capital and collateral requirements introduced by this legislation aim to reduce the systemic likelihood and impact of default for those trades that remain bilateral.
In the US, the Dodd-Frank Act will enforce similar reporting and capital requirements to Basel III/CRD IV that accelerate the pace of regulatory change. The introduction of Dodd-Frank means central clearing for standardised derivative trades will be mandatory by the end of 2012. There will be increased regulatory oversight alongside higher capital and collateral charges for OTC trades, albeit with charge exemptions for commercial, non-speculative hedging trades.
Several other jurisdictions are following a similar path. Although emerging markets remain highly fragmented with little cross-border collaboration or competition, it seems likely the situation will change as regulation in the US and Europe takes hold.
The Emerging Clearing Landscape
In the current landscape of decentralised clearing, market participants can trade via CCPs or directly with each other (bilateral clearing), resulting in complex links between institutions and an opaque market. By contrast, in a centralised clearing environment, participants are compelled to trade via CCPs for all standardised derivative contracts.
With central clearing, institutions only have to manage relationships with one or a handful of CCPs (dependent on the breadth of product coverage offered) rather than trading directly with potentially hundreds of counterparties. This could result in considerable consolidation of the functions and the complexities involved.
More important for many institutions is the fact that central clearing provides a better understanding of the total capital position and – because of the netting arrangements available – has the potential to lower capital requirements. Furthermore, regulatory assessments of the reduced risk weighting of assets for trades via CCP when compared with bilateral trading mean that the capital requirements for centralised trading are considerably more attractive.
Institutions vying to offer their clients the best prices and liquidity across execution facilities will need to determine the appropriate level of integration with a host of competing venues. Which model will offer the best solution is not yet known. It is also difficult to identify exactly where liquidity will be concentrated for given products across the respective regions. The advantages of central clearing and netting across an entire trading portfolio will be counterbalanced by the lower liquidity and operational difficulties of providing this for the most complex trades. The result could well be a volume increase in exchange traded and standardised derivatives, with a still substantial – but more expensive – OTC market catering to more bespoke trades.
Strategic Considerations for Financial Institutions
Although regulation will introduce more choice for financial institutions, it presents several strategic challenges. Despite the uncertainty over the final form of the regulation, banks must begin to consider these challenges now.
Clearing house relationship strategy
Financial institutions will have to identify whether existing arrangements with clearing houses and trading venues are offering the most effective approach. Banks will either need to set up or step up their relationships with clearing houses to assess the impact of interoperability agreements on their cost of trading across different asset classes, collateral agreements and the margins applied – particularly when trading with a counterparty that clears via a different CCP.
There could be an opportunity for global banks to move to a ‘Prime CCP’ model by partnering with a large clearing house. This could allow them to benefit from cost-effective clearing terms due to increased trading volumes, reduced collateral requirements and enhanced counterparty risk management due to more efficient netting, as well as easier relationship management. It would also mean that global banks are able to deliver an integrated service offering to non-financial institutions at a more competitive price. Nevertheless, this is dependent on CCP/exchange interoperability allowing one CCP to offer services across a meaningful range of geographies and product classes.
Client trading strategies and product sales
Financial institutions must also consider how they approach the increased cost of bespoke OTC trading in the post-CCP environment. They will need to either persuade key clients to change their OTC trading strategy to more standardised contracts with lower capital requirements, or pass on the increased cost by raising prices. For clients wishing to remain on bespoke trading, there will likely have to be some effort to market this as a ‘premium’ service. There is also the question of how prices will be affected on existing, long-term trades after the CCP becomes mandatory, as clients are forced to sell OTC contracts in a more transparent way.
The level of investment required to migrate non-core business to a CCP solution may be disproportionately higher than with core, large-volume business. This is likely to result in firms concentrating on core trading strategies and will require many to perform cost benefit analysis on their peripheral businesses to analyse the impact of increased clearing costs and potentially higher capital requirements in this area.
Operationalising clearing strategy
Having determined a strategic approach to centralised clearing across their derivatives book, financial institutions should also prepare for the operational challenges adapting to the new landscape will present.
Risk and price modelling
Central to understanding the effect of moving to centralised clearing will be the models used to determine price, market and credit risk. For example, how will the price and liquidity of existing, long-dated OTC contracts be affected by the new CCP-dominated environment? Quant teams will need to prepare models to answer this and a host of similar questions raised by the likely shift in trading strategies.
High quality collateral is likely to be required for a much greater proportion of derivatives trading – institutions need the systems and controls in place to ensure collateral is being netted and used optimally across the trading book, and to be able to provide a full understanding of the collateral position for themselves and their clients.
Management and regulatory Information
Alongside the move to CCP clearing, regulators are also stepping up their demands for data and reporting on firms’ derivatives exposures. Institutions need to ensure they have the IT infrastructure, data architecture and robust trade capture processes capable of supporting both regulatory and management information requests.
Moving from bilaterally cleared trades to CCP clearing will present system integration, trade automation and scalability challenges for institutions of all sizes. Effective planning now will avoid costly workarounds and potential regulatory scrutiny later. Navigating the post-CCP environment. Uncertainty is no excuse for inaction – despite the lack of clarity in the final form of the regulations, financial institutions must act now to define how their clearing strategy will support their business goals in a radically different marketplace.
Financial institutions should be focusing on defining their clearing strategy and identifying the operational challenges they need to address.
- Trading strategy: understanding current and future exposure to OTC derivatives, across clients, asset classes and jurisdictions, will be essential to planning an effective clearing strategy with the appropriate level of investment.
- CCP relationship strategy: Early engagement with CCPs will help institutions understand the most cost effective model for derivatives trading – whether via a ‘prime’ CCP, multilateral CCP relationships or remaining with bilateral trading for bespoke OTC trades. It will also identify areas where technology investment may be required.
- Operational readiness: identifying and rectifying improvement areas in modelling, controls, processes, data quality and infrastructure will give institutions a head-start while the final details of legislation are confirmed.
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