At the International Derivatives Expo in London earlier this summer, there was no small amount of focus on the fast-approaching mandate for clearing over-the-counter (OTC) derivatives in both the United States and Europe. I was part of a panel discussion there about how clearing houses are building the infrastructure for this change. To understand that, as well as other factors shaping the OTC clearing environment, I have identified five facts that will be important to keep in mind in the coming months:
Fact One : Regulation follows market developments. At least until now.
Clearing of exchange-traded derivatives (ETD) pre-dates anything resembling modern regulation, and the introduction of the clearing of OTC derivatives pre-dates the recent era of closer regulation of clearing. Until the recent legislation on OTC derivatives and clearing was written, regulation had followed to adjust to changes in derivatives markets. Now, markets have to adjust to sweeping changes in regulation.
Fact Two : Legislators, not clearing houses, have pushed mandated or obligatory central clearing.
Early central bank interest in over-the-counter derivatives clearing was followed a decade later by official support by the G-20 for the clearing of OTC derivatives as a pillar of financial stability.
Support for the measure was not driven by clearing houses. In fact, CME Group publicly opposed legislation to mandate clearing because of potential unintended consequences. Despite that, we’ve worked with market participants and regulators to help ensure that the new rules in the U.S. and elsewhere serve the public interest, and foster competition and innovation.
Fact Three : ‘Client clearing’ for OTC is not new for everyone.
Some end-client users of derivatives have been trading cleared OTC products for over a decade. The history is revealing :
– House and client account clearing has always been a structural feature of clearing exchange-traded derivatives. In 2002, NYMEX introduced that feature for OTC energy derivatives, adding other commodities later.
– But, until very recently, OTC financial derivatives clearing was confined, by design, to inter-bank or inter-dealer house account business only. Client-facing clearing of interest rate swaps and credit default swaps is now a principal element of OTC offerings and our OTC clearing has emphasised client clearing from the outset.
Fact Four : There are differences in bilateral and centrally cleared risk management.
OTC clearing, whatever the scope, has always used the four pillars of clearing house risk management developed for exchange-traded derivatives:
1. Initial margin (covering forward price risk)
2. Variation margin (preventing un-covered accumulation of losses)
3. Intra-day margin (covering large changes in portfolio composition, sudden large market moves)
4. Default/guarantee funds to cover un-margined risk.
Risk management of bilateral client-facing OTC derivatives has typically not been so comprehensive and has centred on variation margining.
The more comprehensive approach in central clearing reduces systemic risk and offers enhanced client protection.
Fact Five : Central Securities Depository (CSD) involvement in clearing of derivatives is limited and product-specific.
CSD involvement in derivatives clearing is essentially limited to custody in respect of margin collateral, a role that is likely to increase.
But CSDs play no role in the payment flows (money settlement) for cleared derivatives that do not involve final delivery of CSD-held securities. And the majority of OTC financial derivatives, which are cash or financially-settled, fall into that category.