Untangling the Mess
Written by Duncan Jefferies
How best to clean up the mess left by the financial crisis and ensure it cannot happen again is a source of ongoing debate. But one thing everyone seems agreed on is the need for central counterparty (CCP) clearing for over-the-counter (OTC) derivatives and credit default swaps (CDS).
Unwinding Lehman Brothers’ OTC trades and AIG's CDS deals post-crash proved to be incredibly difficult. It was almost impossible to determine how interconnected the banks were through their various contracts, which contributed to the panic in the markets. Financial institutions ultimately became unwilling to lend to one another.
In response, the G20 leaders agreed that standardised OTC derivatives contracts should be traded on formal exchanges, and processed through CCP clearing by the end of 2012. A clearing house acts as a buffer between the trading parties, ensuring that a transaction is completed in the case of a default. With a central counterparty clearing house, most of the capital comes from the financial institutions that are the main members, thereby spreading and reducing the risk associated with an unsettled trade.
“The financial crisis has put some impetus behind bringing more stability and structure to clearing than would otherwise have been the case,” says Bob McDowall, senior analyst at Towergroup. However, he feels that there is “an element of bolting the stable door after the horse has gone” to current moves to establish centralised clearing mechanisms. “Clearly with the liquidity constraints that institutions are suffering, and are likely to continue to suffer unless the central banks continue printing money through quantitative easing, I foresee the volume of OTC derivatives reducing anyway.”
The sheer size of the OTC derivatives market, as well as its lack of transparency, has undoubtedly contributed to the focus on it in the wake of recent events. But Alberto Pravettoni, managing director, corporate strategy, LCH.Clearnet, warns against overplaying its role in the crunch. “There is certainly a belief that because of OTC products the financial world nearly came to a grinding halt. But during the crisis those instruments that were already centrally cleared in the OTC market actually behaved really well, with few problems,” he explains.
Gert Raeves, SVP of business strategic development at GoldenSource, believes the industry is at a crossroads. “How can we reduce systemic risk? Well, first we all need to agree on a new academic consensus for valuing OTC derivatives, what are the models that we’ll all collectively adopt, and then if we’re wrong at least we’re all wrong in the same way. But trust in the industry has broken down way beyond that point.”
The European Commission has announced its new proposals to regulate OTC markets, putting it in line with the incoming US regulatory regime, the so-called Dodd-Frank Act, signed into law in July. This sweeping piece of regulation is designed to bring more transparency to the market, reducing systemic risk and preventing another Lehman Brothers type collapse. The EC’s draft regulation, meanwhile, has now been passed onto the European Parliament and the EU Member States for consideration.
The proposals, should they come to fruition, would see information on OTC derivative contracts reported to trade repositories and accessible to supervisory authorities, and also suggest that market participants have more information made available to them. Standard OTC derivative contracts will be cleared through central counterparties (CCPs), which the EC said will reduce counterparty credit risk.
In the Asia-Pacific market, Japan Securities Clearing Corporation and Tokyo Stock Exchange have formed a working group to design processes for OTC derivatives clearing. But market fragmentation may make it difficult for a continent-wide plan to succeed. Closer to home, the European Commission (EC) and European Central Bank are the driving forces behind the move to establish centralised European clearing for OTC derivatives.
With plans advancing, exchanges and clearing houses such as Eurex and LCH.Clearnet are looking to expand their centralised clearing services, with a focus on including buy-side investors. “As we have been offering a [clearing] service for OTC derivatives for so many years, we have a good understanding of the dynamics of such markets,” says Pravettoni. “That’s why we have been focusing on such things such as expanding the rates service and moving into new products, a new technology platform and most importantly extending access to the buy-side. We’re now seeing the first clients come along and back load a significant number of their positions.”
The Parliament will eventually pass regulations on which contracts need to be dealt with by clearing houses. It will also outline tougher governing standards for CCPs, and the reporting of deals to trade repositories. Cassandra Kenny, director of the British Bankers’ Association, says most of their members “are quite concerned that CCPs should have what they call ‘skin in the game’ – their own money at stake, not just their users, when making decisions about their risk profile, etc”.
In 2009, several major banks made a commitment to put more CDS through clearing, and have so far met the targets that were set. Since then, the focus has shifted to the kind of policy initiatives the EC is likely to announce. Last year’s consultation document showed that they are concentrating on three main areas within the European market infrastructure legislation. Firstly, the clearing obligation - how that comes to be and how that will be implemented; secondly, the prudential and organisational requirements for CCPs; and thirdly, how contract details will be reported to a trade repository.
What forms the obligation to report derivatives to clearing houses will take is a primary concern for many banks. The bottom-up approach will mean a CCP will decide to clear certain contracts and then be authorised to do so by the local regulator, which would then inform the European Securities and Markets Authority (ESMA) – the pan-European group of national market regulators which forms part of the European System of Financial Supervisors (ESFS) – once the CCP’s request has been approved. ESMA will decide whether to apply that ruling to all EU contracts of a similar type. A top-down approach will be implemented alongside this, with ESMA deciding which contracts should be cleared.
“We’re quite comfortable with [the bottom-up approach to reporting derivatives] as it leaves it to the local regulators to make those prudential assessments of the clearing obligation,” says Kenny. “We’re a bit more worried about the top-down approach, whereby ESMA could just decide that a mandatory clearing obligation should exist for a certain type of derivative product, but no CCP actually yet clears that product. The real reason for our concern is that we’re worried about the race to the bottom in terms of standards. Also, any of the national regulatory authorities who normally approve products will be under a lot of pressure to approve CCPs to clear that product. Risk considerations could possibly come second.”
She does not believe the banks are overly concerned about having to report contract details to a trade repository. “Ultimately the real concern is whether the European Commission will recognise trade repositories that are located outside of the euro zone, and also outside the European Union. And I think that’s because people don’t want multiple trade repositories for certain asset classes popping up. We can’t see how it would be useful to have a trade repository in the US, one here in Europe, and then one also in Asia for the same type of asset classes. That’s not going to provide the overview that regulators say that they’re looking for in terms of being able to go into that trade repository and look for systemic risk building up in an asset class. If it is fragmented across the globe they won’t be able to do that without putting together different pieces of data.”
Although CCPs should increase the transparency of OTC derivatives contracts, they are by no means an infallible solution to market woes. As they become the buyer to every seller, and the seller to every buyer, another pinch point in the financial system occurs. “There comes a point – I don’t think we’re going to reach it in the current trading environment – but clearing houses only have a finite capacity,” says McDowall. “They can only take on so business relative to the security, the collateral, the margin which the members put up. So there is a finite limit there. The regulator wouldn’t want them to be too big to fail.”
Pravettoni says the success of any new model will come down to the capability of clearing organisations to withstand defaults and plan for a worst-case scenario. “You have clearing houses that have a capital of tens of thousands of Euros, and others that have a few hundred million, so there’s clearly some focus on making sure you have organisations that are set up to withstand some shocks. But ultimately it comes down to proper and robust risk management. That’s why it’s important that there are minimum thresholds agreed across Europe as a region.”
It’s also important to remember that not all products are eligible, or can be eligible, for clearing. “There has to be a great deal of liquidity in the product, and there also has to be easily available pricing,” says Kenny. “So there will still be a market for bespoke products, and that shouldn’t be driven out. If you were to force CCPs to clear every single derivative that was ever invented you would be adding risk to the system again.”
As we have seen, in times of crisis central bank funds need to support failing institutions. It’s a scenario that may well happen again despite the prevention measures currently being put in place - no system is perfect after all. However, Raeves feels that offering in advance to back clearing houses with unlimited government funding in the event of a crash is risky strategy. “That seems almost a recipe to repeat some of the excess of the past, where you’re creating a safe play area for market participants. If one of them goes off on a rogue path we end up with another Lehman Brothers type situation.”
Despite the ongoing political and commercial arguments about what form the new centralised clearing infrastructure will take, that’s a future everyone will be hoping to avoid.
The European Commission has recently announced moves to increase the regulation of “over-the-counter” (OTC) derivatives. The banking sector is subject to regulation and compliance regimes that change regularly and need to be adhered to, whilst maintaining the management of a firm’s own technical risk. It’s an increasingly difficult task, especially with new regulations being introduced and older ones continually being updated, and makes for a fluid and fast-paced environment that is progressively problematic and complex for financial institutions to navigate.
OTC trades are a good example of the problems managing complexity, technical risk and compliance can cause. Unlike transactions done through an exchange, each OTC trade is a one-off deal made directly between the parties concerned. Each of these deals requires a unique contract that confirms the exact terms and conditions of the trade. The contract must comply with the relevant regulatory and compliance frameworks, as well as the specifics of that deal. Failure to confirm an OTC trade in an accurate and timely manner can lead to considerable risk exposure, and can jeopardise its enforceability or the ability to net it against other transactions.
The intention of the new regulations announced by the EU is to increase transparency through standardisation, and is also a move towards exchange-based trading. However, there will always be a percentage of products that cannot be standardised, as the new rules acknowledge. In addition, it is likely that the regulations will take some years to come into force, and so there will be an extended transition period.
The clear takeaway is that there is a strategic advantage in being more agile and being able to adapt quickly to changes within a tightly regulated environment, across all asset classes. Clearly it’s a challenging situation for financial institutions that have a lot to lose if they do not manage this complexity correctly. But technology solutions exist that help manage the confirmation process, ensuring that trade contracts are custom-developed in real-time, reviewed and electronically forwarded to interested parties.