Among the many regulatory overhauls introduced to financial markets in recent years, those surrounding clearing have perhaps raised the most question marks for market participants – as well as regulators.
For market participants, those using over-the-counter (OTC) derivatives have seen great change: 23 of the Financial Stability Board (FSB)’s 24 member jurisdictions having hiked capital requirements for non-centrally cleared derivatives (NCCDs) since 2016. Similarly, the majority of markets are now subject to comprehensive margin requirements for NCCDs, and estimated collateralisation rates have risen significantly over the past two years.
Likewise, there’s been relative consensus across the G20 in terms of the need for mandatory requirements to clear certain OTC derivatives through central counterparties (CCPs) capable of taking on the credit risk between two parties in a transaction, absorbing the risk of insolvency and swiftly settling trades.
“CCPs introduced a new post-trade, pre-settlement infrastructure. The CCP performs a central role by becoming a seller to every buyer, and a buyer to every seller,” says Jason Pugh, managing director at D2 Legal Technology.
As a result of that third-party involvement, regulators believe transparency and risk mitigation are being drastically enhanced – thus strengthening markets and rationalising increasing requirements being applied to uncleared transactions.
The OTC derivatives clearing process varies between jurisdictions. Yet the steps involved in CCP clearing are relatively consistent across all G20 markets.
Before an OTC derivative can be cleared through a CCP, core documentation needs to be established between the client, executing broker, clearing member and the relevant CCP. When a transaction needs to be cleared centrally, corporate users are not able to access the CCP directly. Instead, only clearing members of a designated CCP are able to clear an OTC derivative directly with the CCP.
Because CCPs restrict those entities able to become clearing members in terms of financial standing and an initial contribution to its default fund, few corporate users can satisfy the criteria needed to become a clearing member. In turn, clearing membership is largely limited to banks and swap dealers in a position to offer competitive prices for an OTC derivative to be cleared.
Assuming this framework documentation is in place, the client and executing broker will start the clearing process by executing a transaction, and then submit a deal to the designated CCP. Following receipt, the CCP will subsequently submit a request to a clearing member and a notification to the executing broker before the broker is able to accept the trade. From there, the CCP is required to register two trades, creating a back-to-back transaction.
When an OTC derivative has been cleared, margin must also be posted to the CCP, and the clearing member is required to collect margin from its client.
Non-cleared transactions are agreed bilaterally between a buyer and seller. Contracts in non-cleared trades typically take the form of an Isda Master Agreement that places counterparty risk upon both the buyer and the seller. This lack of uniformity makes for a more complex trading environment with lower collateral requirements but higher counterparty risk. That risk and an inherent lack of transparency surrounding these negotiated transactions has led to the introduction of comprehensive margin requirements for NCCDs via high profile legislation such as Dodd Frank, as well as substantially higher capital requirements.
On the flip side, capital requirements in some G20 jurisdictions are actually decreasing for centrally cleared trades.
Beyond cost, there are a number of benefits to this mandated central approach, namely heightened transparency. Because centrally cleared trades are heavily monitored, regulated and facilitated by third parties, trading terms are very standardised. Not only does that standardisation create improved system integrity, but it also simplifies the process and minimises credit exposure between trade participants.
If a clearing member or dealer defaults, centrally cleared OTC derivative transactions can be ported or transferred to another dealer – and transactions can reach closeout promptly. Meanwhile, if the client defaults, a centrally cleared trade can be rapidly closed to better protect the client’s initial margin and any excess variation margin. As a result, taking part in an OTC derivatives swap that’s been handled through a CCP typically means less risk for all parties.
The structure of the global OTC derivatives market has evolved dramatically in recent years as various jurisdictions continue to further their web of central clearing requirements – and while the market is relatively healthy at present, the UK’s looming departure from the European Union could heavily disrupt trading in 2019.
There’s uncertainty surrounding CCPs in London and whether they’ll be forced to disassociate with EU clearing members, and also around the authorisation of UK financial institutions to service uncleared OTC derivatives contracts and insurance products. According to LSE researchers 75% of all euro-based interest-rate derivatives trades are based in the UK.
Fortunately, the European Securities and Market Authority (Esma) has tried to quell some of these fears by announcing plans at the end of 2018 to ensure EU market participants will still be able to clear through UK-based CCPs in the months after Brexit. Likewise, UK CCPs will be allowed to apply for “temporary and conditional” equivalence in the EU.
This year’s European Market’s Infrastructure Reform (Emir) Refit legislation - which seeks to expand the supervisory role of European financial market regulators and introduce a cumbersome new recognition procedure for third country CCPs wanting to do business in the EU – has sparked controversy, and has yet to be passed.
Although this multi-tiered recognition system was introduced as a precautionary measure in the event of a no-deal Brexit and in line with the G20’s reforms agenda, it’s worth bearing in mind the requirements will impact 28 third-country CCPs already recognised by Esma – and the US Commodity Futures Trading Commission (CFTC) has offered up considerable pushback against the process because it will effectively hand EU regulators oversight over third countries.
The outcome of this recognition and equivalence spat will undeniably have major implications for central clearing globally, but an agreement has yet to be struck.
Meanwhile, researchers at the Bank for International Settlements (BIS) indicate European reforms have led to inherent cost increases that have pushed dealer banks to review products and adjust asset classes on offer. Because non-cleared products are considered less transparent and riskier by nature, regulators have made them particularly more expensive and subsequently steered the product mix in a majority of jurisdictions towards centrally cleared OTC derivatives.
As such, 16 FSB jurisdictions had already implemented requirements to centrally clear specific OTC derivative product types by autumn last year, with further regulatory bodies expected to follow suit in the months to come.
For example, a new partnership between the Hong Kong Monetary Authority (HKMA) and the Securities and Futures Commission (SFC) is anticipated to drastically expand the OTC derivatives regulatory regime for Hong Kong by the end of this year – with proposed changes including a requirement to centralise and standardise certain AUD interest rate swaps. Indian regulators also recently approved the central clearing of rate swaps, and there has been a flurry of new CCP authorisations in Canada, Mexico and Switzerland – while jurisdictions like Indonesia, Saudi Arabia and Turkey are in the process of establishing local CCPs.
Bearing in mind the rapid regulatory restructuring taking place across the global OTC derivatives market, there’s been an extraordinary amount of activity in terms of trading.
The gross market value of outstanding derivatives contracts did decline slightly last year to $10trn, which signifies its lowest level since 2007. Stack that figure against a gross market value of $35trn pre-crisis, and it’s fair to say market values have declined just as dramatically as the ongoing structural changes that are being implemented to reshape the sector. An increasing international desire for additional trade compression to eliminate economically redundant positions has also heavily impacted trading. Likewise, a new trend among banks to record variation margin on OTC derivatives as settlement payments rather than transfers of collateral has altered overall market snapshots.
That being said, the gross credit expenditures responsible for adjusting gross market values for legally enforceable bilateral netting agreements have remained stable in recent years – while the notional amount of contracts increased to its highest level for more than three years in 2018, rising to $595trn.
“Of this notional value, the proportion of outstanding OTC derivatives that dealers cleared through CCPs held steady at around 76% for interest rates and 54% for credit default swaps,” says Pugh of D2 Legal Technology.
“We anticipate growth in FX and equity clearing, and also a lot of focus on margin reform for non-cleared derivatives.”
This optimism appears to be relatively widespread, and the OTC derivatives market is rapidly converging in favour of a standardised clearing process flow facilitated by CCPs. In most cases, central clearing is proving to be a safer and simpler way to process OTC derivatives transactions – creating better opportunities and more sustainable markets across the G20 and beyond.
Yet with continued regulatory divergence and the looming threat of political upheaval, the market will likely continue to face uncertainty and hurdles across 2019 and beyond.