Friday, October 9, 2009

CESR: OTC Derivative Trade Compression as a CCP Alternative

Posted on Reuters by Huw Jones:

Policymakers should explore alternatives to central clearing for cutting risk in derivatives markets as mandating standardised contracts would be a step too far, a top European Union market regulator said on Thursday.

European Union and U.S. authorities are debating measures to make the privately negotiated $450 trillion over-the-counter derivatives market safer. [ID:nNO7486067]

The G20 group of countries agreed in September that trades should be cleared on a central counterparty (CCP) where possible and exchange trading on contracts should also be encouraged.

Central clearing of credit default swaps (CDS) has already begun on both sides of the Atlantic, with ICE (ICE.N) clearing contracts with a notional value of $3 trillion since March.

"Up to now we have only been dealing with CCPs. We have not been paying sufficient attention to what's called bilateral compression of positions. That is an alternative to CCPs," Eddy Wymeersch, chairman of the Committee of European Securities Regulators (CESR), told Reuters.

Bilateral compression involves all parties to trades whittling them down to a smaller, less risky net position.

"It certainly would not result in a concentration of risk. One of the issue with CCPs is they lead to quite heavy risk concentration," Wymeersch said.

"You can only put through CCP derivatives that have a sufficient volume, but in bilateral compression you can compress when the volumes are much lower and that is a serious advantage," Wymeersch said.

"If you don't have sufficient standardisation you won't have sufficient volume, therefore you could not have the CCP leading to a real reduction in positions."

Hans Hoogervorst, chairman of Dutch markets authority AFM, said banks will fight hard to keep their "high margins" on OTC derivatives. "Contracts have been too cheap due to lack of regulation," Hoogervorst said.

Jochen Sanio, president of German regulator BaFin, said the CDS market remained the "great unknown" of the financial system.

"If we don't get this corner under control then I would be very pessimistic about how soon we might get the next accident," Sanio told a meeting of the International Organisation of Securities Commissions (IOSCO) here

Wymeersch said that standardisation of contracts -- which the industry and users fear will kill the bespoke nature of many contracts used to hedge risks -- will largely depend on encouraging the trade body International Swaps and Derivatives Association to make further progress. regulation is a little bit over the top. What we could do is probably have a capital charge which is a little bit higher for the non-standardised contract, build in incentives to make it more efficient," Wymeersch said.

The EU's executive European Commission, which has powers to propose EU financial regulation, is due to issue a policy paper on OTC derivatives later this month.

"I would expect they will go for putting more derivatives through CCPs or perhaps equivalent mechanisms. More post-trade transparency," Wymeersch.

Unlike the United States Treasury, the Commission is expected to stop short of an outright call for mandatory exchange trading of derivatives.

"Up to now we have never done that. I would be very doubtful if the members would be willing to impose exchange trading, it's a bridge too far," Wymeersch said.

"But things evolve over time and if the system of CCPs, repositories and extensive transparency is not satisfactory then that may be the next step," he added.

Hoogervorst, however, said as much trading as possible should be pushed onto exchanges.

The bulk of OTC derivatives are traded in London and New York, even when one side of a trade is elsewhere.

Martin Wheatley, CEO of Hong Kong's Securities and Futures Commission, said OTC derivatives don't feature "high on the Asia radar screen" at the moment as clearing and capital charges are handled in the trading centres.

"My expectation is the business will be done in a slightly different way in future, with trades booked in Hong Kong."

Such a shift will oblige regulators in Asia to look at whether an Asia-based CCP is required, Wheatley added.

In Japan, many of the OTC contracts are booked in London or New York and there may not be enough volumes locally traded to make a CCP viable, a source familiar with the Japanese market said.

He expressed concern that too much focus on a small number of CCPs or exchanges in the west "will create an oligopoly".

"We would like to see more competition there so countries that don't have CCPs are not disadvantaged," the source said.

BaFin's Sanio said: "If you have too many CCPs, they will start a race to the bottom."

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