Monday, January 18, 2010

OTC clearers pose fresh dilemma

Posted in the Financial Times by Aline Vanduyn and Jeremy Grant:

In the months that followed the near-implosion of financial markets, regulators scrambled to figure out how to rein in the vast over-the-counter (OTC) derivatives markets that were seen as central to the crisis.

But, as numerous high-level meetings this week by central bankers and regulators show, the hunt for solutions has thrown up a fresh dilemma: new risks posed by clearing houses.

Clearing houses have been touted as the perfect shock absorbers for risks associated with the $600,000bn, privately-traded or OTC derivatives markets, since they guarantee that trades are completed even when a party to a trade – such as a derivatives dealer – defaults.

Clearing is widely used but mostly in markets where financial contracts are traded on exchanges.

The near-collapse of the financial system after the demise of Bear Stearns, the default of Lehman Brothers and the near-collapse of AIG – never regarded as a big derivatives dealer – has changed all that.

“  ‘Clear more, and faster’ is what we are being told to do,” says an executive at a derivatives dealer. Indeed, dealers who met regulators in New York on Thursday are expected to sign up to just that. However, it is rapidly dawning on regulators that, while forcing more OTC derivatives into clearing houses removes systemic risks from one area of the financial system, it may at the same time be concentrating new risks in clearing houses themselves.

Minds are being focused in recognition that many of the OTC products that look set to be cleared have never been handled by clearing houses before.


Regulators are realising that clearers also must be robust enough to withstand a default by any of their members in this new environment. A clearing house uses funds – or margin – posted by market participants to guarantee trades are completed.

In a policy paper on OTC derivatives out last week, the Federal Reserve Bank of New York said: “If a CCP [central clearing counterparty] is successful in clearing a large quantity of derivatives trades, the CCP is itself a systemically important financial institution. The failure of a CCP could suddenly expose many major market participants to losses.”

That concern is mirrored in Europe. Alexander Justham, director of markets at the UK’s Financial Service Authority, says: “We should be under no illusions that clearing houses are highly systemic, therefore what goes into them and the risk standards that apply must be extremely high.”

Work is therefore starting on creating new standards to cope with a greater collapse than has been commonly assumed in such risk reduction systems.

For many years, systems used to offset and manage risks in financial markets were run on the assumption that they would have to withstand the default of their biggest participant.

Now, after the demise of big derivatives dealers and the avoidance of the collapse of others only through huge interventions by governments, that is no longer seen as enough of a test.

In Europe, clearing concerns have been magnified by reforms pushed by the European Commission that were intended – before the crisis – to encourage competition between clearers and lower post-trade costs.

They call for clearers to forge links with each other to facilitate cross-border clearing and give traders a choice over where to send their deals for clearing, rather than being tied to one monopoly clearer.

Yet regulators are now concerned that the creation of these links – a process called “interoperability” – could be the source of another systemic crisis. The worry is that the weakest in the chain could bring others down if it were involved in a default and was insufficiently capitalised to meet margin calls.

This week EuroCCP, a small European clearer, suggested that instead of clearers requiring margin deposits from each other – creating a form of financial interdependency – each clearer would instead ask its members for more margin to be ring-fenced and used in a default.

Partly as a result of concerns over interoperability, Brussels now proposes sweeping new rules for clearing houses. They go beyond US plans, encompassing not only OTC derivatives clearing but other assets such as equities.

In a discussion paper sent to EU member states by Brussels this month, Commission staff recommend tough new legislation governing clearing, including “robust regulatory requirements for CCPs”.

Rory Cunningham, public affairs head at LCH.Clearnet, Europe’s largest independent clearer, says: “It’s the biggest thing that’s hit our industry for decades and implies significant changes to all CCPs and the markets they serve.”

Yet there are many other questions that need answering even before new rules are set. The complexities are so great that a new regulatory group has been created to tackle them.

The OTC Derivatives Regulators Forum, which has about 40 members, meets today in New York.

They will discuss how much of the information gathered by trade repositories – which increasingly track all private-traded derivatives deals – should be shared among different regulators. There are also questions about how much of the data regulators can legally be entitled to see, and how much of it should be shared.

Second, regulators want to map out ways to ensure “co-operative oversight” over the trade data repositories and the central counterparties to ensure traders cannot pick and choose between the ones with the loosest oversight.

Third, is the tricky question of who regulates clearing houses. In the US, this is split between the Federal Reserve and securities and futures regulators.

In Europe, clearing houses are regulated by the national securities regulators in each country. But some say that given the systemic importance of clearers, it should be central banks that oversee clearers.

Last month Xavier Rolet, chief executive of the London Stock Exchange, warned that it was “very dangerous” for clearing houses’ capital bases and risk models to differ from country to country and called for central bank oversight over clearers.

Damian Carolan, a partner at Allen & Overy, warns: “There is a real risk that the focus on ensuring that CCPs are sufficiently robust to withstand these historically unseen risks is lagging behind the work to push derivatives through those clearing houses. The two have got to go hand in hand.”

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