Tuesday, February 9, 2010

More clarity sought on central clearing plans

Original posted on Asian Investor by Joseph Marsh:

There seems to be a broad consensus that moving over-the-counter (OTC) derivatives to a system of centralised clearing would help manage both individual counterparty risk and market-wide systemic risk. Less widely agreed upon, however, is the effect such a system would have on trading liquidity, costs, spreads and volume.

Global survey findings published last week by Greenwich Associates showed that market participants require more information from regulators about the timing, scope and specific provisions of centralised clearing initiatives. They also indicated that there are serious concerns about the impact of reforms on the functioning and liquidity of markets.

Of the 330 financial firms and corporates surveyed*, almost half (47%) say they are not familiar at all with current OTC clearing proposals or less familiar than they would wish. That is a "surprisingly high" proportion, says US-based consultancy Greenwich. (Respondents included 61 asset managers, 45 banks, 25 hedge funds and 13 insurance companies.)

While only four of the surveyed firms are based in Asia, it is clear that companies in the region are less well informed on clearing proposals than their counterparts in Europe or the US, says Abhi Shroff, a vice president at Greenwich Associates in Singapore. This is despite initiatives by entities such European securities depositaries Clearstream and Euroclear in Shanghai and elsewhere in the region.

A major issue in Asia concerns interest rate derivatives, one of the two most important asset classes marked out for centralised clearing, he tells AsianInvestor. "In the fixed-income space, around 75% of derivatives contracts are done in local currencies," says Shroff, "so it will be interesting to see how it is impacted, if at all. Local-currency contracts may even be exempted [from clearing legislation]."

Other findings in the global survey included that participants wanted clarification on basic issues, such as which asset classes would be affected and whether centralised clearing would apply to customer trades or only inter-dealer trades.

Not surprisingly, preference as to which organisations should run central clearing houses for OTC derivatives varies by region. Europeans favour Eurex, North Americans CME Group and UK firms LCH Clearnet. Globally, Eurex was the most popular choice, selected by 49% of total respondents, while CME was next with 43%.

Mitigation of counterparty credit risk was the clear choice as the most important benefit of centralised clearing, with 89% of financial firms citing it. Netting of positions and mitigating systemic risk were next, both of which were cited by 57% of financials.

Yet some remain skeptical about risk mitigation, with one respondent from a European energy company suggesting that any change would not reduce risk at a global level, as it would merely "shift risk from counterparty to liquidity".

Interestingly, the least cited benefit of central clearing was 'lower transaction costs', with a quarter of those surveyed citing it.

When asked about the likely effect of central clearing on derivatives volumes, the largest portion of respondents (42%) say there will be no change in activity. Financial institutions, however, were more optimistic, with 44% saying that trading volumes would increase, as against 28% of corporates. Nearly half of corporates (47%) say they would expect volumes to fall as a result of central clearing, for two main reasons: potential increases in costs and possible drops in the ability to customise contracts.

As for the impact on trading costs, 42% of corporates (and 11% of financial firms) say bid/ask spreads will widen, while 61% of financials believe they will tighten (as against 38% of corporates). Many corporate express what seems to be a logical point of concern, says the report: there will be costs associated with creating and maintaining the clearing system that will ultimately passed onto customers.

Among the points made by individual corporate executives include that likely reduced volumes that would result from clearing would make products less liquid and thus more expensive. Another suggested that "dealers will price to the lowest common denominator, instead of giving good credit the benefit of good pricing".

* Greenwich Associates conducted the survey from 11 to 15 January; 155 respondents were corporates and 155 were financial firms.

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