Saturday, February 6, 2010

SIFMA SmartBrief Special Report: Derivatives Clearing and Settlement

As the global financial system continues its recovery, credit default swaps and other over-the-counter derivatives have become an area of particular focus for policymakers. At the center of this debate is determining the most efficient way to improve the trading and clearing of these instruments. What role should regulators play in the process? And how can market participants work constructively with them to achieve shared goals?

SIFMA and its members believe that a critical component of reforming our financial system is to bring greater regulatory transparency and oversight to derivatives markets and products. This Special Report looks at the most recent efforts that are under way to address important questions regarding these products and what the future might hold for this corner of the financial services industry.

New rules for OTC derivatives are expected this year
Regulators and market participants agree that steps should be taken to reduce risks associated with over-the-counter derivatives. For example, reform proposals include requiring standardized OTC derivatives contracts to trade on exchanges or other established platforms and be cleared through centralized counterparties.

Regulators want more OTC derivatives clearing, sources say
Dealer-bank executives were asked at a recent meeting at the Federal Reserve Bank of New York to ramp up efforts to send swap transactions through clearinghouses. Regulators may encounter some resistance from hedge funds and other buy-side participants, however, as they have little supervisory authority over that area of the industry.

Regulators realize clearinghouses also pose risks
Regulators and central bankers have been encouraging over-the-counter derivatives dealers to route trades through central clearinghouses as a way to reduce risks. However, clearinghouses also pose risks because they must be strong enough to survive defaults by any of their members. "If a CCP [central 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," the Federal Reserve Bank of New York wrote in a policy paper.

Officials review standards for post-trade systems
The International Organization of Securities Commissions and the Committee on Payment and Settlement Systems started a "comprehensive review" of post-trade risk, including standards for central counterparties, securities-settlement systems and payment systems. The review, with participation from the World Bank and the International Monetary Fund, is part of an effort by the Financial Stability Board to limit risk from the interconnectedness of the broader financial system. Read the IOSCO news release.

Sen. Kaufman discusses overhaul of financial regulation
Sen. Ted Kaufman, D-Del., discussed the financial market and areas in which he said changes need to be made. He said that in terms of credit default swaps, regulatory agencies, particularly the Securities and Exchange Commission and the Commodity Futures Trading Commission, should be handling issues that have emerged. Kaufman also discussed clearing, short selling and other aspects of the market in which regulatory changes are expected.

CFTC oversight of derivatives is not top priority, Sen. Dodd says
Christopher Dodd, chairman of the Senate banking committee, said there are many questions to be answered before considering putting over-the-counter derivatives under the oversight of the Commodity Futures Trading Commission. Dodd said the Senate has other issues to consider before making a decision on the supervision of OTC derivatives.

CFTC's Gensler ramps up call for OTC derivatives regulation
Gary Gensler, chairman of the Commodity Futures Trading Commission, is pushing for regulation of the over-the-counter derivatives market. "Some opponents of reform ... would say this really wasn't at the center of the crisis, the crisis was about mortgage underwriting practices, the crisis was about not enough capital in the banks and so forth," Gensler said. "But I believe that the over-the-counter derivatives marketplace was in fact part and parcel to this crisis."

EU: Clearinghouses might need approval for some derivatives
Before clearinghouses can clear some types of over-the-counter derivatives, they might have to gain authorization from financial regulators, according to an EU document. The move is part of efforts to reduce risks in derivatives markets. "It might therefore be advisable to introduce a process which would reflect the need to exercise a degree of regulatory discipline over the objective to ensure that a significant volume of derivatives contracts is indeed centrally cleared," the European Commission said in a paper for EU members.

Creation of clearing choice in Europe moves forward
The European Multilateral Clearing Facility is striving to clarify how it will work with LCH.Clearnet and X-Clear in a proposed three-way tie-up of the clearinghouses. The move indicates progress is being made in the effort to develop clearing choices in Europe. The movement to promote "interoperability" had been stalled as regulators raised concerns that the effort could pose a threat to the broader financial system.

European firms want exemptions for OTC derivatives rules
More than 160 of the largest nonfinancial companies in Europe signed a letter expressing their concerns regarding proposals by the European Commission for additional regulations for the over-the-counter derivatives markets. The businesses argue that some aspects could hinder economic growth and increase the cost of hedging market risks. In December, an official in the commission's internal market and services unit said the staff thought it would be impossible to exclude OTC derivatives users unrelated to the financial industry.

Rules could push some out of OTC derivatives market, group warns
Anthony Belchambers, CEO at the Futures and Options Association, said increased regulation could lead to additional costs and force some companies to withdraw from the over-the-counter derivatives market. "It is an economic test," Belchambers said. "If you live in a flood plain, you have to decide if you want to pay the very high premiums for house insurance. Some companies may simply decide the costs of hedging their business outweigh the underlying risk."

LCH.Clearnet SA to start clearing credit default swaps
LCH.Clearnet SA, a Paris-based division of the largest independent clearinghouse in Europe, plans to launch clearing for credit default swaps in March. European regulators have pushed the industry to develop clearing for CDS, and LCH.Clearnet SA is the third clearer to start such a service. "LCH.Clearnet SA has targeted its business launch by end of March upon approval from direct authorities, and additional approvals with U.K. and U.S. regulators would help shortly after to strengthen the service offer[ing]," a representative said.

LCH.Clearnet works toward deal to offer clearing in Japan
Roger Liddell, CEO at LCH.Clearnet, said the global clearinghouse is negotiating with regulators and financial institutions in Japan to offer access to its interest rate swap clearing service. "We have been spending quite a bit of time in Japan with some of the larger banks there, but also with the regulators and the central bank trying to agree on an access model that would allow the large Japanese banks to become members of our SwapClear service," Liddell said. "We haven't gotten there yet, but we think we are getting close."

Chinese companies bypass credit-support provisions for derivatives
Corporations and foreign banks incorporated in China are bypassing credit-support provisions tied to the country's master agreement on derivatives by drafting their own derivatives documentation. The master agreement has been touted as the standard for China's over-the-counter derivatives market, but the State-owned Assets Supervision and Administration Commission, the ultimate regulator for the companies, is not requiring state-owned companies to sign on. The corporate in-house derivatives documents could undermine the master agreement.

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