Part IV – Can they add comfort to clearing OTC derivatives
Recommendations on clearing OTC derivatives
The use of a clearing through clearing house has the potential to mitigate each of the types of counterparty risk associated with OTC derivatives. With respect to credit risk, clearing would achieve through multilateral netting. Margining arrangements typically would then eliminate or collateralize the net exposure on a daily basis. A clearing house has the potential to reduce liquidity risks by broadening the scope of payment netting. Legal risk would be reduced by clearing house’s default procedures often supported by specific provisions of national law. A clearing house could reduce operational risks by imposing high standards of operational reliability and by promoting further development of automated systems for confirming transactions. Thus, the value proposition of central counterparty clearing services is to ensure market integrity.
Central counterparty clearing houses are a key element, together with other market infrastructures and service providers, of an integrated and efficient post-trade process, which serves to increase market efficiency by improved market operations with standardized, electronic processing of transactions.
European CCPs coped successfully with the recent default of Lehman Brothers International (Europe), and the Icelandic banks, by closing-out or transferring the positions of the defaulter, without impacting other participants, and within the collateral amounts and other financial resources available to them.
The European Association of Central Counterparty Clearing Houses, in February 2009 has come out with a set of recommendations on clearing OTC derivatives. Some key recommendations are:
- Transparency and effective risk management are key elements to reduce systemic risk in financial markets
- Effective risk management is the most important benefit to deliver in clearing derivatives markets as they significantly exceed the amount of counterparty risk to be managed in cash markets
- The value proposition of clearing houses includes the automation of transaction processing, which increases the efficiency of market operations and reduces the likelihood of manual errors
- It can serve as part of the blueprint to effectively mitigate counterparty risk and improve operational efficiency in OTC derivatives markets across asset classes and products
- Sound market regulation includes as a guiding principle that the same rules are applied for the same activities in order to avoid regulatory arbitrage. Derivatives markets are global by their nature and product distribution
Does a CCP add anything to OTC derivative markets?
A central counterparty can add benefits to the OTC derivative markets.
Concentrative Approach
- Systemic market risk can be reduced by multilateral netting and the application of margin to collateralise losses and protect against future price changes
- Multilateral netting can improve capital efficiency
- Multilateral netting can lead to significant reduction in ‘open’ contracts to be tracked and managed
Extensive Approach
- Active counterparty credit risk management through close-out netting and collateralization
- Extension of credit to customers is an important competitive tool for financial institutions
- Supports competition and continued derivative product innovation
- Risk diversified away from a single piece of infrastructure
Conclusion
In an ideal world, the need for central counterparty may not arise only when the systems are upgraded to provide for real time gross settlement – payment / receipt of funds and receipt / delivery of the underlying securities. This could be possible only when all the systems – settlement and payment systems – are linked across borders. This has been recognized as a minimum requirement of a truly globalised and matured international market. For this one may need synchronization of the best practices in all parts of the financial markets – commodities, equities, foreign exchange, fixed income and derivatives (commodities, equities, foreign exchange, fixed income, interest rate and credit derivatives to begin with) and prescription of common rules and regulations. Let us hope the arrival of such an integrated market may not be very far off given the need of the market place and also the growing awareness and advances being made in the technology space.