Managing Risk in the Derivatives Industry under the New Regulatory Regime
The regulatory changes, which have been implemented across the globe in the derivatives market, are having a substantial impact on the way in which risk is managed by institutions. Central clearing requirements as well as margin requirements are the main reasons why risk management processes have to change.
In the past, risk management in the derivatives space involved assessing counterparty credit risk and market risk and occasionally collateral risk. Central clearing will fundamentally change this, since the Central Clearing House will effectively absorb counterparty credit risk. Banks will therefore have to become focused on what the clearing house rules of their elected clearing houses provide for (porting rights and default waterfall being some of the key points to consider) in their risk management process. End users who cannot access the clearing houses directly, will need to focus on what the terms of the client cleared agreement provide for, as part of their risk management processes.
Clearing houses may set limits for banks and brokers who wish to clear trades through them, meaning that banks would need to understand and manage these limits both for their own proprietary positions as well as their clients' positions. Sometimes it may be difficult for a bank clearing member or client of a clearing member to know beforehand if their trade will be accepted for clearing or not. This introduces an element of risk into the transaction, since if a trade is not accepted for trading, it may be unwound at a default rate (increasing collateral requirements for the trade to be done as an uncleared trade).
Collateral requirements for cleared trades will be calculated by the clearing houses, meaning clearing members and their clients will need to understand the collateral calculation models implemented by the clearing houses. From a risk management point of view one would need to have transparency of the clearing limits and collateral calculations before a trade is done in order to properly assess the risk profile of a trade. This pre-trade, real-time risk analysis that is required will be a substantial variation from current risk management processes.
Collateral is being required for trades that are not cleared, as well as for trades that are cleared and therefore liquidity risk becomes a key component of risk management processes. Assessing one’s ability to find liquidity in the right assets required for collateral will be a main function of the new risk management procedures both on the buy side and sell side of the industry.
Clearing houses themselves need to have robust risk management processes in place, particularly ensuring that they can continue to operate in times of market stress and crisis. The failure of a clearing house will constitute the most substantial risk in the derivatives market of the future (they have become the too-big-to-fail entity in the market). Since clearing members are likely to be clearing members to multiple clearing houses, it means the default of one clearing member could potentially impact on multiple clearing houses. The clearing house must therefore be focused on their default waterfall structure, ensuring they hold sufficient collateral, and be discerning about who is able to become a clearing member. Clearing houses should at all costs try to avoid failure and resolution, and ensure that their risk management processes are robust and allow for recovery. The clearing house has the important task of balancing the amount of skin it has in the game: ensuring enough skin in the game to keep the clearing house honest and align its interests with the clearing members; but at the same time ensuring not too much skin in the game, which could result in resolution of the clearing house if the market turns.
Risk management going forward will therefore be focused on transparency, pricing trades, collateral requirements and liquidity.
Have a look at this whiteboard explanation of risk management by ISDA®:
If you haven’t already attended our sessions on The Financial Markets Act and/or Regulatory Update, you may find it useful to do so given the current and imminent regulatory changes which are being rolled out in SA and the rest of the world.
These regulatory changes will affect the way in which we trade OTC derivatives going forward. Asset Managers and their funds, financial institutions and insurance companies will all be affected.
The courses will touch on the margin rules which are imminent in SA and which are already in place in the US and Europe. The courses will also cover reporting obligations and central clearing, amongst other topics.
With all the regulatory changes happening, it is imperative as a business and as a legal department to keep abreast of how these changes will impact your business going forward.
We hope you will join us at these upcoming sessions - for the last time in 2017:
Wednesday 29 November 2017 (9-5)
The Da Vinci Hotel, Sandton
Friday 01 December 2017 (9-5)
The Da Vinci Hotel, Sandton
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