During the recent ISDA® AGM held in Lisbon in May, a panel discussion highlighted a few of the challenges that have arisen in the clearing space, and this article aims to highlight some of these.
Regulators have imposed higher levels of margin on uncleared OTC derivative transactions. Regulators have purposefully done this in order to encourage parties to clear transactions, since clearing is designed to reduce systemic risk. The concern is that there are certain products, which by their very nature, cannot be cleared: they are too bespoke, non-standard and difficult to price. As a result of this, they are ‘unclearable’. Yet these unclearable transactions are subject to the higher margin requirements imposed on uncleared transactions. It was argued that these types of unclearable transactions should not be subject to punitive uncleared margin rules because there simply isn’t a platform to clear these types of transactions. It leads to the unintended consequence that these essential bespoke hedging transactions become too expensive for the market players to enter into, and it is argued that not having a way of hedging these risks could lead to more systemic risk than allowing these transactions to be exempt from the punitive uncleared margin levels. The participants on the panel suggested that this conversation needs to start with the regulators in order to come up with a new category of transactions that are ‘unclearable’ and assign relevant margin rules to these types of transactions.
As an aside, it is interesting to note that South African regulators have not yet approved a local clearing house, and as a result there is no local clearing platform (which will accept ZAR margin). Yet, the regulators are pushing ahead to try and finalise and roll out the uncleared margin rules as soon as possible. Effectively this will mean that once uncleared margin rules are implemented, unless an exception is applied, SA market participants will have to subject all their transactions to the punitive uncleared margin rules, despite the fact that they will have no choice to clear. It is hoped that the regulator in SA will approve a local clearing house before imposing the uncleared margin rules to avoid this situation arising.
The other point that was raised was around the fact that clearing houses are only able to clear highly liquid and regular swaps where regular pricing is available. In this case it is easy to set relative margin requirements. The danger is forcing products which aren’t liquid and easily priced into clearing because then it is very hard to set realistic margin requirements for these.
The Basle Committee on Banking Supervision (BCBS) is also reluctant to align capital requirements with margin requirements. Since not everyone will be able to be a clearing member, buy side firms will have to access the clearing house through a direct clearing member. Clearing members will have to clear on behalf of these clients. The issue is that the BCBS standardises its approach for measuring counterparty credit risk, and isn’t sensitive to risk reducing services like client clearing. So when it looks at a clearing member who is offering clearing services to clients (and effectively offering risk reducing methods), the BCBS would see these additional transactions as additional exposure and capital requirements would increase. This could mean that clearing members may be disincentivised to clear for clients. This needs to be addressed and the BCBS should rather change the rules relating to clients margin, which is posted, and make capital requirements for clearing members aligned to actual systemic risk.
The last question that was raised was around whether the ‘too big to fail’ problem has been resolved by the new regulations. Some argued that central clearing has created fewer larger counterparties (i.e. the clearing houses have become the largest counterparties, with most transactions being concentrated into these few counterparties.) In addition only the largest financial institutions will be eligible clearing members, meaning again the large majority of transactions will be concentrated and flow through a smaller number of entities. It was therefore suggested that central clearing may indeed have exacerbated the too big to fail concern.
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The Legal Documentation Required for Clearing
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