BoE Concerned Over Access to Clearing

Shanny Basar

The Bank of England is concerned that some small UK firms find it difficult to obtain cost-effective access to central clearing and may decide to cease hedging interest rate risk.

The UK central bank issued its latest annual report of its supervision of financial market infrastructures this month. The Bank supervises four central counterparties in the UK – LCH.Clearnet, part of the London Stock Exchange Group, ICE Clear Europe, LME Clear, and CME Clearing Europe. The value of margin and default funds held by these four UK CCPs to help them guarantee trades was an average of £90.6bn ($131bn) last year. The report covered the period from 14 March 2015 to 4 March 2016.

Central counterparties will become more systemically important as the first mandatory clearing requirement for over-the-counter derivatives in the European Union will begin on June 21. The frontloading requirement started last month.

“The largest users of derivatives will become subject to mandatory central clearing rules for certain OTC interest rate derivatives, and mandatory clearing for certain OTC credit derivatives will likely follow,” said the Bank of England.

As a result, the regulatory standards for CCPs have substantially increased and the Bank of England is co-operating internationally on a range of regulatory work as well as reviewing whether reforms are working as intended or if there are conflicts between different regulatory objectives. For example, last year the Bank chaired global colleges for LCH.Clearnet Ltd and ICE Clear Europe, bringing together supervisory authorities from a range of countries.

The report said: “The Bank welcomes the announcement by the European Commission and the Commodity Futures Trading Commission of a common approach regarding requirements for CCPs. This promotes global regulatory convergence, and should mean that European CCPs will be able to do business in the United States more easily and that US CCPs can continue to provide services to EU companies.”

Last month the European Union and the US agreed on a “common approach” to the regulation of clearing houses which will allow European regulators to grant equivalence to US clearing houses before mandatory clearing begins in the EU and means that trades cleared through US CCPs will not face additional capital changes under European regulations.

The Basel Committee on Banking Supervision is currently considering how to treat derivative exposures for centrally cleared client transactions as some market participants have argued that the leverage ratio imposes excessive capital requirements on centrally-cleared client trades. The Bank of England said: “Though the leverage ratio does not normally allow collateral to reduce exposures, the Bank supports an exception to allow initial margin to reduce leverage exposures for centrally cleared client trades to promote the continuity and affordability of client clearing services.”

The UK central bank also argued that a more differentiated approach to banking regulation according to the size of firms could facilitate competition, growth and stability. The Bank has responded to the European Commission’s consultation on how revised bank capital requirements have affected lending and given examples of how some regulation could be changed – including removing small financial counterparties from the clearing obligation under Emir.

“Some UK firms are finding it difficult to gain access to central clearing on cost-effective terms,” said the report. “The Bank is concerned that some may decide to cease hedging interest rate risk: for example on fixed rate mortgage lending.”

Last year the Bank completed an assessment of UK CCPs’ default management “fire drills” by simulating the default of a clearing member and identified a number of potential improvements. In order to simulate the default of a clearing member being managed by more than one CCP, the Bank of England together with BaFin and Deutsche Bundesbank, the German regulators, carried out an exercise last month for LCH.Clearnet Ltd and Eurex Clearing. The report said: “The Bank is working with BaFin, Deutsche Bundesbank, and fire drill participants to assess the outcomes.”

The Bank of England is also part of a study group on central clearing inter-dependencies to explore the potential for any spillovers related to recovery steps taken by CCPs or banks where such interdependencies exist.

In addition to increasing their use of central clearing, participants in the OTC derivatives markets have been voluntarily using compression, which allows counterparties to tear up certain offsetting trades without altering the risk profile of their portfolio. They benefit from operational efficiencies by reducing the number of trades and from using capital more efficiently. A reduction in notional value means that banks can hold less capital against their outstanding positions under the Basel III requirements.

TriOptima, the post trade infrastructure provider, said today that market participants have eliminated more than $750 trillion in notional principal outstanding since the 2003 launch of triReduce, its multilateral compression service for OTC derivatives in collaboration with clearinghouses and CLS, the bank-owned physical settlement system for foreign exchange.

Peter Weibel, chief executive of triReduce, said in a statement: “The positive effect of compression is clearly reflected in the declining outstanding notional amounts reported by the BIS. We are planning to introduce triReduce compression cycles in more CCPs later this year and will continue the expansion of our catalogue of compression products.”

The Bank for International Settlements said in December that the overall volume of compressions increased strongly in 2014 but continued to grow in the first half of 2015.

The BIS added that central clearing has enabled the use of sophisticated compression techniques and contracts between dealers and other financial institutions, including CCPs, stood at $360 trillion at end-June 2015, down from $421 trillion at end-December 2014.

“More recently, compression methods have emerged that do not require third-party involvement. This has led to a further pickup in compression volumes,” said the BIS. “And some newly available electronic trading platforms for OTC derivatives – such as swap execution facilities (SEFs) – have also started to offer efficient mechanisms for cancelling offsetting positions between counterparties.”

Featured image by chrisdorney/Dollar Photo Club

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