Clarity on Clearing

Terry Flanagan

CCPs may not be a panacea for the problems that led to the G20 reforms.

The establishment of centralized clearing for OTC products, a major pillar of the G20 financial reforms, raises complex issues of cost and risk management.

In particular, with the expected hike in transactions that are mandated to be centrally cleared, CCPs need to build out the necessary infrastructure for such a vast undertaking.

“With the increased importance of CCPs in the post trade infrastructure for OTC products, further dilemmas arise,” said Keith Bear, director of business development, financial markets at IBM. “While several, such as the CME, are already offering clearing services, the bulk of product migration is yet to come.”

CCPs face a curve of increasing OTC product complexity and more challenging liquidity characteristics as the expected 60-70% of OTC volume migrates to centralized clearing, according to Bear.

CCP’s therefore face issues on how to handle risk calculations (especially for more complex products), data sourcing (especially for market data that’s not easily available), and processes for managing counterparty default

“CCPs therefore face a dilemma of what approaches to take for managing such major uncertainties against the tight timescales imposed by G20, with a market that may resist multiple attempts to “get it right,’” Bear said.

CCPs have worked well for the futures market, but the characteristics of the OTC markets of highly variable product complexity, varying liquidity and long dated instruments is a very different world, said Bear.

“It could be argued that migrating such trades to centralized clearing, with the consequent reliance that CCPs having the ability to measure risk for the more complex illiquid instruments, as well as managed closing out of trades from a failed counterparty, raises the overall risk given the much greater dependency on the abilities of a small number of CCPs to manage in this environment,” Bear said.

For clearing members themselves, centralized clearing represents a major new opportunity to offer clearing services to their clients, as the trading model moves away from bilateral trading.

Initial margin requirements for OTC centralized clearing for the market have been variously estimated at ~$1-2 trillion, causing the buy side major issues in terms of how such margin requirements will be funded, according to Bear.

“In many ways, centralized clearing will therefore create a new transaction services business opportunity for many sell side firms,” he said. “Clearing members therefore face dilemmas with the relative attractiveness of the market opportunity to offer clearing services, versus the cost and complexity of offering such services.”

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