Clearing Conundrum

Terry Flanagan

To clear or not to clear, that is the question.

The thrust of reforms in the global market for over-the-counter derivatives, which was valued at $639 trillion in 2012, is to improve transparency by mandating that swaps be traded, cleared, and reported via central facilities, rather than private, one-off negotiations.

That vision, however, clashes with the traditional role played by big banks as the intermediaries between counterparties, usually global corporations looking to hedge interest-rate or foreign-exchange exposures.

The issue is framed by the margin requirements that regulators are seeking to impose on swaps that are not cleared, that is, bilateral swaps. Financial rulemakers say it’s proper to mandate such requirements for non-cleared swaps because it’s in the spirit of the OTC reforms, embodied by the Dodd-Frank Act in the U.S. and European Market Infrastructure Regulation.

“That’s a reasonable approach, inasmuch as the regulations are intended to encourage clearing,” said Emre Carr, a principal at Washington-based consultancy Berkeley Research Group and a formerly an economist at the U.S. Securities and Exchange Commission.

For swaps-market participants, the bottom line is that central clearing increases the amount of capital that needs to be set aside for margin requirements. The transition from a bilaterally cleared OTC business to a centrally cleared OTC derivatives market is likely to be accompanied by an increase in exchange-traded derivatives that are the economic equivalent of OTC transactions.

OneChicago, a security futures exchange, provides a marketplace for trading over 2,800 futures in more than 1,500 individual equities and exchange-traded funds. OneChicago’s Exchange Future for Physical is the economic equivalent of OTC equity swaps, specifically stock lending and equity repo transactions.

Securities lending and equity repos, which are secured lending of stock for cash or the lending of cash for collateral, are covered by a binding agreement, which provides for the terms of the loan.

“We look at our product as a futures product which is the economic equivalent of an equity repo,” said Thomas McCabe, chief operating officer at OneChicago. “We compete with security-based swaps that are traded OTC.”

The SEC and Commodity Futures Trading Commission have jurisdictions over separate parts of the swaps market. The SEC oversees security-based swaps based on a single name or narrow index, while the CFTC oversees all other OTC swaps.

“The Dodd-Frank Act is all about managing risk in an appropriate way, whether it’s an OTC swap or an exchange-traded future,” said McCabe.


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