Costs of Central Clearing

Terry Flanagan

Central clearing of OTC derivatives is undeniably reducing overall systemic risk, although adapting to it at the individual firm level is proving problematic.

All financial entities have been required to clear swaps since June 10, 2013, for swaps entered into on or after that date. Buy-side market participants transacting swaps must determine whether they are subject to the mandatory clearing requirement.

“The buy side have made it through the first deadline, i.e., the beginning of central clearing, but as products become more clearable there will be additional networking, technology and operations requirements,” said Robin Powers, a derivatives attorney at Rimon pc, during a panel discussion this week. “The most challenging aspect is the different regulatory regimes, whether between the SEC and CFTC, or between Dodd-Frank and Emir.”

Under Emir, for example, the buy side will be responsible for reporting swaps transactions directly to trade repositories. “The need to differentiate between different reporting scenarios will create an operations and technology nightmare,” Powers said.

Relationship documentation between swap dealers and/or major swap participants (SDs and MSPs) and their counterparties must contain a notice that if a swap is executed bilaterally and then submitted for clearing, upon acceptance of the swap for clearing, the original swap is extinguished; the original swap is replaced by equal and opposite swaps with the DCO; and all terms of the swap conform to the product specifications of the cleared swap established under the DCO’s rules.

Accordion to an analysis of the OTC derivatives market by the International Swaps and Derivatives Association (Isda), portfolio compression and central clearing have had a salutary impact on the size of the OTC derivatives market in recent years.

During 2012, $48.7 trillion in notional amount of OTC derivatives were eliminated via portfolio compression, including $44.6 trillion of interest rate derivatives (IRD).

A total of $214.3 trillion of OTC derivatives has been eliminated in the past five years via portfolio compression. Portfolio compression reduces notional outstanding by eliminating matched trades or trades that do not contribute risk to a dealer’s portfolio.

While portfolio compression reduces the size of the market, the continued growth in central clearing of OTC derivatives has the opposite effect because of the double-counting of cleared trades (in a cleared transaction one bilateral trade becomes two centrally cleared trades, which doubles the notional amount).

At year-end 2012, approximately $173.2 trillion of OTC derivatives were centrally cleared, including 53.5 percent of all IRD.

“The industry has made great strides to reduce counterparty credit risk and help make the derivatives markets safe and efficient through netting, collateralization, portfolio compression and central clearing,” said Isda CEO Robert Pickel. “While the increase in compression continues to impact adjusted OTC derivatives volumes, underlying market activity remains robust.”

The analysis also shows the risk mitigation benefits of netting and collateral. Gross Market Value, a measure of credit exposure in the OTC derivatives market, was $24.7 trillion, or 3.9 percent of notional at year-end 2012. Gross Credit Exposure, which reflects the impact of netting, was $3.6 trillion, or 0.6 percent of notional value. Netting and collateral reduce credit exposures to 4.2 percent of the Gross Market Value and to 0.2 percent of the notional amount.

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