Derivatives Clearing Organizations Face Greater Scrutiny with OTC Rules Set to Come Into Play

Terry Flanagan

The role played by central counterparties—which are large and globally interconnected financial institutions—has received renewed market and regulatory scrutiny.

“As more derivatives go through clearing houses, it is imperative that clearing entities not only be adequately regulated, but also that regulators conduct risk-based supervision of these entities—and not just a compliance-based approach—to ensure that they have an adequate capital cushion to sustain unexpected losses,” Mayra Rodriguez Valladares, principal at compliance-training provider MRV Associates, wrote on TabbFORUM.

Derivatives clearing entities have gained enormous importance since the G20 group of nations at its Pittsburgh Summit in 2009 agreed that over-the-counter derivatives should be cleared in a bid to reduce risk and increase transparency following the financial crisis. This agreement gave rise to new derivatives clearing requirements on both sides of the Atlantic, the main derivatives venues, both under the U.S. Dodd-Frank Act and Emir in Europe.

“The global regulatory landscape is very uncertain at the moment, making the next five years difficult to predict,” said Chip Register, managing director at Sapient Global Markets, a provider of services to financial and commodity markets.

As well as Dodd-Frank and Emir, Register says that regulations such as Basel III, the Regulation on Energy Market Integrity and Transparency (Remit) and the Foreign Account Tax Compliance Act (Fatca) “are changing incredibly complex market structures and mechanisms and this will ultimately affect operating models in ways we just don’t yet fully understand”.

According to the U.S. Commodity Futures Trading Commission, a derivatives clearing organization (DCO) is “a clearing house, clearing association, clearing corporation, or similar entity that enables each party to an agreement, contract or transaction to substitute, through novation or otherwise, the credit of the DCO for the credit of the parties; arranges or provides, on a multilateral basis, for the settlement or netting of obligations; or otherwise provides clearing services or arrangements that mutualize or transfer credit risk among participants”.

As of the end of November, 14 companies were registered as DCOs in the U.S., according to the CFTC.

“It is tremendously important that the CFTC does not simply examine DCOs using a compliance-based approach that is just making sure that clearing entities follow rules and principles,” wrote Valladares of MRV Associates. “The CFTC should strengthen how they conduct risk-based on-site and off-site supervisions of DCOs, particularly given their increasing role as systemically important financial institutions.”

DCOs have great exposure to operational risk, such as a breach in the day-to-day running of the business due to people, processes, technology and external threats.

As DCO volumes rise, there is more scope for operational risk simply by the virtue of the fact that people and systems need to keep up with the changing nature of the business.

“Risk-based supervision allows regulators to focus on an organization’s problem areas and on those entities that have higher risks,” Valladares wrote.

A risk-based supervision approach entails that the CFTC would evaluate how a DCO identifies, measures, controls and monitors its macro risks (country and economic) and its financial risks (credit, market, operational, liquidity, legal and reputational) across all legal entities and geographic locations.

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