Derivatives Users Find Clearer View on Collateral Management

Terry Flanagan

Upcoming over-the-counter derivatives regulation in Europe, which is set to bring in significant structural changes when transitioning to a more electronically traded and centrally-cleared environment, is forcing many market participants in the previously opaque industry to quickly adapt to the new obligations.

New rules that are set to go live at the end of this year in the guise of the European Market Infrastructure Regulation (Emir), part of the G20 group of nations’ diktat to better regulate the $700 trillion OTC derivatives market, promise to increase collateral requirements and add a greater complexity to clearing. The volume of bilateral trades is also set to diminish as the OTC market is pushed on to more regulated exchanges.

In the post-trade process, Emir, like the similar Dodd-Frank Act in the U.S., is set to revolutionize proceedings by enhancing transparency and reducing risk. The previously unregulated OTC derivatives sector, which accounts for roughly 95% of all derivatives trades, has been blamed, in some quarters, for the 2008 collapse of Lehman Brothers, a heavy user of derivatives trades, and also the subsequent global financial crisis.

The European Securities and Markets Authority, the pan-European regulator, is currently in the process of writing the technical standards for Emir that will form the basis of how derivatives market participants will operate in a more regulated trading environment.

“We’re closely following the evolving regulations so that we can provide our customers with flexible technology prepared for current and future regulatory requirements,” said Javier Tordable, chief executive of Cinnober, which supplies clearing systems to markets globally. “Efficient collateral management will be a success factor—if not a matter of survival—for the OTC derivatives participants and the CCPs [central counterparties] aiming to offer swaps clearing.”

Clearing houses are set to take on the risk that interposes itself between two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer. Currently, OTC trades are negotiated between two parties in private. But all standardized contracts will, from the end of the year, be forced to be cleared on-exchange, incurring clearing costs, although bespoke bilateral trades will still be allowed off-exchange but will be subject to even more stringent capital and collateral requirements. All trades will also have to be reported through trade repositories to provide market participants with a clearer view of the market.

The London Metal Exchange (LME), where derivatives products of metals are traded on its exchange, has selected Cinnober as its core technology provider for its new clearing house, LME Clear.

The 135-year-old U.K. exchange, the world’s largest metals market, which Hong Kong Exchanges and Clearing (HKEx), the Hong Kong stock exchange, is currently in the process of attempting to purchase for $2.2 billion, already uses Cinnober for its electronic trading system, LMEselect.

Under the agreement, Cinnober will provide LME Clear with its TRADExpress RealTime Clearing system. This includes real-time risk management and clearing functionality. The system will process and clear on-exchange and OTC markets.

“In today’s clearing environment, regulatory, market and client demands emphasize the need for high performance systems, in terms of resilience, processing ability and the move to real time risk management,” said Trevor Spanner, managing director of post-trade services at the LME. “We are pleased and excited to have a technology partner who shares our commitment to delivering this capability.”

HKEx supports the development of the new LME Clear system.

Meanwhile, shareholders of the LME will vote on July 25 on whether they want to proceed with the takeover by HKEx. The deal, if approved, has to be rubber stamped by 75% of shares and 50% of shareholders. It has been reported that some smaller shareholders have voiced opposition to a takeover and top shareholder JP Morgan is also reluctant to vote in favor of HKEx.

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