Fears Mount Over Centralized Clearing

Terry Flanagan

Some market participants in Europe are worried that regulatory moves to push the vast majority of over-the-counter derivatives trades through centralized clearing could, in fact, just move risk from one part of the financial trade cycle to another.

The mandate by the G20 group of nations to force the previously opaque and unregulated $700 trillion global OTC derivatives market through clearing houses by the start of 2013, to safeguard the financial system against large defaults, has created new interest in the post-trade space but has also seen fears arise that central counterparties (CCPs) will be unable to cope with correlated default events.

“Bank regulation is likely transferring banking risk to highly leveraged and potentially under-resourced CCPs, which may not be able to sustain a correlated tail-risk scenario,” said JP Morgan analysts in a recent note.

JP Morgan said that further turmoil in the eurozone debt crisis could cause a systemic crisis within clearing houses, which, in smooth running markets, ensure the safe passage of trillions of dollars worth of derivatives and securities trades.

Other market participants, meanwhile, are concerned that new proposals expected in the upcoming European Market Infrastructure Regulation rules governing OTC derivatives in Europe to set up a default fund to which clearing members of the CCP would have to contribute, creating a last line of defense if one or more clearing members default and all other financial resources have been used, will create undue expenses for investors.

“The new rules would create prohibitive costs,” one London-based source told Markets Media.

Some clearers, though, are going further still in a bid to pre-empt regulatory requirements. Anglo-French clearer LCH.Clearnet has become the second clearer globally, after Japan Securities Clearing Corporation, through its credit default swap clearing service CDSClear to adopt a system whereby once all other methods have failed, including the default fund, then member firms would have to take a haircut on their variation margin, allowing for a more orderly resolution, and thus preventing a wider crisis.

“Some loss allocation mechanism must exist,” said Edwin Budding, assistant director, risk and research, at the International Swaps and Derivatives Association, (ISDA) a trade body, in a letter to the Bank of England about CCPs and regulation in April. “We consider it would be desirable for the loss allocation mechanism to be equitable and fair, and fall on the clearing members and clients down to the beneficial owner. The rules for the default management process and the use of resources in a CCP default waterfall need to be encoded into a CCP’s operating rules.”

ISDA added that a fairer method would effectively stabilize financial markets as market participants would only lose a small percentage of its assets. It added that a cap should be brought in to prevent unlimited liability and that variation margin haircutting should be “the last gasp of breath for the CCP”.

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