Markets Embrace OTC Clearing

Terry Flanagan

Central clearing of OTC derivatives is creating new challenges and opportunities for derivatives market participants.

Swap dealers, major swap participants and private funds active in the swaps market have all been required, from March 11, to begin clearing certain index credit default swaps and interest rate swaps.

All other financial entities will be required to clear swaps beginning on 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.

“Vanguard has welcomed clearing because of the reduction in systemic risk by having a clearinghouse standing between counterparties,” said Sam Priyadarshi, head of fixed income derivatives at Vanguard Group. “In addition to reducing systemic risk, clearing allows us to compact positions and post net margins across different asset classes, such as swaps and futures, and do portfolio level margining, which could not be done under the bilateral model.”

Sam Priyadarshi, Vanguard

Sam Priyadarshi, Vanguard

An overarching theme is the ‘futurization’ of the swaps market, by which formerly bilaterally executed and cleared OTC transactions are being moved to, and in some cases, replaced by, futures exchanges.

“With certain swaps now likely suitable for the clearing protections that have long been required for futures, some have claimed that there is regulatory arbitrage occurring, with futures and swaps competing against each other,” said Walter Lukken, president and CEO of the Futures Industry Association, at a congressional hearing on the future of the Commodity Futures Trading Commission on Tuesday.

Most market participants welcome the broadened array of products available in a cleared environment and will continue to use both swaps and futures products to meet their individual risk management needs as appropriate, Lukken said.

“The way these new regulations are impacting the fixed income derivatives markets are multifold,” Priyadarshi said. “There are sweeping changes in regulations surrounding derivatives. There are a lot of mandates kicking in pertaining to derivatives clearing, both for interest rate swaps and credit default swaps. There is a mandate for real-time reporting of swaps. There is a mandate to trade these swaps electronically on SEFs.”

In 2012, the total number of futures and options contracts traded on exchanges worldwide fell by 15.3%. However, overall trading and clearing volumes have risen over the past 10 years.

Even before the clearing mandate for certain swaps and swap market participants took effect in March, the volume of swaps submitted voluntarily for clearing was up in January:

LCH.Clearnet experienced a major surge in interest rate swap clearing, with volume exceeding $55 trillion in notional value in January, an all-time high.

CME Group also saw all-time highs in interest rate swap clearing, with January volume of more than $250 billion notional cleared and $750 billion in open interest.

The notional volume of credit default swaps cleared by ICE Clear Credit totaled $400 billion in January.

As the clearing mandate took effect in March for swap dealers, major swap participants and active funds the infrastructure responded relatively well; many of these entities had been engaged in voluntary clearing efforts prior to the March date.

The next effective date of June 10 will bring in many more participants and will likely present many more challenges to the new regulatory regime.

“Now there is a concentration of risk at clearinghouses, so we want robust clearing and risk management practices to be implemented at clearinghouses,” said Priyadarshi. “They have become too big to fail. We want regulatory oversight and good risk management practices for clearing members and clients. Clearing will impose additional costs, with clearing members, i.e., FCMs, passing costs of clearing on to users. At Vanguard, we have relationships with multiple FCMs.”

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