Transition to Central Clearing Underway

Terry Flanagan

Banks need to overhaul collateral infrastructures.

The move from bilateral to central clearing of many OTC swaps contracts will entail great changes for all participants.

“While there are many aspects to EMIR and Dodd-Frank, one area that that has gained a significant amount of attention is the proposed move of standard OTC derivative trades to a central clearing model,” Martin Loxley, director of collateral management at Omgeo, told Markets Media.

“This move would elevate the complexity of derivatives trade processing, since many non-clearing member firms will have an increased number of counterparts and more significant demands on their collateral,” Loxley said.

At the same time, OTC trades that remain bilaterally cleared will be subject to timely confirmation, robust and resilient auditable processes with frequent reconciliation and effective dispute management, as well as appropriate capital requirement levels.

“As a result, there is and will continue to be an increased demand for collateral management automation by market participants worldwide,” said Loxley.

Omgeo ProtoColl provides a comprehensive collateral and margin management solution for that mixed (bilateral and central) clearing environment, he said.

Efforts to standardize the way collateral is calculated have subsumed many other issues associated with the move to central clearing.

ISDA’s Standard Credit Support Annex, for example, aims to align the processes for bilateral and cleared derivatives.

A credit support annex is an agreement to an OTC derivatives contract that governs the calculation of collateral. The SCSA seeks to standardize market practices by removing “embedded optionality” in the existing CSA.

The SCSA also seeks to promote the adoption of overnight index swap discounting for derivatives.

An overnight indexed swap (OIS) is an interest rate swap where the periodic floating rate of the swap is equal to the geometric average of an overnight index (i.e., a published interest rate which is also called Overnight Rate) over every day of the payment period. The index is typically an interest rate considered less risky than the corresponding interbank rate (LIBOR).

Discounting methodologies that take into account OIS spreads—that is, the difference between OIS rates and LIBOR—are increasingly popular and are progressively replacing LIBOR-based methodologies, BNP Paribas noted.

CCPs, notably LCH.Clearnet, are moving to OIS discounting methodologies in their swap-clearing activities.

Since 2010, LCH has been using the (OIS) rate curves to discount its interest-rate swaps portfolio in its SwapClear IRS service.

Previously, in line with market practice, the portfolio was discounted using LIBOR.  However, an increasing proportion of trades are now priced using OIS discounting.  LCH.Clearnet decided to move to OIS to ensure the most accurate valuation of its portfolio for risk management purposes.

The SCSA supports the move to OIS discounting by grouping derivatives into separate buckets or “silos,” based on currency. Each currency silo is evaluated independently to generate a required movement of collateral in the relevant currency.

This aligns bilateral collateral structures to be more consistent with the LCH and other CCPs that adopt consistent margin approaches, ISDA said.

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