What is clearing?
Clearing is risk management. It’s the process by which an organisation acts as an intermediary between the buyer and the seller of a financial instrument to ensure the transaction is carried out in compliance with market rules.
While banks are authorised to clear some securities, certain types of derivatives have to be cleared by a third party known as a clearing house or central clearing counterparty (CCP). Financial counterparties and above threshold non-financial counterparties (NFC+) are subject to a clearing obligation under EU law.
The clearing organisation will be involved as soon as a transaction is agreed upon right until it’s settled, assuming the legal counterparty risk throughout. Main responsibilities will include checking the availability of funds and the solvency of the parties, risk margining, and monitoring and recording the transfer. In extreme cases, it will be called upon to cover losses if a member defaults.
Can all transactions be cleared?
Yes, in theory, though the scope of eligible financial instruments evolves all the time. The main focus has recently been on derivatives which are considered riskier investments. A G20 statement released during the Pittsburgh Summit in 2009 advised that ‘all standardised [over the counter (OTC)] derivative contracts should be…cleared through central counterparties by end-2012 at the latest”.
The 2007/9 financial crisis brought with it the fear that derivatives, especially those traded OTC, may have played a key part in destabilising the market. The collapse of Lehman Brothers in 2008 was a turning point for the financial markets as it bought to light how important clearing can be to prevent financial risk from spreading. It saw the investment bank file for chapter 11 bankruptcy after nearly 80% of the counterparties to its derivatives trades urgently closed their trades and kept the collateral it had given to back these up.
“With a large chunk of derivatives trading being rerouted to CCPs on the back of European Markets Infrastructure Regulation [Emir], Basel III rules etc, our role and importance in establishing stability in the economy grows,” says Roger Storm, head of clearing at SIX Securities Services. “With open access being mandated by the Markets in Financial Instruments Directive [Mifid] II there is further potential.”
As a result, a growing number of derivatives is being pushed through CCPs. Both the US and the EU mandate that certain classes of interest rate, credit and FX derivatives are subject to a clearing obligation though they differ when it comes to how they are cleared.
“These regimes tend to shoehorn certain things in certain categories – one of the drawbacks from the financial crisis is that markets are more conservative,” says Hirander Misra, chief executive of GMEX Group, which provides creates and operates electronic exchanges and post trade infrastructure. “But the regulatory framework has encouraged more competition.”
Why is clearing important?
A growing proportion of the global $940 trillion global derivatives market is subject to clearing. The Bank of International Settlements estimates that 76% of interest rate derivatives were cleared in the six months to December 2016, compared to 44% of credit default swaps and one percent of FX derivatives.
As a rule, CCPs hold collateral deposits on behalf of members as a security for trades, and can use it to cover losses if one of the members defaults. Because of this they have been credited for the stabilising role they play, and the fact they contribute to making trades quicker, and more transparent and efficient.
But clearing houses have also come under fire because some market participants believe they can concentrate risk. Questions also arise over the amount of collateral needed to ensure trades are cleared efficiently.
“CCPs need to know their member firms can support required collateral call and settlement timeliness amidst maintaining required contributions to fund cash reserves to protect liquidity and business as usual operations in times of default or market stress,” said Joshua Satten, director at Sapient Global Markets.
Exchange-traded markets (the London Stock Exchange for example) are regulated and are governed by clear rules, but derivatives traded OTC are more problematic. International Monetary Fund economist Manhmohan Singh estimates CCPs globally need in the region of $2 trillion in fresh collateral to properly deal with OTC derivatives.
What risks do CCPs face?
“The main risks a CCP faces are credit, liquidity as well as operational risks,” says Thomas Laux, chief risk officer at Eurex Clearing. “While the first two are pretty much mitigated, operational risk is a key focus item in risk management for a clearing house."
Many CCPs now have a systemic status because of the sheer volume of derivatives they clear. London-headquartered LCH Clearnet, for instance, one of 17 CCPs registered in the EU, controls more than 95% of the cleared OTC interest rate swaps market and 75% of global euro-denominated derivatives. While no CCP has ever failed or come close to failing, lines of defence are always ready. Recovery and resolution measures are put in place in extreme cases to ensure no bailouts are needed.
What does the law say?
Key pieces of legislation regulating derivatives clearing were implemented in reaction to the financial crisis though clearing as a general activity carried out by financial institutions has been around for much longer.
Clearing is an increasingly regulated activity because of the frequency and speed of transactions carried out online. While the Dodd-Frank Act in the US, and the European Markets Infrastructure Regulation (Emir) and the Markets in Financial Instruments Directive (Mifid) framework in the EU regulate trade reporting though the regimes, are similar on some points, they also have key differences.
Under Dodd-Frank, only one counterparty to the trade needs to report it but both parties have to do so under Emir. Another divergence is that the EU makes clearing of exchange-traded derivatives and swaps mandatory, but the US only focuses on those traded OTC. There are also differences when it comes to the calculation of margins for customer accounts.
But recent amendments to the Mifid system (under Mifid II) have brought regimes closer.
According to Liz Carter, managing director for trade reporting and clearing at Tradeweb, Mifid II now mirrors US practices in Dodd-Frank, especially following the introduction of regulatory technical standard (RTS) 26 which specifies the obligation to clear derivatives traded on regulated markets and timing of acceptance for clearing.
"Isda noted in an August paper that a location policy could increase risk and costs in the EU and raise overall initial margin levels by 15%-20%"
“Under the Emir clearing mandate, while clearing was mandated, the process was not prescribed,” she said. But under RTS 26, there are now conditions attached: if you trade a cleared trade electronically, the trade has to be submitted by the trading venue to the clearing house within 10 seconds from electronic execution.
What about Brexit?
More derivatives (both EU and globally) are cleared in London than in any other financial centre globally – for example, it’s estimated that the city is responsible for more than 75% of all euro-denominated trades.
The UK’s decision to leave the EU by 2019 has sent shockwaves through the financial services sector, and this could affect its status as a major clearing centre. Commission vice-president Valdis Dombrovskis highlighted in June a location policy for the clearing of euro derivatives, arguing it would need to be relocated within the eurozone. MEP Markus Ferber wrote in IFLR’s September 2017 edition that the critical importance of the clearing of euro-denominated derivatives for the financial system inside the European Union means they should be have full EU oversight powers, full compliance with its regulatory regime and sufficient intervention powers.
Misra says too much fragmentation could be bad for the financial markets. “There should continue to be nothing stopping an EU clearing house from having products cleared in London: it’s ultimately a question of bulk and critical mass,” he said. “London has managed to achieve economies of scale on correlated products, notably though the use of collateral efficiency and margin offsets.”
The International Swaps and Derivatives Association noted in an August paper that a location policy could increase market fragmentation and vulnerability, arguing that it could increase risk and costs in the EU and raise overall initial margin levels by 15%-20%.
This leaves many questions answered for the moment when it comes to the role London could potentially play in the EU clearing market post-Brexit.
Could ‘third country equivalence’ be the way forward for London?
The EU Commission may deem that non-EU country clearing regimes are equivalent to the requirements mandated under Emir. It has so far declared, following advice from the European Supervisory Markets Authority, that regimes in a number of countries including the US, Canada, Hong Kong, Australia and Singapore are equivalent.
This could be a possible solution to London’s status when it leaves the EU. But former US Commodity Futures Trading Commission chairman Timothy Massad said in January he believes that the EU would apply ‘tougher conditions’ than for other countries in clearing negotiations with the UK, because of London’s status as a major financial hub.
If equivalence talks fail, however, it would be more expensive for EU firms to clear trades in the UK. Clarus Financial Technology has estimated that banks could need an additional $80 billion in extra margin cash for trades if the market fragments.
“FX and interest rate swaps are very important asset classes for the real economy so it’s important that the EU27 ensures there is a functioning market,” said a senior EU source. “If a crisis happens, I am not sure different clearing regimes authorities and priorities would work, especially if a decision is needed quickly.”
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