OTC Swaps Clearing Risks Take Center Stage

By Radi Khasawneh

Originally published on TABB Forum 

Cross-border regulations aimed at moving bilateral, over-the-counter (OTC) swaps onto exchange-like venues and through central clearing have created additional concerns over the risk that also will move into the heart of a wider market ecosystem. Recent moves in the market, however, underscore the tangible steps that have been made to quantify and manage this risk within the new system.

The International Organization of Securities Commissions (IOSCO) this past week published a paper giving further guidance on recovery plans for what it calls market financial infrastructures – essentially, the central counterparties (CCPs) that clear the new, wider universe of contracts. This issue is important, as the systemic risk now removed from the bilateral world becomes concentrated in the fewer, regulated entities that have the blessing of the regulators.

Meanwhile, clearinghouses, and their Future Commission Merchants (FCMs) intermediaries, have increasingly moved to a more transparent and standardized model now that the smoke has cleared on regulatory implementation. Last week, the CME announced that its clearing operation would start next year charging a new fee schedule for a wider array of fixed income assets posted as collateral starting (as well as paying interest on cash).

This aligns with TABB Group’s view that there is growing consensus among the FCMs in the types of fees they charge. A TABB report published this month, “OTC FCM Business 2014: Momentum Stalls and Challenges Emerge,” concludes that the standard fee structure has moved from straight transaction and maintenance fees to incorporating additional margin requirements for OTC contracts (54% of those FCMs interviewed had adopted some form of this fee). When asked whether they expected major new types of fees to emerge, the majority did not think so.

All of this is positive for market certainty. A key point in the IOSCO report is that the tools used for recovery (essentially, to cover a member default or major loss scenario) should be transparent to all and that the incentives for all should be aligned to reduce unnecessary risk taking. That means a new race to the bottom on fees is unlikely. The major battleground will be the margin benefits and portfolio offsets offered by CCPs and approved by regulators. These can still be a major differentiator among clearinghouses, and the FCMs can and do offer analytics that allow clients to better understand the difference in treatment among firms.

Unfortunately, resources and bandwidth at regulatory bodies tasked with oversight of this process are under pressure. In addition, the original Dodd-Frank implementation teams are starting to move on. Earlier in the week, the CFTC’s Ananda Radhakrishnan decided to move on, to be replaced as director of clearing and risk by Phyllis Dietz. The internal move is a temporary one, but the post will be critical, as cross border agreement deadlines with Europe loom at the end of the year. The temporary relief and coordination with European entities has been a sticking point for the past year, and it can only be hoped that momentum and agreement can help stabilize swaps trading as the new clearing paradigm is effectively extended across the regions.

Ultimately, all of this activity points to a more comfortable and confident market than we have seen for three years. Rules and trading conventions have been established and the push and pull between global regulators and market participants is reaching a more constructive level. The next step will be to ensure that any cross border agreement comes within a framework that is truly equivalent, without moving from a fragmented market to a skewed one.

Timothy Massad, the new chairman of the CFTC, said as much in a speech on Oct. 16, pointing out that a delay in higher capital charges from the European regulators had helped harmonization efforts. “I am pleased that European Commission has decided to postpone the imposition of higher capital charges on European banks participating in our markets,” Massad said. “It was this threat of higher capital charges that was going to fragment the market, not the existence of dual registration, which has actually been the foundation for the growth of the global market.”