The Migration Towards Central Clearing

Regulations following the global financial crisis established central clearing as an important focus to reduce global systemic risk.  However, each major financial center around the world has taken a slightly different approach to implementation.  In a recent report from the Bank of England’s Financial Market Infrastructure Directorate entitled Over-the-Counter (OTC) Derivatives, Central Clearing and Financial Stability, Arshadur Rahman , from the Bank’s Financial Market Structure Infrastructure Directorate, outlines the current state of play and hurdles ahead on the road to central clearing in Europe.  

Following are some highlights from his research.

Progress made

The European Union (E.U.) currently lags behind Japan, which first made central clearing effective on November 1, 2012, and the United States, whose mandate was effective on March 11, 2013. Europe is set to begin implementation of its clearing obligation for interest rate swaps (IRS) in 2016.

What will be cleared?

Regulators in different jurisdictions have focused on five different contracts when considering the clearing obligation: IRS, basis swaps, forward rate agreements (FRAs), overnight index swaps (OIS), and credit default swap (CDS) index contracts.

The characteristics used for selecting what classes of OTC derivatives should be cleared on central counterparties (CCPs) are their degree of standardization, volume, and liquidity as well as fair and accurate pricing information.

What will support and what will hurt the movement towards central clearing?

Although central clearing is expected to increase in the future, not all contracts will transition to the world of central clearing seamlessly.

One major factor limiting the full scale transition to central clearing is liquidity. Specifically, the report describes market concentration – “whether there are a sufficient number of active market participants to enable a CCP to exit a derivatives position inherited from a defaulting clearing member” – as an important part of derivatives market liquidity. 

Another serious concern is the overall availability of clearing. Economies of scale in the delivery of clearing services leads to a small number of CCPs. Likewise, there is a relatively small number of clearing members for these CCPs, and even fewer that offer client clearing, an issue that could hamper accessibility and create a build-up of risk within the CCPs themselves.

In addition, not all derivatives are appropriate for clearing. Contracts that fall outside of the clearing mandate will be subject to new bilateral margin requirements. In some jurisdictions, including most that fall under the authority of the Bank of England’s Financial Stability Board (FSB), derivatives that are not centrally cleared will face higher capital requirements, which could impact liquidity.

How the clearing mandate is implemented across national boundaries will likewise factor into adoption, as  a considerable portion of OTC derivatives activity occurs outside the home jurisdiction of the CCP clearing for a market where at least one overseas participant is involved.

Current market conditions

Currently, basic, or “plain vanilla,” IRS contracts are the most clearable types of derivatives and the most frequently cleared. Specifically, for the U.S, $90 trillion of IRS contracts, or 50 percent, are cleared, and that number continues to grow (see chart below):

da comm migration resized 600

In addition, these charts indicate that OIS, basis swaps and FRAs have considerable potential for central clearing, as do a large portion of CDS index contracts for both U.S. and European corporations. Single-name CDS also have potential, but there are possible liquidity limitations for these contracts, which could inhibit their clearing prospects. 

To read the report in full, including a discussion of risk management practices for systemically important CCPs and how to ensure resiliency, click here.