Non-cleared v Cleared Derivatives: What does the future hold?

The financial crisis of 2008 brought to the fore the pitfalls of over-the-counter (OTC) derivatives, exposing the vulnerability of the financial system. The fall of Lehman Brothers and the near-collapse of AIG[1] showcased the pitfalls of OTC derivatives trading and prompted the G20 leaders to enact significant reforms to mitigate the inherent risks associated with them. These reforms included a push for all standardized OTC derivatives to be cleared through Central Counterparties (CCPs) and for increased regulation of non-centrally cleared derivatives.

 

Subsequently, in 2011 the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organisation of Securities Commission (IOSCO), at the request of the G20, formed the Working Group on Margin Requirements (WGMR). Its purpose was to propose new margining requirements for non-centrally cleared derivatives to better align them with their cleared counterparts.

 

Over-The-Counter (OTC) Derivatives

To understand the significance of these requirements, it is necessary to reflect on the state of OTC derivatives preceding their implementation. Generally a derivative is a contract which derives its value from the performance of an underlying asset. Subsequently, OTC derivatives are securities that are traded directly between two parties as opposed to a trade on an exchange. These can be further broken down into two categories: Cleared OTC derivatives and bilateral or (non-cleared) OTC derivatives. But what distinguishes them and which is superior?

 

Non-cleared trades are agreed bilaterally between a buyer and a seller with the contract typically taking the form of an ISDA Master Agreement. In this instance, both parties typically bear the counterparty risk (i.e. that the other party will default on a payment). In contrast, cleared trades involve the imposition of a central counterparty. A third party, that interposes itself between the two parties to the trade, acting as counterparty to each original party. As is demonstrated by the diagram below, Party B ceases to be Party A’s counterparty and Party A ceases to be Party B’s counterparty. The CCP becomes the counterparty of both Party A and Party B. The effect of this is to transfer to the CCP the counterparty risk held by each party to the trade.

Bilateral (Non-cleared) vs Cleared

The recent financial crisis emphasised the precariousness of non-cleared OTC trades, particularly with Lehman Brothers and AIG defaulting on their many OTC derivative contracts; this caused severe repercussions and exposed the fragility of the financial system. At the end of June 2016, the Bank for International Settlements (BIS) reported that the cost of closing out all outstanding OTC derivatives positions in the international market was estimated to be around US $21 trillion.[2] With Global GDP estimated to be US $75 trillion, the potential implications for the financial system are staggering.

 

As non-cleared OTC trades are negotiated bilaterally between parties, they lack the market uniformity and relative transparency attributed to cleared OTC derivatives. The absence of comprehensive regulation allows for more complex trading, often at lower collateral requirements for parties. This however, comes with higher counterparty risk and relies on bespoke operational approaches that vary from party to party. Unsurprisingly, with so much left to the discretion of the counterparties, new comprehensive regulation was unavoidable.

 

[1] AIG was bailed out by the U.S Government to the sum of $85 billion in exchange for 80% of the firm’s equity.

[2] ‘OTC derivative statistics at end-June 2016’ (BIS, November 2016) < http://www.bis.org/publ/otc_hy1611.pdf> accessed 12 May, 2017

Since this crisis there has been a large push towards clearing through CCPs. To date, cleared OTC derivatives trading, as opposed to bilateral, non-cleared trading has been predominantly more regulated. Article 4 of the European Market Infrastructure Regulation (EMIR) brought in the requirement that all standardised derivatives must be cleared subject to a phase-in schedule which started in June 2016.

There are many benefits of central clearing. Predominantly, the imposition of a CCP substantially mitigates counterparty risk. CCPs are typically shareholder- owned entities and as such they impose generally conservative risk management practices to further protect against substantial losses (e.g. pragmatic collateral valuation, trade netting and daily posting of collateral).[1] Furthermore, with centralised trades reporting, they can provide the post trade transparency that is ultimately deficient in the generally opaque non-cleared OTC derivatives market.[2]

 

Although clearing has come to prominence in certain derivative products (e.g. interest rate derivatives), significant quantities are still traded bilaterally on a non-cleared OTC basis. There are many reasons for this, the most predominant of which is the complex nature of some which prevents them from being cleared. Often the complexity of these products is generally one step ahead of regulation.[3] As such, bilateral, non-cleared contracts gain the upper hand, allowing counterparties the freedom and creativity to trade in complex derivatives. This is particularly prevalent in instances whereby the complex bespoke commercial risks faced by a party could not be hedged otherwise. Additionally, the concentration of risk in these CCPs is a potentially overlooked liability; an oversight that is eerily reminiscent of the ‘too big to fail’ analogy attributed to banks prior to 2008. Furthermore, the high exposure calculations for CCPs are often dissuasive for counterparties contemplating cleared approaches.

 

Unsurprisingly, bilateral, non-cleared derivatives will not be disappearing anytime soon as central clearing is not proficient enough to comprise absolutely every derivative classification; inevitably, new margining requirements have emerged to advance the regulatory environment for non-cleared derivatives.

 

[1] 1 OTC-Cleared Derivatives: Benefits, Costs, and Implications of the “Dodd-Frank Wall Street Reform and Consumer Protection Act”’ Journal of Applied Finance – Issue 2, 2010, 24

[2] ‘What’s a clearinghouse?’(The Economist, April 2010) <http://www.economist.com/blogs/freeexchange/2010/04/derivatives> accessed 12 April 2017

[3] Kane, E. J., 1988, “Interaction of Financial and Regulatory Innovation,” American Economic Review Vol. 78 (No. 2), 328-334. Citied in Culp, C. L., 2010 ‘1 OTC-Cleared Derivatives: Benefits, Costs, and Implications of the “Dodd-Frank Wall Street Reform and Consumer Protection Act”’ Journal of Applied Finance – Issue 2, 2010, 24

New Margin Requirements for non-cleared derivatives

The new Uncleared Margin Requirements (UMR) for non-cleared OTC derivatives came into force through Title VII of the Dodd-Frank Act for the United States and article 11 of EMIR for the European Union. The requirements endeavour to introduce the necessary protocols for more secure bilateral trading. Among the many requirements, they necessitate the exchange of Initial margin (IM) and variation margin (VM) and provide protocols for greater uniformity in their calculation. Both EMIR and Dodd Frank place rules on the kind of collateral that can be used to post margin in a trade. They also stipulate maximum valuation percentages that can be attributed to eligible forms of collateral; this is to ensure that the collateral will be able to withstand market turmoil as much as possible. The requirements also specify that these will be phased in over an appropriate time period depending on the entity types involved. (See the phase in dates for EMIR below)

[3] 1 OTC-Cleared Derivatives: Benefits, Costs, and Implications of the “Dodd-Frank Wall Street Reform and Consumer Protection Act”’ Journal of Applied Finance – Issue 2, 2010, 24

[4] ‘What’s a clearinghouse?’(The Economist, April 2010) <http://www.economist.com/blogs/freeexchange/2010/04/derivatives> accessed 12 April 2017

[5] Kane, E. J., 1988, “Interaction of Financial and Regulatory Innovation,” American Economic Review Vol. 78 (No. 2), 328-334. Citied in Culp, C. L., 2010 ‘1 OTC-Cleared Derivatives: Benefits, Costs, and Implications of the “Dodd-Frank Wall Street Reform and Consumer Protection Act”’ Journal of Applied Finance – Issue 2, 2010, 24

‘Margin requirements for uncleared derivatives’ (FCA, 6th February 2017) <www.fca.org.uk/markets/emir/margin-requirements-uncleared-derivatives>

 

The new regulations not only reduce the counterparty risk inherent in non-cleared OTC derivatives, but additionally they render it less appealing to financial entities due to the imposition of stricter margining requirements and operational procedures. This in turn provides a greater incentive for central clearing. It also provides greater uniformity in the OTC derivative market, with bilateral trading now more consistent with its cleared counterpart.

 

Furthermore, the implementation of these regulatory initiatives has caused considerable strain on financial institutions, despite several delays in the phase-in dates of VM for EMIR. For many market participants this has meant remediating thousands of collateral agreements to make them compliant with UMR standard. The cost of amending these agreements has been substantial, severely impacting counterparties; in many instances business as usual trading has had to be suspended while these agreements are remediated. Nevertheless, given the size of the non-cleared derivatives market and the risks attributed to it, the imposition of new comprehensive regulation was ultimately inevitable.

 

In conclusion, it is still very early to determine the lasting effect of these regulations. Nonetheless, it is perceptible that the dichotomy between non-cleared and cleared OTC derivatives, which poses a significant threat to the financial system, has now been addressed to some extent. The new rules have provided a significant incentive for parties to utilise clearing, with central clearing making significant inroads into the OTC derivatives markets.[6] Furthermore, in instances where derivatives products cannot be cleared, significant advancements have been made to protect against the adverse risks associated with non-cleared trades. Ultimately, it is the combined effort of both clearing and more stringent regulations for bilateral trading that is necessary to protect the otherwise vulnerable financial system against the risks associated with OTC derivatives.

 

[6] ‘OTC derivative statistics at end-June 2016’ (BIS, November 2016) < http://www.bis.org/publ/otc_hy1611.pdf> accessed 12 May, 2017

Fabian Doherty

Fabian joined FinTrU in 2015 through our second Financial Services Academy. He has since worked as part of the Legal Services team alongside the Bank Resource Management team of a Tier-1 investment bank.

 

Fabian graduated from Queen's University Belfast with an LLB (Honours) in Law.  Fabian subsequently came on board to further expand his knowledge of law in the financial services industry.

 

As part of the Legal Services team, Fabian negotiates OTC derivatives documentation on behalf of his client. He has experience with ISDAs, CSAs and CDEAs and has recently worked on a remediation project brought about by the new uncleared margin regime (UMR) rules. Fabian keeps up to date with financial services regulation and applies his knowledge in a professional and client-focused manner.

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