From the moment the mandate was passed down, the debate over who should decide what can and can’t be cleared raged. On the one hand, regulators are keen to ensure that the market does not obfuscate contracts in order to exempt them from central clearing, however there are concerns over how a regulator can force a clearing house to clear a product without assuming some responsibility for the viability of that clearing house.
WMBA chairman David Clark outlines the problem: “One of the key questions is should or how can the regulators play God on what can and can’t be cleared? From a European perspective, it might be suitable to clear a product in one country and not in another.
“We don’t know how that is going to work but the working assumption is that Esma lays down guidelines to the national supervisors who look within the context of what guidelines have set out and decide what can and can’t be cleared. So we could have a situation where regulators disagree on what can and can’t be cleared. A market that is more liquid might be able to clear a product, while a less liquid market might not be.”
The most comprehensive review of this question has been compiled by the International Organisation of Securities Commissions, which published its Requirements for Mandatory Clearing report in February 2012 and the study has been the foundation of much of the Dodd-Frank and Emir text.
IOSCO sets out two models: a bottom-up approach whereby a CCP approaches a regulator with a product that it wants to clear and that product is then mandated for central clearing, and a top-down approach whereby the regulator has the power to identify OTC derivative contracts for clearing irrespective of whether a CCP has proposed to clear them.
A top down approach is fraught with complexities. On an operational level, CCPs will have to be comfortable clearing a product if it is not to undermine their risk management processes. What happens if a regulator mandates a product for clearing that no CCP is willing to clear?
And then there are issues with the binary nature of such an approach. If a contract becomes standardised over time, at what stage does a local authority mandate that product for clearing and conversely, if a product becomes less liquid, when is a decision taken to remove that instrument from the clearing mandate?
The G20 made the pledge that all standardised contracts should be cleared through central clearing but it is by no means clear what constitutes a standardised contract.
Clark says: “It is the sheer practicalities of the mandate. Take for example one year interest rate swaps, the bulk of which are already cleared. Getting a one year interest swap into clearing is easy and cheap and it saved the world in 2008 when LCH managed to clear up most of the unmatched risk created in the Lehman default.
“But what about Malaysian one year ringgit swaps? They aren’t standardised. What is the cost of margining them? Who is going to clear them? It becomes impossible to implement this mandate across the board. The regions won’t compete but trying to lay down the laws that apply globally is exceptionally difficult.”
There are some radical views. John Hull, Maple financial professor of derivatives and risk management at the Joseph L Rotman School of Management at the University of Toronto, argues that the key requirement for clearing a transaction centrally “is that it be possible to value the transaction daily for the purposes of calculating daily variation margins”.
However, this argument fails to account for the requirement for liquidity in a product in times of market stress so as not to expose the CCP to undue liquidity risk. IOSCO sets out three criteria on which a decision to mandate clearing should be based: the degree of standardisation of a product’s contractual terms and operational processes; the nature, depth and liquidity of the market for the product in question; and the availability of fair, reliable and generally accepted pricing sources.
These have been adopted in both the US and Europe and for the time being, legislation on both sides of the Atlantic is pursuing both a top-down and bottom-up approach with CCPs applying to clearing a product and regulators mandating product groups for central clearing.
It is clear that a top-down approach is unworkable. CCPs must have the power to decide what they can and can’t clear. A bottom-up model would encourage innovation by CCPs to clear contracts and overcome many of the challenges of who decides what is acceptable for clearing. CCPs will be incentivised to develop clearing models for as many products as possible and they will be required to do so in consultation with, and following demand from, the market.
Next week, we will look at how many clearing houses there will be in the new world order and how they should compete.
READ PART I HERE:
OTC clearing: Does the market need a mandate at all?