OTC Derivatives Clearing: Central Counterparties …pifs.law.harvard.edu/wp-content/uploads/2016/03/Harvard-Symposium...Basel Committee on Banking Supervision (2011), “Basel III:

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Cristiano Zazzara, Ph.D.

Managing Director, Global Risk Services, S&P Global Market Intelligence [email protected]

OTC Derivatives Clearing:

Central Counterparties (CCPs) And Capital Requirements

Session on “Divergence between U.S. and E.U. Regulations (focus on CCPs, Capital),

SYMPOSIUM ON BUILDING THE FINANCIAL SYSTEM OF THE 21ST CENTURY:

AN AGENDA FOR EUROPE AND THE UNITED STATES

Armonk, New York

April 9, 2016

2 Permission to reprint or distribute any content from this presentation requires the prior written approval of S&P Global Market Intelligence. Not for distribution to the public.

Agenda

• PART I – OTC Derivatives and Central Clearing

– The New OTC Derivatives Landscape

– Sizing up the OTC Derivatives Market

– Central Clearing: Mandatory OTC Clearing Roll-Out

• PART II – Issues on Central Counterparties (CCPs) and Capital

– Mandatory OTC Clearing in Europe and U.S.

– Central Counterparties: Risk, Capital and Supervision

– The Default Risk Protection System of a Clearing House

• Further Reading


OTC Derivatives And Central Clearing


The New OTC Derivatives Landscape

• Primary legislations and regulatory bodies

– U.S., Dodd-Frank: CFTC (Commodity Futures Trading Commission) and SEC (Securities

Exchange Commission)

– Europe, EMIR: ESMA (European Securities and Markets Authority) and EBA (European

Banking Authority)

– Asia, Local Legislations: Domestic regulators

• Key requirements of the reform

– Transparency: Mandatory reporting to Trade repositories (Centralized Databases)

– Central Clearing: Central Counterparties (CCPs) for standardized OTCs

– “Electronification”: Standardized OTC products to be traded on Exchanges or

Electronic Platforms

– Margins and Capital requirements for Uncleared trades: Bespoke OTC products subject to

minimum Margining and higher Capital Requirements (per Basel III)


• Largest Product Segments:

– Interest Rates

– FX

– Credit Derivatives

• Reform kicks in for new Trades

– Back loading of old trades not

mandatory for Central Clearing

Source: BIS, “OTC Derivatives Statistics”(March 2016). Data as of 30 June 2015.

Sizing Up The OTC Derivatives Market

• This is a Market of around $553 Trillion of Notional Outstanding

• Almost nine times higher than that of the Exchange-Traded Derivatives

(around $63 Trillion)

Notional Amount Outstanding

USD Trillions Percentage

Interest Rates $434.7 78.6%

FX $74.5 13.4%

Credit Derivatives $14.6 2.6%

Equity $7.5 1.3%

Commodities $1.7 0.3%

Unallocated $19.8 3.6%

TOTAL $ 552.8


Central Clearing: Mandatory OTC Clearing Roll-Out

• Mandatory clearing introduced in the U.S. for Interest Rate Swaps (IRS) and certain

Credit Default Swaps (CDS) indices, as follows:

– 11 March 2013: Swap Dealers, Major Swap Participants, and Private Client Funds

– 10 June 2013: Asset Managers

– 9 September 2013: Pension Funds

• European Clearing Mandate taking effect on June 21, 2016 (phased approach)

• Implemented in Japan, Korea and India

– Rest of Asia… to be determined

• Central Clearing (via Central Counterparties, CCPs) requires for all counterparties in a

trade to post Margin (i.e., Collateral in the form of cash or securities). CCPs apply Portfolio

Risk and Pricing Models to calculate Initial and Variation Margins

• According to the Financial Stability Board (November 2015), almost 79% of Interest Rate

Derivatives (compared to 56% currently) and 51% of Credit Derivatives products

(compared to 19% currently) could be potentially centrally cleared, with obvious

implications in terms of transparency and liquidity for the entire OTC Derivatives Market


Issues On Central Counterparties (CCPs) And Capital


Mandatory OTC Clearing in Europe and U.S.

• CCPs are going to manage more risk from now on due to the

Clearing Mandate

– New products

– New entities (buy-side and non-financial firms)

• OTC Derivatives Clearing is very different from Cash and Exchange-Traded

Derivatives Clearing

– Market liquidity plays a key role in pricing, measuring and managing the risk of

OTC Derivatives

– OTC Derivatives Market is large in terms of notional and average deal size, but doesn’t

trade that often

– Based on evidence (as of July 2012) from ISDA and TABB group, Credit and Interest Rate

Derivatives trade around 3.45 and 6.8 times a minute respectively, against 4,300 contracts

a minute for Interest Rate Futures, and 77,000 per minute for U.S. equities

• Are CCPs Risk Managers of Insurers?


Central Counterparties: Risk, Capital And Supervision

• Central Counterparties viewed as Systematically Important Financial

Institutions

– Defaults are unlikely events, but when they occur they are usually not independent; under

stressed scenarios, risks are interconnected

• How CCPs manage risk and defaults?

– Total Loss-Absorbing Capacity: the “Default Waterfall”

• Capital Calls for CCPs from Clearing Members and Buy-Side Institutions

– What’s the Regulators’ view?

– Should CCPs be allowed to fail?

• Cross-Border Supervision of CCPs: E.U. vs. U.S. (March 2016)

– ESMA and CFTC just agreed on a “Substituted Compliance” Framework: U.S. CCPs can

operate in E.U. and vice versa

– Several issues still to be worked out, but Regulatory convergence between E.U. and U.S.

is taking place


The Default Risk Protection System Of A Clearing House

Default Waterfall Contributed by Regulatory Framework

- Initial Margin Clearing Members Dodd-Frank/EMIR

- Variation Margin Clearing Members Dodd-Frank/EMIR

- Clearing Member's Default Fund Clearing Members Basel 3

- CCP's Own Capital CCP Dodd-Frank/EMIR

Source: Our elaborations on EMIR (2012, 2013) and Basel Committee on Banking Supervision (2011).

Typically a CCP has three levels of defence against defaulting members:

• Firstly, there are the Margins (Initial and Variation) posted by Clearing Members against

their positions

• If the Margins are not sufficient, the next layer of defence is the Default Fund contributed by

Clearing Members

• After that, the last level of defence is the CCP’s own Capital, the so-called “Skin-in-the game”

amount

If the CCP’s Capital also proved to be insufficient, the CCP would default and the Clearing

members would need to mutualize the losses


Further Reading

Basel Committee on Banking Supervision (2011), “Basel III: A Global Regulatory Framework for more

resilient Banks and Banking Systems”, June (www.bis.org).

EMIR (2012), “Regulation (E.U.) No 648/2012 of the European Parliament and the Council of the European

Union on OTC Derivatives, Central Counterparties and Trade Repositories”, July.

EMIR (2013), “Supplementing Regulation (E.U.) No 648/2012 of the European Parliament and of the Council

with regard to regulatory technical standards on requirements for central counterparties”, February.

Financial Stability Board (2015), “OTC Derivatives Market Reforms. Tenth Progress Report on

Implementation”, November (www.financialstabilityboard.org).

ISDA (2013), “CDS Market Summary: Market Risk Transaction Activity”, October (www.isda.org).

S&P Global Market Intelligence (2015), “Understanding the New OTC Derivatives Landscape. OTC

Derivatives Reform: Market Insight”, authored by Cristiano Zazzara, March (www.spcapitaliq.com).

TABB Group (2012), “The New Global Risk Transfer Market: Transformation and the Status Quo”, September

(www.tabbgroup.com).

11

http://www.bis.org/

http://www.financialstabilityboard.org/

http://www.isda.org/

http://www.spcapitaliq.com/

http://www.tabbgroup.com/

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