The New Europe
24 May 2010
One of the major pillars of the regulatory and political response to the financial crisis has been the push to central counterparty clearing of over-the-counter derivatives.
This policy, on which authorities around the world have developed a high-level
consensus (although with differences of detail), has a number of different objectives:
To prevent a ‘domino effect’ resulting from the default of a major sell-side firm causing others also to default;
To increase transparency of positions and exposures to regulators and potentially, in a sanitised form, to the general public;
To mitigate the credit exposure of buy-side clients to their clearing brokers.
On the third item, a key point is that traditional CCP clearing as it evolved in the listed derivatives markets does not necessarily protect a client against their clearer’s insolvency. The extent to which it does this at all is a function of the rules of the clearing house, its jurisdiction, and the jurisdiction of the clearing member amongst other factors - the variance between different offerings and the degree of legal complexity can be considerable.
From an early stage in the development of post-crisis policy around CCP clearing in OTC markets it has been clear that closing this gap is on the to-do list and there has been a great deal of work to develop approaches to this. Significant examples are the client clearing extension to LCH. Clearnet’s established SwapClear service for IRS and also the ICE Trust and CME offerings for CDS products.
The pace of this work, leapfrogging stages of development that might have taken years, has been very rapid. However large scale uptake has not yet begun, and actually incorporating new structures and workflows into the business models of buy-side participants will require sustained effort. Navigating this transition period
will be a challenge for asset managers and other buy-side participants, as there is still a level of uncertainty about how this process will play out, but some observations can be made:
It seems likely that, with the possible exception of non-financial end users, buy-side participants will be obliged by regulators to move progressively into OTC clearing, and other distinct but related infrastructure linkages (e.g. use of trade repositories)
There are very real advantages to OTC clearing for the buy-side: most obviously dramatically reduced counterparty risk but also operational risk reduction and transparency. However it is unlikely that these benefits will positively and discernibly impact the bottom line in the near term.
There are also real costs, and these will come through more quickly and visibly than the benefits – costs of implementation work and increased operational establishment will be felt immediately and it is likely that increased commitments of collateral and possibly additional cost in fees will follow
Despite rapid progress, the end-to-end process specifics of how buy-side clearing will work are not yet fully developed or consistent across the major OTC asset classes.
Given these points, the decision for asset managers is fairly clear: do I want to be a trailblazer, or run with the pack? And what would be the costs to being a straggler?
Which of these is the best option will vary for different players; for example pension funds, traditional asset managers, large hedge funds and small hedge funds should all emphasise different criteria. But with a clear movement towards change, the ‘ostrich strategy’ however would probably be a poor one!
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