OTC clearing: a post-crisis panacea?
Soon after Lehman Brothers collapsed in September 2008, several Asia-Pacific jurisdictions pledged at the G20 2009 Pittsburgh Summit to bring over-the-counter derivative transactions onto a central clearing and reporting platform by the end of 2012.
G20 finance ministers and central banks view the mandatory central clearing, trading and reporting of OTC transactions as a solution to the risks brought on by structural deficiencies and opaqueness of the OTC universe.
Five years on, however, some of those Asia-Pacific jurisdictions have missed the agreed deadline.
Hong Kong Exchanges & Clearing (HKEx), the city’s designated central clearing counterparty (CCP), has postponed its OTC clearing platform several times already this year, with the launch now expected in the fourth quarter. And the Australian Securities Exchange (ASX) only cleared its first OTC interest rate derivatives trade on September 12.
That said, Singapore Exchange (SGX) is believed to have been the first in Asia to launch an OTC clearing service – in November 2010.
While clearing via central counterparties has started gaining traction in Asia and elsewhere, concerns have arisen that the CCPs are another example of institutions that are too big to fail and will ultimately bring new challenges to the global financial system.
Feelings are certainly mixed among market participants. “Over the long term, I do not doubt that OTC clearing will bring greater pricing transparency and better secondary market liquidity on OTC swaps,” says a risk officer at a fund of hedge funds advisory firm.
“However, there are many complications before we can get there. For example, how are these CCPs managing margin and liquidity to the point that we [can be confident they] can mitigate credit default risks of a counterparty?”
Michael Syn, head of derivatives at SGX, admits it’s possible for CCPs to be engineered badly with regard to achieving to systemic risk reduction.
There is the issue that CCPs may not ultimately succeed in eliminating counterparty risks, but could merely shift the risks into these new institutions.
On top of that, the creation of too many CCPs – particularly in Asia, where each country is developing its own CCP – risks splitting liquidity. Ultimately, users of these CCPs would have to post collateral with each of these CCPs and jurisdictions at a time when collateral resources are already tight, due to regulations such as Basel III.
Hence, it is important that when trading counterparties are considering which CCP or jurisdiction to use, they take into account the price formation process for the OTC asset class they intend to clear, argues Syn.
Moreover, as each Asia-Pacific jurisdiction builds its own national CCP ‘champion’, rules look set to become increasingly complicated for institutions’ risk officers and operations managers.
Under Dodd-Frank, for example, if an Asian institution transacts a swap with a US counterparty, it must be cleared through a derivatives clearing organisation (DCO) regulated by the US Commodity Futures Trading Commission (CFTC). And if the Asian entity is in a jurisdiction where its clearing house has not been recognised as a DCO by the CFTC, the US counterparty may refuse to trade with them.
As if that were not enough, competition is set to rise among CCPs offering the same OTC instruments. For example, the SGX has started and HKEx will eventually offer clearing services on non-deliverable forwards in many Asian currencies, including renminbi.
Unsurprisingly, clearing providers remain bullish. Rohan Delilkhan, general manager of derivatives and OTC markets at ASX, expects OTC clearing volumes in Australia to increase towards the end of this year.
“ASX has seen strong demand for a local OTC clearing solution from buy-side institutions, including asset managers, superannuation funds and Australian state government treasuries,” Delikhan tells AsianInvestor.
ASX has received input from nine major Australian fund managers and state government treasuries worth a collective A$750 billion ($702 billion) in AUM and representing nearly 40% of the country’s assets under management.
These institutions want to be able to clear trades locally, with risk and collateral held onshore and subject to Australian laws and regulations, Delikhan says. He adds that often local investors prefer onshore clearing platforms as they are more familiar with local rules.
Asia’s OTC market – including instruments such as currency, commodity and interest rate derivatives; equity-linked notes; and credit-default swaps – stood at $42.6 trillion at the end of 2012.
Last year’s turnover totalled $186 trillion, with swaps dealers such as investment and commercial banks accounting for nearly half of that amount, with hedge funds, insurers, securities firms and other banks making up a quarter, according to research firm Celent.