Just three years ago the G20 leaders agreed upon a common course to regulate the financial markets, with focus on standardising OTC derivatives. In that time regulators have created the largest reform packages since the dawn of modern financial history including Dodd-Frank and the European Market Infrastructure Regulation (EMIR).
But are market participants prepared to cope with the consequences of these regulatory behemoths? With regards to OTC derivatives, under the new rules, these are supposed to be traded electronically and cleared centrally – provided they are ‘standardised’. Let’s look at two corresponding aspects of the G20 clearing mandate: the term ‘standardised’ and the instruments that are deemed to be clearable.
Standardisation
The G20 mandate speaks of ‘standardised OTC derivatives’ that should be centrally cleared. But what and who defines ‘standardisation’? There is now an understanding that this will be decided by the relevant regulatory body – but in close coordination with the clearing house(s). This results in two approaches. The bottom-up approach is where a clearing house approaches a regulator with a product which is then mandated for central clearing. A top-down approach sees the regulator with the power to identify OTC derivative contracts for clearing irrespective of whether a clearing house can actually clear them. The top-down approach makes some market participants squirm as many questions are unanswered, raising the level of insecurity.
Instruments
Instrument-wise there is also uncertainty around what is going to be clearable from the start and even more importantly, what will be clearable in the mid- to long-term future. For now, there is a common understanding in the derivatives market that single name and index credit default swaps (CDS) as well as single-currency interest rate swaps (IRS), will be immediately clearable, as clearing houses offer this service already today. Currently not eligible for clearing for example are IRS that are denominated in less common currencies, have two currencies (e.g. cross-currency swaps) or possess an optionality in the contract (e.g. a break clause).
Clearing regulation is fraught with complexity but market participants now have certain guidelines on which to base their clearing strategy. However, there is a strong case for each financial institution (FI) to establish a standing clearing working group (involving ALL affected business units front-to-finance) that is up to speed with the latest developments on regulation, clearing houses and market initiatives. FIs should also ensure that they are engaged with their respective representative industry bodies in order to prepare adequately for the future.
Stay tuned for the next part of this OTC clearing blog series which will look at regulatory complexity and the alignment of exemptions.
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