CCP interoperability will not resolve fragmentation in the OTC markets, say panelists at ISDA Europe conference in London

By Nick Sawyer, published September 20, 2011, Risk Magazine online

Interoperability between central counterparties (CCPs) in the over-the-counter derivatives market is not a realistic prospect in the near term, according to a panel of clearing experts, speaking at an industry conference this morning. Their comments will disappoint some regulators, who had hoped CCP interoperability might help mitigate the impact of multiple, domestic clearing houses being established in individual jurisdictions.

A number of regulators, including those in Australia, Japan and Hong Kong, have already expressed a preference for a domestic CCP to ensure their banks can access clearing services directly, as well as ensure local supervisors maintain oversight of derivatives activity in their own currency.

More recently, a policy paper by the European Central Bank in July stated that any CCP clearing euro-denominated contracts should be legally incorporated in the eurozone – a proposal that if copied by others would fracture the operations of global CCPs clearing multiple currencies.

This policy is the subject of a legal challenge by the UK Treasury, which claims the ECB proposal contravenes the principles of the European single market. But there are other, broader concerns. Any requirement that local banks should clear through a domestic clearing house, or stipulation that CCPs have to be legally incorporated in a particular country in order to clear that currency, would lead to the fragmentation of derivatives markets, participants claim. In other words, global derivatives users would be forced to split their trades among multiple CCPs, reducing netting efficiency and increasing costs.

“If we get too many small, localised CCPs springing up, it will undoubtedly increase costs and there will be all manner of inefficiencies, not just on members, but on the clients of members. Perhaps most worryingly, it could increase the risk, because in the event of default, you are unlikely to see harmonisation and cooperation among very disparate CCPs operating under very different regulatory regimes,” said Michael Davie, chief executive of SwapClear, the interest rate swap clearing platform run by London-based LCH.Clearnet, speaking on a panel discussion on clearing at the International Swaps and Derivatives Association Europe conference in London.

One proposed solution is for the various clearing houses to become interoperable – essentially, allowing each of the two counterparties to use whichever CCP gives them the greatest margin efficiency, and then have the two CCPs face each other. However, this solution is some way from becoming a reality, clearing houses say.

“I have children, and whenever they encounter a problem at home or school, they usually invent a word to describe it – a safe and cuddly word that isolates the problem and makes it more comfortable,” said Davie. “For me, that is interoperability. Obviously, it does mean something and it exits, but if anyone thinks interoperability is the salvation in the near term for OTC markets, I think they are crackers.”

Other participants agreed, noting that while CCP interoperability now exists in the cash equities market, it will be much harder to achieve in the OTC space. One hurdle is the different margin standards and default fund requirements used by individual clearing houses, meaning it would be difficult to calculate the exposures between two entities. Even if a best guess were made, the exposures between CCPs would then need to be collateralised – which may not be straightforward.

“Clearing houses only have access to two forms of collateral – one is the client collateral, and the other is the funds that are put in by the participants to secure the default risk beyond the initial margin they hold,” explained Paul Swann, president and chief operating officer at Ice Clear Europe in London. “Do we really want to introduce a new form of interconnectivity into the financial system when we have spent the past three years trying to remove it?”

Another concern was that interoperability between CCPs would mean clearing members and clients might be exposed to entities they may specifically have chosen to avoid, possibly due to concerns about risk management practices.

“I choose a CCP because I understand that system and I think it works, but I have no visibility on that second CCP, or perhaps I even chose not to go there. But suddenly, trades come in the back door, and it could create a very dangerous risk,” said Athanassios Diplas, global head of systemic risk management group at Deutsche Bank in New York.

Not everyone was entirely pessimistic. Kim Taylor, president of CME Clearing at CME Group in Chicago, argued that interoperability could work, so long as the appropriate risk management procedures are in place – but agreed it would be difficult to achieve in OTC markets.

“Connections between clearing houses can work, but they need to be done in such a way that they make economic sense, and they have to be able to make risk management sense so the clearing houses are not unduly exposed to each other and there are protections in place that mitigate the interconnectivity risk. But this is easier to do in a listed derivatives world than in an OTC world, at least at the moment,” she said.

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