ISDA publishes a paper on Non-Cleared Swaps: rumors of its demise are greatly exaggerated

On March 12th ISDA released a paper “Non-Cleared OTC Derivatives: Their Importance to the Global Economy”. It is worth a look.

ISDA seems to be trying to make sure that non-cleared swaps don’t get the reputation as the black sheep of the derivatives world. It is easy to see how that could happen. Regulators have blamed the web of complex, non-standardized bilateral trades for much of the financial crisis. The recent IOSCO/BCBS paper on initial margin (IM) for non-cleared swaps recommended considerably higher IM levels (vs. cleared or, for that matter, swap futures). This is driven by the time horizon used in the VaR model: non-cleared @ 10 days, cleared swaps @ 5 days, and swap futures @ 1 day. It’s a big difference. We wrote about this on Feb. 19th in “BCBS and IOSCO clarify non-cleared derivatives margin rules and allow broader collateral eligibility – the cake is almost baked”. A link to the IOSCO/BCBS paper is here.

Conventional wisdom is that non-cleared swaps will become much more expensive due to higher IM and capital costs. But rumors of its death are premature.

The paper did an excellent job of describing the kinds of deals that won’t be cleared. They quoted figures from an IMF study which said “…25% of the interest rate derivatives market, 33% of the credit default swaps market, and significant percentages of other types of OTC derivatives will remain non-cleared…”

ISDA expects the following types of deals to remain non-cleared:

  • Interest rate swaptions
  • Interest rate options
  • Cross currency swaps
  • Inflation swaps
  • Single-name CDS
  • Various equity and commodity swaps
  • Illiquid (and hence difficult to price) sectors of otherwise clearable OTC swaps
  • Transactions involving exempt end-users including sovereigns, central banks, corporations, and other exempt entities

Many think non-cleared swaps fall into that bucket simply because they are too complex to price in CCPs. But that doesn’t tell the full story. Some trades are box-standard, but are in illiquid parts of the market where prices are not widely available. But is this a difference without a distinction?

ISDA brought up the now familiar argument: If users find the markets have become too expensive, they may be forced into hedging instruments which may not exactly match their needs, creating basis risk or forego hedging altogether – adding risk to the system. But is ISDA suggesting non-cleared trades have lower IMs and smaller capital charges? The G20 would probably hope the non-cleared world simply atrophies away (although if trades with sovereigns remain non-cleared they might want to be careful what they wish for) but that is not likely anytime soon.

A link to the ISDA paper is here.

A link to the IMF paper is here.

A link to the ISOCO/BCBS paper is here.

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