The recent financial crisis, culminating in the insolvency of Lehman Brothers in 2008, highlighted risks within the over-the-counter (OTC) derivative markets, in particular in relation to counterparty credit risk and lack of transparency. Reforms initiated by the Group of 20 leading nations in September 2009 to push ‘standardised’ OTC derivatives into clearinghouses are now being implemented following the passing of the Dodd-Frank Act in the United States and the proposed European Union regulation on OTC derivatives, central counterparties and trade repositories.
In broad terms, the EU and US approaches share a great deal in common. However, the details for implementation, currently being worked on by regulators, will inevitably reveal significant and possibly conflicting differences, and many challenges will need to be overcome in the months and years ahead.This article focuses not on the proposals themselves, but on how central clearing works, and how a shift to central clearing will affect the buy side (or ‘end-users’).
Trading under ISDA master agreements
Most readers will be aware that, currently, an end-user wishing to enter into an OTC contract (meaning a derivative contract not traded on a derivatives exchange) will first select a potential dealer counterparty and negotiate and sign an ISDA Master Agreement with that counterparty. In addition, the parties may include a Credit Support Annex or other collateral agreement to collateralise positions, depending on their perception of credit risk against each other. Transactions executed between the parties are then governed by those arrangements. The key proposition is that these transactions are private contracts between two parties (see Fig.1).
How clearing changes this
In simple terms, the relationship between the end-user and the dealer will continue, but the dealer, in its capacity as a clearing member of the clearinghouse, will act as a ‘conduit’ or ‘clearing agent’ for the end-user. The relationship between the end-user and the clearing member will continue under a new customer agreement or modified ISDA Master Agreement, and the clearing member (and to a certain extent the end-user) will be subject to the clearinghouse rules (see Fig.2).
To take the analysis a step further, we can see how the clearing process places the clearinghouse in the middle of a trade, by a transfer (commonly referred to as a ‘give-up’ or ‘novation’) of each cleared trade to the clearinghouse (see Fig.3).
The clearinghouse now stands between the parties to a trade, effectively guaranteeing performance of each party’s obligations under that trade.
Agent or principal
Under current models for clearing OTC derivatives, the capacity in which the clearing member acts, as either agent or principal, determines the structure of the cleared trades. Where the clearing member acts as agent, the end-user will face the clearinghouse directly because, although the clearing member may appear to be a party to the trade, it is not the true counterparty (here, there is just one transaction, albeit involving three parties). Where the clearing member acts as principal, the end-user will face the clearing member, and the clearing member will face the clearinghouse (here, there are two identical ‘back-to-back’ transactions among the three parties).
Fig.3 looks at the clearing process, from execution to settlement. (Readers should note that this is for illustration purposes only, and there are a number of different ways in which execution and clearing can be effected.) The end-user (acting as a trader on its own account, or acting through a broker) enters into a trade with a market participant. That trade is then submitted by each party for clearing through its respective clearing member. When the trade is accepted for clearing, a give-up or novation of the original contract takes place through which the clearinghouse is substituted as the counterparty on both sides of the trade.
Under agency clearing models the clearingmember, as agent, is generally required to guarantee the performance of the end-user’s obligations to the clearinghouse, although the guarantee does not go the other way i.e., the clearing member does not guarantee the performance of the clearinghouse.
Some clearing models may add further complexity by converting OTC derivatives contracts into futures before clearing.
End-users will need to examine whether a clearinghouse operates on an agency basis or a principal-to-principal basis as part of their risk analysis before choosing clearing platforms. The basic proposition is that under an agency clearing model the end-user takes greater exposure to the clearinghouse, and in a principal-to-principal clearing model there is greater exposure to the clearing member. However, matters are likely to be complicated by both the clearinghouse rules and the underlying documentation between the clearing member and the end-user.
The structure of documentation which an end-user will enter into will depend on a variety of factors including to what extent the clearing platform adopts a futures clearing approach, and indeed whether an OTC contract is ‘exchanged’ for a futures trade before being submitted for clearing, or whether the contract remains an OTC contract during the clearing process.
Certain clearing platforms will require that each end-user enters into a futures customer agreement with an addendum to deal with OTC derivatives. Others will require that end-users use an existing (or new) ISDA Master Agreement with an addendum to deal with cleared transactions. Both sets of documentation will need to accommodate the clearinghouse rules, and in some cases the end-user may be required to enter into an agreement directly with the clearinghouse.
Parties will be able to continue to use their existing ISDA Master Agreements for non-cleared trades. We will hear relatively soon from the US and European regulators what types of trades will not be subject to mandatory clearing, and what conditions will apply to such trades (for example to include collateral and capital requirements).
Margining/collateral maintenance procedures for OTC derivatives will be different in the clearing environment. A unilateral credit relationship will apply whereby clearinghouses will require that collateral is posted with them to cover their exposure, but not necessarily with a parallel requirement to deliver collateral the other way. However, in practice, an end-user may receive a payment from its clearing member to cover the end-user’s exposure at a particular point in
The robustness of a clearinghouse from a creditworthiness perspective will depend on a number of factors including how much margin it takes and how it holds it, and how much capital the clearinghouse has to fall back on.
A key issue being discussed at the moment concerns segregation of customer collateral. Customers of Lehman found that their collateral was not where they thought it was, and was unexpectedly swept up in the insolvency process. This has focused end-users’ minds on where, and how, collateral is held, and the extent to which it is ring-fenced and recoverable, should the worst happen.
Segregation of collateral in a clearing context should improve the ‘portability’ of positions (i.e., the transfer of positions to a new clearing member) in the event of the failure of a clearing member, because the clearinghouse will be more capable of finding a willing transferee if the positions can be transferred with sufficient margin to support the positions.
Gross and net margining
End-users will need to examine whether they are required to margin their trades with their clearing member on a ‘gross’ or ‘net’ basis, and whether their clearing member is required to post margin to the clearinghouse on a gross or net basis. In general, gross margining should improve the portability of positions between clearing members, although posting margin on a net basis is a more efficient use of capital because it allows offsetting risks to decrease the margin required.
A clearinghouse may hold collateral in different pools for different groups of customers. Collateral deposited by clearing members for their own proprietary positions should in any event be held in a separate ‘house’ account. Customers may be offered the ability to margin on a gross or net basis, or a combination of the two, with collateral being held in separate pools, one for ‘gross margining customers’ and one for ‘net margining customers’.
Ring-fencing of accounts
To take this analysis a step further, certain buy side participants have been pushing for a further level of segregation which would involve each buy side participant’s collateral being ring-fenced from collateral provided by other participants, to avoid exposure to a default by those other participants. In this way, customers may require segregated accounts on a ‘per fund’ basis or perhaps a ‘per manager’ basis – in the latter case a fund would accept default risk against other funds, but only those within its own ‘stable’.
However, a rise in segregated accounts could lead to increased costs – if clearinghouses are not able to tap into omnibus accounts in a default scenario, the extra ‘shield’ provided by the omnibus accounts is taken away, with the result that the clearinghouse’s default fund (i.e., reserve capital) needs to increase. Such increased costs would be borne predominantly by the clearing members, and may be passed on to end-users.
Development of platforms
The existing clearinghouses such as CME, ICE, LCH and IDCH are working on developing their platforms for OTC derivatives in response to the new regulatory environment. The existing technological resources and expertise of these operators give them a head start, and the extent to which new entrants appear remains to be seen. The major clearing operators are looking to expand their product offering, from the present variety of energy derivatives, interest rate swaps and credit default swaps, to “multi-asset OTC clearing”. In theory, all OTC derivatives are capable of being cleared. In practice, only the most standardised contracts will be cleared until the industry has developed sufficiently to overcome the relevant operational and technological hurdles.
How many clearinghouses will there be? There are good arguments for a small number of well capitalised clearinghouses rather than a large number of smaller ones. The failure of a clearing broker which is a clearing member of multiple clearinghouses points to greater systemic risk. There are concerns about insufficient liquidity if positions are dispersed across many clearinghouses. And, finally, there are the costs of clearing membership to think about, and the benefits of economies of scale. To counter these arguments, it is important that there is adequate competition between clearinghouses.
End-users such as hedge funds are likely to choose their clearing member relationships based on their existing futures clearing and prime brokerage relationships.
For end-users, some key legal consequences of moving their OTC derivatives trades to a central clearinghouse are likely to be as follows:
• The clearing member will hold the whip hand – although subject to negotiation, the customer agreement (or modified ISDA Master Agreement) between the end-user and the clearing member will, in common with futures clearing agreements, favour the interests of the clearing member;
• The ‘quid pro quo’ for end-users is that their trading will move to what should be a more robust rules-based framework with reduced credit risk, including the ability to transfer positions between clearing members;
• Margin requirements will be higher if positions are margined on a gross basis, and there are question marks over cross-margining at both clearinghouse and clearing member levels;
• Introducing a clearinghouse into the mix introduces new structures and greater inherent complexity, for example parties will need to become used to the possibility of rejection of trades at clearing member and/or clearinghouse levels;
• End-users will need to consider whether they should maintain multiple clearinghouse relationships (to diversify their risk in terms of central counterparties) and whether they should maintain multiple clearing member relationships (for credit risk as well as product reasons);
• End-users will need to conduct a thorough independent legal/contractual risk analysis through their legal counsel in order to be able to make their own overall risk analysis.