Reflections on Central Clearing: 15 Years after the Pittsburgh Summit

The Global Financial Crisis 

The failure of Lehman Brothers in September 2008 and the subsequent crisis at AIG developed into a Global Financial Crisis (GFC). The GFC exposed weaknesses in the structure and operation of over-the-counter (OTC) derivatives markets. This vulnerability amplified the systemic risk during the GFC through contagion arising from the inter-connectedness of OTC derivatives market participants and the limited transparency of counterparty relationships. 

Derivatives are an essential risk-management tool which enables firms to hedge their positions against risks and encourage them to engage in economically beneficial activities. On the other hand, OTC derivatives are exposed to: 

i) counterparty credit exposures that are not managed adequately;
ii) opaque counterparty and credit exposures; and
iii) risk propagation due to the interconnectedness of market participants. For example, the jump to default risk from credit default swaps (CDS) was recognised acutely in the GFC.

The cross-border nature of OTC derivatives transactions has presented significant challenges for regulators in comprehending the global configuration of the OTC derivatives market and the accumulation of exposures. This has led to the broad recognition of the need to proceed urgently with reform of OTC derivatives markets, along with Basel III, transforming shadow banking into resilient market-based finance, and ending the concept of “too big to fail” (the establishment of effective resolution regime). 

G20 Leaders’ Commitments 

The inaugural G20 Summit was convened in Washington D.C. in November 2008¹. At this summit, the G20 leaders called on the Finance Ministers and the Central Bank Governors for recommendations to enhance resilience and transparency in credit derivatives markets. The leaders also requested that the then Financial Stability Forum (FSF) enhance its effectiveness as a mechanism for national authorities, standard-setting bodies (SSBs) and international financial institutions to address vulnerabilities and to develop and implement robust regulatory and supervisory policies for financial stability. Consequently, the FSF underwent an upgrade to the Financial Stability Board (FSB) in April 2009. 

At the G20 Summit in London in April 2009, the leaders declared their intention to promote resilience in credit derivatives markets through the establishment of central counterparty (CCP) subject to effective regulation and supervision. These issues were revisited at the G20 Summit in Pittsburgh in September 2009, where the leaders committed to implementing reforms to OTC derivatives markets with the aim of reducing systemic risk, enhancing transparency in derivatives markets and preventing market abuse. The leaders further resolved that standardised OTC derivatives must 

i) be traded on an exchange or electronic trading platform (ETP) where appropriate; and
ii) be cleared by a CCP; and
iii) OTC derivatives contracts must be reported to a trade repository (TR).

At the G20 Summit in Cannes in November 2011, members reached a consensus to implement margin requirements for non-centrally cleared derivatives contracts, with the objective of incentivising the utilisation of CCPs. 

Emergence of Challenges 

Although high-level international accords were formulated expeditiously, almost no jurisdiction possessed pertinent regulations at that juncture. The interval preceding the formulation of national regulations by each country was insufficient for international coordination. Consequently, the scope of mandatory clearing at CCPs was stipulated variably in domestic laws and regulations from jurisdiction to jurisdiction, concerning entity and asset classes, as well as registration and licensing requirements for dealers and CCPs. 

Against this backdrop, certain national and regional authorities determined that cross-border OTC derivatives transactions with direct and significant connections to their respective economies should be subject to their regulatory oversight. As a result, the majority of derivatives transactions could be subject to multiple regulatory regimes once regulations were implemented across the major derivatives jurisdictions. The extra-territoriality resulting from the cross-border application of national regulations emerged as a significant concern. 

The inconsistencies that have emerged among national and regional regulations, particularly concerning the content of regulation and the timing of implementation, have given rise to a series of regulatory conflicts, gaps and duplications. In order to mitigate these issues, regulators must engage in meticulous coordination with their foreign counterparts. This coordination should encompass the scope of entities and products subject to regulation, as well as the fundamental approach to be employed, both domestically and extraterritorially. 

The existence of regulatory inconsistencies among major markets has the potential to diminish international transactions, leading to market fragmentation by imposing additional costs on market participants and, in certain instances, rendering their operation in different jurisdictions unfeasible. These inconsistencies should be eliminated to the greatest extent possible, not only to prevent regulatory arbitrage and the race to the bottom, but also to ensure a level playing field across different jurisdictions. 

Measures Taken 

In order to coordinate the work of these SSBs, particularly on the central-clearing mandate, the FSB established the OTC Derivatives Coordination Group (ODCG). This group consists of the chairs of the Basel Committee on Banking Supervision (BCBS), the International Organization of Securities Commissions (IOSCO), the Committee on Payment Systems (CPSS)², the Committee on the Global Financial System (CGFS) and the FSB itself. The ODCG has reached a consensus on the following four key initiatives, collectively termed the "Four Safeguards":

i) the establishment of equitable and accessible pathways for market participants to access CCPs,
ii) the implementation of collaborative oversight mechanisms between pertinent authorities of global CCPs,
iii) the formulation of recovery and resolution frameworks to ensure the continuity of core CCP functions during periods of crisis, and
iv) the implementation of adequate liquidity arrangements for CCPs in the currencies of their respective clearing.

Additionally, the G20 expressed its consent for a review of pertinent international standards. In 2012, the CPSS and IOSCO were directed to formulate the Principles of Financial Markets Infrastructures (PFMI), which integrated the then-current four specialised standards. The PFMI delineates 24 principles and five responsibilities for authorities³, encompassing domains such as credit risk, liquidity risk, legal risk, general business risk, custody and investment risks and operational risk of financial markets infrastructures, inclusive of CCPs that clear OTC derivatives. 

The PFMI is consistent with and enhances the strategies of the G20 and the FSB, including the four safeguards. Financial and liquidity requirements for CCPs have been strengthened substantially to ensure their smooth operation even under extreme but plausible market conditions [CPSS-IOSCO 2012]. However, international standards such as CPSS-IOSCO's PFMI are often general in nature and were not designed to address all concerns a host state may have about matters. The considerable heterogeneity among jurisdictions, stemming from their unique circumstances, rendered the aspiration of achieving absolute uniformity across national regulations as impractical. Instead, more pragmatic approaches acknowledging and respecting these differences were needed. 

In this regard, the most practical approach entails the bilateral recognition of other jurisdictions' rules as equivalent to one's own, provided that certain conditions are met. The assessment of the equivalence or comparability of foreign laws and regulations should not be conducted through a rudimentary word-by-word comparison or the similarity of regulatory prescriptions. Instead, it should be evaluated based on whether foreign regulatory systems achieve comparable outcomes. Achieving this understanding necessitates a profound comprehension of the underlying principles of each system's legislative and regulatory framework, encompassing the historical underpinnings of the respective economies and societies. A uniform, "one-size-fits-all" approach across diverse jurisdictions is ill-advised in such cases. 

Reliance on foreign regulation is an effective solution to address the issue and provide relief to entities operating cross-border and to transactions that take place across borders. This approach not only facilitates the efficient and effective utilisation of limited supervisory resources by regulators but also, more crucially, serves to eliminate legal uncertainty and mitigate compliance costs for market participants and infrastructure operators across all jurisdictions [Kono 2013]. 

In light of these developments, the OTC Derivatives Regulators Group (ODRG) was established in 2011 with the objective of identifying and resolving cross-border issues associated with the implementation of the G20's reform agenda. Since then, the ODRG had submitted annual progress reports to G20 leaders [ODRG 2014]. Regulators from the member jurisdictions convened regularly and engaged in extensive dialogue to enhance mutual comprehension and exchange best practices. 

The Status Quo and Going Forward 

In the 15 years since the Pittsburgh Summit, the OTC derivatives markets have witnessed a substantial reinforcement in stability, marked by the expansion of asset classes and the reduction of exemptions, owing to the central clearing of OTC derivatives. The collaborative efforts of these institutions have led to the elimination of significant discrepancies in regulatory frameworks across different jurisdictions. The FSB has concluded that the implementation of the G20's OTC derivatives reforms has advanced well. More than two-thirds of FSB member jurisdictions, including Japan, have comprehensive standards for mandatory central clearing in force [FSB 2022]. 

In the financial markets, OTC derivatives cleared by CCPs have increased, while the volume of non-centrally cleared transactions of interest-rate swaps, the most widely traded product type, has decreased [ISDA 2024]. It is noteworthy that no CCP has experienced a failure to date. In terms of regulatory oversight, the role of SSBs has been reinforced, and national and regional authorities have enhanced their communication through multilateral and bilateral channels established following the GFC. 

However, the reform is not yet complete. In some jurisdictions, efforts to enhance the robustness of CCPs remain unfinished. Additionally, peer reviews of the implementation of the PFMI in the CPMI-IOSCO member countries are ongoing. Nonetheless, the progress of the reform has stagnated in recent years. Even in jurisdictions where the reform is nearing completion, ongoing monitoring is essential to identify any emerging gaps. In light of this, a proactive approach to reviewing current standards is imperative, guided by a commitment to respond swiftly to evolving external factors without preconceived notions. The adequacy of the requirements on margin, capital and liquidity of participants needs to be constantly examined, including whether or not their levels hinder incentives to directly and indirectly use CCPs. 

Regulators must observe market developments meticulously, encompassing liquidity, pricing and operations in the markets, to ascertain whether there are unintended consequences from the central clearing mandate. In this regard, a good balance between safety and cost needs to be struck. 

The experiences of various stakeholders in the reform of OTC derivatives markets provide valuable lessons to prevent the recurrence of financial crises in the future. Harmonisation, once rules are established in legal forms such as statutes and acts, can be costly. Amending laws or regulations in certain jurisdictions can be particularly onerous, necessitating considerable resources and time. Consequently, effective coordination and information exchange among regulators are paramount to ensure the success of such endeavours.

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References 

ODRG (2014) “Report of the OTC Derivatives Regulators Group (ODRG) to G20 Leaders on Cross-Border Implementation Issues November 2014” 

CPSS-IOSCO (2012) “Principles for Financial Market Infrastructures” 

FSB (2022) “OTC Derivatives Market Reforms: Implementation progress in 2022” 

ISDA (2024) “Key Trends in the Size and Composition of OTC Derivatives Markets in the First Half of 2024” 

Kono, Masamichi (2013) “Overview of International Work towards OTC Derivatives Markets Reform and Remaining Challenges” Financial Stability Review, No. 17. Banque de France.

¹ The official designation of the meeting is "Summit on Financial Markets and the World Economy." 

² The CPSS was subsequently renamed the Committee on Payments and Market Infrastructures (CPMI). 

³ The Responsibility E stipulates cooperation among competent authorities of FMIs.