Mikael Öhman, Chief Architect of Risk Management Solutions, Cinnober takes us through a 'new world' for CCPs.
The clearinghouse landscape has been dramatically transformed since the financial crisis by a plethora of regulatory initiatives including Dodd Frank, the European Market Infrastructure Regulation (EMIR) and parts of Basel III.
This has not only led to a wider range of contracts being traded on electronic platforms and cleared centrally, but also increased the importance of central counterparties (CCPs) as backbones of financial market infrastructure and safeguards of financial stability.
The result is that interest rate, credit and foreign exchange derivatives are increasingly being cleared alongside standardised exchange traded derivatives. A significant fillip in activity was observed in the wake of the 1 March 2017 deadline which saw the new variation margin rules for uncleared OTC derivatives come into effect under EMIR.
For example, LCH.Clearnet processed $244tn of gross notional outstanding — a broad measure of all outstanding derivative positions globally — in interest rate swaps in the three months to 31 March 2017, a rise of 45% on the same period in 2016. Over $105tn of that total was cleared in March alone, a year-on-year rise of 72%, according to the London based CCP.
Overall, figures from the fourth quarter Bank for International Settlement report show that over 70% of notional values in all major currencies are now centrally cleared in interest rate derivatives and electronic trading platforms, including swap execution facilities in the US, which have made inroads. At the end of June 2016, 75% of dealers’ outstanding OTC interest rate derivatives contracts were against central counterparties, compared with 37% for credit derivatives and less than 2% for foreign exchange and equity derivatives.
As with any new paradigm shift, there have been opportunities but also challenges in terms of increased complexity. In the new world, CCPs must manage both their clearing members as well as the clients of these members which can translate into hundreds, or more likely, thousands of accounts. Due to regulatory burden on capital requirements, efficient margining processes and proper modelling of stress tests are ever more important to stay competitive as collateral is becoming a scarce resource.
Combined, this ups the requirements on sophisticated risk management, and coping with these new demands with the existing infrastructure has been difficult. Many CCPs still rely on disparate legacy clearing and risk management systems that were added over time and often include manual processes. They are now faced with the need to invest in a more streamlined operational framework, sophisticated risk tools and robust data management systems that can handle the increasing volumes of information that must be reported and processed in near real time. Getting an efficient infrastructure in place will be essential as cost is one of the arguments used against central clearing of OTC instruments.
The other main issue and perhaps irony is that while clearinghouses have been mandated to reduce counterparty and systemic risks, concerns have been raised about the potential systemic risks arising from increased central clearing itself. Therefore, there has been much greater focus on default fund management and frameworks for CCP resolution efforts to ensure that there is enough capital in case of major credit events such as member default scenarios.
While there are many risk management systems on the market, the majority were created to suit banks and brokers that have their own set of needs and obstacles, different to those of a central counterparty. CCPs require solutions tailored to their business that offer real-time risk and collateral management across markets – OTC and listed instruments together. Such solutions need to model the risk waterfall available to CCPs in the event of member default and aid the default management process. Furthermore, they need to provide a way to assess the liquid resources available to a CCP to meet any short-term deficits in the same situation. This is essential to ensure that the CCP can successfully manage the default and re-establish a matched book.
The benefits of a cross-market approach cannot be underestimated. Take the Brazilian exchange and clearinghouse operator B3 (formerly BM&FBOVESPA) which is poised to launch phase two of its Post-Trade Integration Project (IPN that aims to consolidate its four clearinghouses on a single platform). This will not only lower operational costs and optimise cash management but more importantly, enhance its capital efficiency by integrating the risk calculations across the product spectrum - derivatives and financial futures, stock options and OTC products. The cost savings will be significant if phase one is anything to go by where the total amount of margin release was around BRL 20 billion (USD 8.8 billion).
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