Addressing Global OTC Derivative Clearing Mandates
Introduction
Over-the-counter (OTC) derivatives, such as swaps, play a crucial role in global financial markets. These derivatives are traded bilaterally between parties via swap trading venues or interdealer brokers, rather than on regulated exchanges, providing users with flexibility and customisation to address their idiosyncratic risk-hedging needs, including global swap dealers, investment funds, pensions and local banks. Key milestones in the market's growth include the International Swaps and Derivatives Association (ISDA) Master Agreement produced in 1987, which provided a standardised legal contract for bilateral OTC derivatives, enabling the netting of multiple trades between two parties.
Another notable feature is their significant cross-border trading, for example between a Cayman Island hedge fund and the UK subsidiary of a Japanese bank[1]. The majority of outstanding OTC derivatives globally pertain to interest rates, followed by foreign exchange[2].
Evolution of the OTC Derivative Markets for Central Clearing
The 2008 financial crisis marked a turning point for OTC derivative markets. The bankruptcy of Lehman Brothers exposed the vulnerabilities and interconnectedness of the financial system, which, unlike centrally cleared exchange markets, was amplified by a lack of oversight and opacity. The crisis led to widespread skepticism about who should bear further losses due to the cascading effects of the bankruptcy.
In response, regulators worldwide introduced clearing mandates for standardised OTC derivatives through central counterparties (CCPs), as part of broader regulatory reforms under the "Pittsburgh G20 Commitment," along with trading mandates (e.g., trading on US SEF/EU MTF), and requirements to report each trade to licensed trade repositories. Thus, CCPs function as risk managers, reducing counterparty risk, enhancing transparency, mitigating systemic risk, and promoting financial stability, as well as providing operational efficiency by the netting of multiple portfolios with a single counterparty. Regulators in each jurisdiction have implemented the clearing mandate in phases, such as Japan (2012), the US (2013), and EU (2016).
Despite the significant work required, the industry has made substantial progress, with a notable portion of OTC derivatives having shifted from bilateral to cleared markets. For example, an estimated 76.9% of all interest-rate derivatives are now centrally cleared [3].
The benefits of central clearing, combined with OTC derivative trading mandates, are increasingly enjoyed by customers as well as clearing members, linking liquidity pools in each jurisdiction on a global scale, without the ex-ante bilateral legal arrangements between counterparties required in uncleared markets. Global rules on margin for uncleared derivatives have also played an important role in incentivising voluntary clearing by those not subject to mandated clearing.
New Clearing Mandate – SFT
The success of OTC derivative clearing mandates has been recognised by policymakers and markets. The next phase of central clearing is now being considered for securities financing transactions (SFTs), such as government bond outright and repo trades, as recommended by the FSB [4]. In particular, the US SEC has set deadlines for the clearing of US Treasuries: Dec. 31, 2026 for cash transactions and June 30, 2027 for repo transactions. While there needs to be further discussion, such as on facilitating customers to clear their “done-away” trades, the benefits of central clearing remain unquestionable, especially given concerns about leverage taken by non-bank financial institutions (NBFIs), in terms of market transparency and monitoring their risks.
In fact, the clearing of Japanese government bonds (JGB) has been a success, with 80% of domestic JGB trades cleared at JSCC, despite the absence of a regulatory clearing mandate for JGBs [5]. Now JSCC is working to introduce sponsored clearing for Japanese money reserve funds in June 2025, and to revamp its agency clearing model to better accommodate offshore customers, with a view to extending central clearing to a wider range of market participants.
Clearing Mandates Are Not a Panacea
While central clearing mitigates counterparty risks, it does not eliminate risk entirely. Given the concentration of counterparty risk into CCPs, a significant impact could occur if a CCP's clearing operations were to be disrupted by the default of its clearing members or other operational issues, despite their robust risk management.
Clearing members and their customers are required to post collateral on cleared positions, including initial margin (IM) to cover potential future exposure, variation margin (VM) to cover current exposure (or MTM settlement as prescribed in some CCP rulebooks), as well as clearing member contributions to the default fund to cover "extreme but plausible" stress losses.[6]
These CCP risk management practices, while necessary and sensible, can create challenges for CCP users. For instance, CCP IM may be procyclical during market stress events. VM in bilateral markets may involve non-cash securities as long as both counterparties agree, but CCP VM must be paid in cash as CCPs pass through cash VM from loss-making positions to profitable ones, which may create liquidity stresses for counterparties with losing positions in a severe market stress event. Thus, timely pass-through of VM cash by CCPs would be desirable. Recognising these issues, CPMI-IOSCO published reports in 2025 on CCP IM and VM [7]. Further discussions on implementation will continue both globally and at jurisdictional levels.
While global policymakers agree on the benefits of central clearing, some contradicting policies and practices hinder access to clearing, particularly for customers of clearing members, due to the bank capital rules imposed on clearing brokers in the banking groups to facilitate customer clearing, operational and regulatory costs for customer clearing services, or required internal returns, as highlighted in the FSB Report "Incentives to centrally clear over-the-counter derivatives" of 2018 [8]. While some mitigations have been made such as the recognition of risk-reducing effect of customer margin in leverage ratio [9], high costs on customer clearing mostly remains unresolved, and clearing brokers are continuing to withdraw from the market. In fact, from 2014 to 2023, despite almost an eight-fold increase in swap customer margin, the continued decrease and concentration of CFTC-registered FCMs persists.[10]
New and Viable Clearing Infrastructure for OTC Derivative Markets Launched by a Traditional Stock Exchange
Originally initiated by the Tokyo Stock Exchange in 2011, JSCC has operated clearing services for yen-denominated credit default swaps (CDS) and interest-rate swaps (IRS) for more than a decade. In particular, JSCC’s IRS clearing service has experienced exponential growth in recent years, with clearing volume doubling in 2024 compared to the previous record set in 2023, driven by Japan’s rapidly changing interest-rate environment and risk hedging needs.[11]
However, making a foray into the OTC derivative markets through the launch of a new and viable clearing infrastructure was a significant task (as summarised below), requiring innovative thinking.
- OTC derivative markets are supported not just by clearing members and their customers, but also by third-party vendors, such as trade affirmation platforms linking multiple trading venues (not traditional exchanges) and CCPs, trade compression service providers, which are integral to reduce bank clearing members’ capital costs under the Basel rules, and trade repositories. Thus, unlike exchanges, CCPs in OTC derivative markets would be viewed as merely part of a wider ecosystem rather than the market itself.
- While each CCP has legally binding rulebooks that are reviewed by regulators, it is crucial to draft a rulebook through intensive collaboration with industry participants, which often requires a delicate balance between flexibility and sound risk management.
- Clearing OTC derivatives is highly competitive, given the global nature of markets and the netting efficiency for CCP users with a limited number of CCPs. For example, while JSCC clears only yen-denominated swaps (IRS and CDS), to remain competitive its clearing fees are around half to one-third of those charged by other major global CCPs.
- Given that most OTC derivatives are traded on a cross-border basis, CCPs need to obtain licenses in relevant jurisdictions where clearing members or their customers are domiciled. While CPMI-IOSCO [12] established the "Principles for Financial Market Infrastructures (PFMI)" in 2012, setting global risk management standards for CCPs, each jurisdictional regulator has developed its own regulatory regime, often with requirements that are duplicative and even conflict with those of the foreign CCP’s home country, making it difficult for foreign CCPs to operate clearing services in some jurisdictions, limiting clearing choices for risk hedgers and restricting their access to the OTC derivative markets with the deepest liquidity and opportunity.[13] While appropriate safeguards and cooperative arrangements between regulators are necessary to ensure robust risk management at foreign CCPs, to maximise the true benefit of central clearing, global regulators should work to facilitate cross-border liquidity flows of OTC derivatives, deferring to the home country regime of the foreign CCP to the maximum extent possible, based on the proportionality in the possible systemic risk pertaining to that CCP.
Reassessment of the Regulatory Reform
The future of OTC derivative markets will be significantly influenced by ongoing regulatory developments and technological advancements. Regulators are continually refining and enhancing the regulatory framework to address emerging risks and ensure the resilience of the financial system.
On the other hand, enhancing the efficiency of clearing, for example by expanding the scope of eligible trades for clearing or making collateral and cash settlement operations more efficient, would be important as well to increase the liquidity. For example, tri-party services by global custodians, which are common in bilateral markets, would further enhance efficiency in the clearing space, through the swift transfer of collateral between CCPs and their users. Blockchain or DLT may bring disruptive innovation to the markets enabling much faster and efficient collateral transfer from clearing members to CCPs, but regulators should rely on existing policies applied for the operational risks of CCPs to the maximum extent [14], rather than creating new and redundant rules simply because these are new and innovative technologies.
With the expansion of central clearing into SFTs, regulators should take the opportunity to reassess existing regulatory reforms and fine-tune them as necessary to maximise the benefits of central clearing. This would further enhance transparency, mitigate systemic risk, and promote the financial stability of OTC derivative markets, while facilitating access to the deepest liquidity pools for all market participants.
[1] Three-quarters of yen-denominated interest-rate swaps cleared at JSCC are cross-border trades between counterparties and/or branches in different jurisdictions. Full lists of clearing members and their customers of JSCC IRS clearing services are available on JSCC`s website: https://www.jpx.co.jp/jscc/en/participant/irs/irs2.html
[2] Source: OTC derivatives statistics at end-June 2024, BIS (21 November 2024): https://www.bis.org/publ/otc_hy2411.pdf
[3] Source: KEY TRENDS IN THE SIZE AND COMPOSITION OF OTC DERIVATIVES MARKETS IN THE FIRST HALF OF 2024, ISDA
[4] Leverage in Non-bank Financial Intermediation - Consultation Report - 18 December 2024 https://www.fsb.org/uploads/P181224.pdf
[5] Source: Statistics for Japanese Government Bonds, JSCC (Jan 2025)
https://www.jpx.co.jp/jscc/en/jgbcc/qtsnlk0000001ykf-att/STE202501.pdf
Analysis: Comparison with Total Volume (Face Amount) and Number of JGB DVP Settlements at Bank of Japan
[6] Principle 4: Credit risk, Principles for Financial Market Infrastructures (2012)
[7] Transparency and responsiveness of initial margin in centrally cleared markets - review and policy proposals, BCBS CPMI-IOSCO, January 2025
https://www.bis.org/bcbs/publ/d590.pdf
Streamlining variation margin in centrally cleared markets – examples of effective practices, CPMI-IOSCO, January 2025
https://www.bis.org/cpmi/publ/d226.pdf
[8] Available at FSB website: https://www.fsb.org/uploads/R191118-1-1.pdf
[9] Basel Committee finalises revisions to leverage ratio treatment of client cleared derivatives and disclosure requirements to address window-dressing (June 26th 2019): https://www.bis.org/press/p190626.htm
[10] Re: Regulatory Capital Rule: Large Banking Organizations and Banking Organizations With Significant Trading Activity (OCC Docket ID OCC–2023–0008; Federal Reserve Docket No. R–1813, RIN 7100–AG64; FDIC RIN 3064–AF29), FIA, January 16, 2024
[11] JSCC Press Release: Record-Breaking Monthly and Yearly Volume in Clearing Service for Interest Rate Swap (Jan. 6th, 2025)
https://www.jpx.co.jp/jscc/en/information/press_releases/qtsnlk0000001vbl.html
[12] CPSS-IOSCO was changed in its name to CPMI-IOSCO after the publication of the PFMI.
[13] The CFTC Global Market Advisory Committee (13th February 2023) U.S. Swap Customer access to non-U.S. Exempt DCOs, Tetsuo Otashiro, Japan Securities Clearing Corporation: https://www.cftc.gov/media/8166/GMACSlides021323/download
[14] These have been addressed by the PFMI, including Principle 2(Governance) and Principle 15(General business risk), and a separate guidance on cyber resilience by CPMI-IOSCO. Cyber risks at FMIs have been continuously monitored in the CPMI IOSCO framework as Level 3 assessment.
Guidance on cyber resilience for financial market infrastructures (June 2016): https://www.bis.org/cpmi/publ/d146.pdf
Implementation monitoring of the PFMI: Level 3 assessment on Financial Market Infrastructures’ Cyber Resilience (November 2022): https://www.bis.org/cpmi/publ/d212.pdf
Also, the CFTC Global Market Advisory Committee made the recommendation which could expand the use of non-cash collateral through DLT.
CFTC Press Release: https://www.cftc.gov/PressRoom/PressReleases/9009-24