Central Clearing Begins to Bite

Welcome to the first of a series of weekly blog posts looking at the over-the-counter (OTC) derivatives reform measures that are currently being implemented across the globe.

The extensive OTC derivatives market reforms that resulted from the G20 Pittsburgh summit in 2009 have graced the pages of the financial press ever since. But far from being confined to column inches, these reforms are already changing the way the derivatives market operates - and further developments are afoot.

Part of the agreement made by G20 leaders was the requirement for all ‘standardised’ OTC derivative contracts to be cleared through a Central Counterparty (CCP). Certain countries, such as the U.S. and Japan, have already made central clearing mandatory and Europe is expected to introduce similar rules at the end of 2015 under the European Market Infrastructure Regulation (EMIR). 

Casting a Wide Net

All European Union firms, financial and non-financial, will be subject to Central Clearing of Standardised OTC products, with the only exceptions being Central Banks and Corporates that are using OTC Derivatives to hedge commercial risk. Firms should also be aware of the extraterritorial scope of EMIR, since clearing will also be mandatory for transactions between an in-scope EU counterparty and a third country entity that – if it were established in the EU – would be subject to the clearing obligation, according to Mayer Brown.

The implementation of the clearing obligation will be overseen by the European Securities and Markets Authority (ESMA), which is also responsible for publishing a list of clearable products.  While the full list is still a work in progress, on 1 October, 2014, ESMA released its final draft regulatory technical standards (RTS) for the central clearing of Interest Rate Swaps (IRS), which determined that four IRS classes will need to be centrally cleared. 

According to ESMA, these are:

  • Basis swaps denominated in EUR, GBP, JPY, USD
  • Fixed-to-float swaps denominated in EUR, GBP, JPY, USD
  • Forward rate agreements denominated in EUR, GBP, USD
  • Overnight index swaps denominated in EUR, GBP, USD

As expected by the market, ESMA has outlined a phased implementation for IRS clearing, which is likely to set a precedent for all other standardised OTC products and is as follows:

  • Clearing members (6 months after the RTS entered into force)
  • Financial counterparties and other alternative investment funds (12 months)
  • Financial counterparties and other alternative investment funds with a low level of activity in un-cleared derivatives (18 months)
  • Non-financial counterparties (3 years)

New Requirements, New Challenges

In terms of market impact, under Europe’s new central clearing rules, all counterparties will be required to post margin - i.e. collateral in the form of cash or securities - according to their positions. Central counterparties (CCPs) apply portfolio risk and pricing models to calculate Initial and Variation Margins for their counterparties.

The Initial Margin is payable in cash, although the major CCPs also accept sovereign bonds, U.S. agency debt and MBS, corporate securities, and gold. CCPs usually apply haircuts on collaterals in the form of securities, however. In addition, the Initial Margin needs to be segregated for clearing transactions. In other words, it can’t be recycled (re-hypothecated) for other purposes. 

Against this backdrop, firms will need to carefully consider their collateral sources and segregation controls once European mandatory central clearing kicks in.

I review this topic and more in detail in our latest whitepaper. Read “Understanding The New OTC Derivatives Landscape” to find out more. Stay tuned for next week’s post, which will cover electronification.

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