The Center Ground: CCPs Could Shift—Not Eliminate—Systemic Risk

If there is one phrase that defines the financial crisis and its aftermath in years to come, it will be “systemic risk.” If you were to look up the term in the dictionary 50 years from now, it would probably be illustrated with the Lehman Brothers logo. The collapse of Lehman, along with Bear Sterns, sent shockwaves through the global economy, the aftereffects of which are still taking shape today. Regulators swung into action following the credit crunch and the subsequent crisis, legislating with the reduction of said systemic risk in mind, and one of the areas most affected has been the structure of the over-the-counter (OTC) derivatives markets.

In Europe, proposals by the Group of Twenty (G20) nations after the collapse of Lehman mandated the eventual centralized clearing of standard derivatives contracts through central counterparty (CCP) clearinghouses, and the reporting of data on those trades to trade repositories. The European Securities and Markets Authority (ESMA) published its draft rules and technical standards earlier this year, and with the adoption of the regulation by the Council of the European Union (EC) in July, European markets are one step closer to an overhaul of the way in which they operate.

Sound Structure
The argument, so it goes, is that bringing a more formalized, technology-based approach to the way these markets are regulated can only help to reduce the risk of total collapse, as was narrowly averted when Lehman was allowed to fail.

“OTC derivatives impact both financial markets and the real economy but have not been subject to regulatory requirements. This absence has resulted in negative consequences for financial markets, investors and the real economy,” says Steven Maijoor, chair at ESMA. “The draft technical standards developed by ESMA set out the measures for the implementation of the regulatory framework established under the European Markets Infrastructure Regulation (EMIR). These measures will ensure that EMIR’s objectives of reducing risks arising from OTC derivatives, improving transparency, and ensuring sound and resilient central counterparties will be applied in practice. These proposals will contribute to enhancing the protection of investors and promote stable and well-functioning financial markets in the EU, and allow the EU to play its role in strengthening the global financial regulatory system.”

If the proposals are ratified and become law as-is, derivatives contracts that meet predefined eligibility criteria, as decided by ESMA, will be required to clear through CCPs.

“The regulation requires that counterparty trading risks in the OTC derivatives market be transferred to clearinghouses. It remains to be seen, however, whether the concentration of these risks with clearinghouses will lead to different types of systemic risks that put the financial system at serious risk.” —Kern Alexander, University of Cambridge

Central counterparty clearinghouses, in their broadest sense, sit between the counterparties in a trade, and act as an intermediary between buyer and seller. They ensure that counterparty risk is reduced by guaranteeing that the buyer will receive its part of the deal, and the seller will receive what they have agreed. The trade data will then be reported to trade repositories, which will aggregate received information in order to provide regulators with a detailed overall picture of the market. Large numbers of market participants see the proposal as a move in the right direction, but there are some who remain hesitant about unanswered questions inherent in the regulation.

“The EU regulation is an important step to building a more robust regulatory regime in Europe to control systemic risks in the OTC derivatives markets,” says Kern Alexander, senior research fellow in the Judge Business School, University of Cambridge. “The regulation requires that counterparty trading risks in the OTC derivatives market be transferred to clearinghouses. It remains to be seen, however, whether the concentration of these risks with clearinghouses will lead to different types of systemic risks that may themselves put the financial system at serious risk. Important questions arise, including what role central banks would play in supporting a derivatives clearinghouse that is experiencing financial stress during a crisis. These have not been answered by policymakers or regulators.”

Unforeseen Consequences
Much of the criticism of the ideas underpinning this regulation has been around both the solvency and stability of CCPs themselves. ESMA’s draft standards have provisioned a so-called “default fund” into which all clearing members will contribute, but processes for the orderly wind-down of a failed CCP aren’t clear at present, and some buy-side firms express skepticism about the process entirely.

“Some large buy-side firms prefer the bilateral model, particularly if they only trade with other large institutions that are similarly risk-averse and well-capitalized,” says Steve Grob, director of group strategy at Fidessa. “For them, centralized clearing is potentially riskier as they don’t know which other firms their margin is being combined with, or the credit ratings of these firms. In addition, CCPs generally do not hold a banking license, so there is also the fundamental question around the risk associated with the bank or custodian that the CCP deposits its collateral with. While CCPs certainly play a central role in mitigating counterparty risk, the politicians need to understand that they don’t remove it entirely.”

On the technology side, too, extant problems with turning a predominantly voice-based market into an electronic one haven’t gone away. While equities and foreign exchange (FX) have been relatively simple to trade electronically for many years now, the relative lack of liquidity in fixed income and some OTC derivative instruments have meant that they just aren’t suited to the kind of electronic trading processes that define such markets now. Given the lack of clarity around the number of CCPs and their technical specifications, this potentially opens problems for the future.

“A bigger problem, though, concerns the sheer practicality of moving relatively ‘odd-shaped’ OTC contracts onto electronic platforms,” Grob says. “Both Dodd–Frank and EMIR recognize this challenge by including the clause ‘provided there is sufficient liquidity’ in their legislation. But defining ‘sufficient’ in this context is almost impossible as no one knows how many platforms there will be or how they will interoperate, if at all.”

Data Dynamic
CCPs are only half the equation, of course. Reporting to trade repositories will become an issue of discussion as ESMA looks to finalize its standards by the end of the year, in line with the G20 target. Non-financial companies using hedge accounting via derivatives contracts will not be required to do this, something that has relieved treasury departments from a potentially large cost of compliance.

“From the point of view of non-financial businesses that use derivatives to mitigate real-world commercial and treasury financing risk, ESMA’s draft rules are mostly good news,” says Paul Higdon, CTO at IT2 Treasury Solutions. “The proposed regime enables non-financial users to continue to access tailored derivatives that can most accurately match and mitigate risk by matching the cash flow schedule of the underlying exposure that is being hedged. If a company already undertakes hedge accounting for its derivatives, much of the work will already have been done. Perhaps most importantly, the rules promote best practices in reporting, regular mark-to-market and management of counterparty risk. In fact, many corporate users are already ahead of the game, having brought central management of financial risk, risk-mitigating derivatives, and hedge accounting within the single environment of the corporate treasury.”

For financial firms, however, question marks remain over what exactly the reporting will entail. On the part of the repositories themselves, and firms, the data aggregation and presentation to regulators could potentially induce a headache of monumental proportions.

“The need to centrally collect and report data held in trade repositories has huge implications on a firm’s data management infrastructure as well as its governance processes. The impact is particularly significant as the majority of current systems were not built to cope with the onslaught of requests for greater transparency the markets are currently witnessing,” says John Mitchell, vice president of sales at Asset Control. “Financial institutions will require some form of interface between their own data management system and that of the trade repository—and it will need to be an automated interface given the well-known perils and risks associated with manual processing. They will also need to adopt standardized classification of derivative products. Without standardization, it is difficult—if not impossible—to accurately collateralize against them. This adds yet more weight to the move toward to adoption of legal entity identifiers (LEIs).”

The Access Question
Under the rules, exchanges and multilateral trading facilities (MTFs) will also be given access to CCPs in the same way that participants will. However, there is a question of access and permissions. Privately, senior-level sources in several tier-one investment banks expressed concern over the provisions of indirect clearing access through their own memberships, and the assumption of risk that would entail. None would comment officially, citing their organizations’ need to digest the rules and formulate an official business line, but several say there needed to be more consultation on the issue.

“Some of the details around indirect clearing are a concern,” says one source at a major investment bank operating in the UK, who asked not to be identified. “We think that the details around how access is provisioned to third-level clients, and the level of liability on our part, if we’re doing that, should be looked at again. But we expect it to be addressed, as some other regulators may have their own concerns with it.”

The banks added, however, that they were more or less ready to begin operating in this capacity from the word go, having been engaged in this model for some time in preparation.

Contagion and Containment
The consensus, however, is that the proposals are sound. They have been expected, after all, and firms that operate in markets outside of the EU have also been preparing for, and engaged in, similar processes, regarding the reformation of derivatives markets globally.

As with most modern-day regulation, whether it’s the Dodd–Frank Act, the Markets in Financial Instruments Directive, or EMIR, specificity remains the key point. If data structures need to be updated—and at this point, it’s almost certain they will—then the end-of-year implementation could potentially be challenging. Structurally,  although the regulation is designed for the reduction of systemic and counterparty risk, a lack of an exit strategy in itself could lead to dire consequences. ESMA is currently accepting comment on its proposals, and further votes among European bodies are scheduled for later in the year.