Central clearing and exchange trading of OTC derivatives is a concept so dear to regulators’ hearts that it has become something of a mantra for them – particularly since the demise of Lehman Brothers and the counterparty risks that were brutally revealed by that event. So when Patrick Pearson, head of financial markets infrastructure at the European Commission’s DG Markt unit, stood up to address an ABS conference in London on June 15 his words took some in the audience by surprise. “Clearing houses don’t reduce counterparty risk,” he stated. “They simply redistribute it. Central counterparties (CCPs) can act as a channel for risk. Their failure is far more dangerous than the failure of one single counterparty.”
Hang on! The market has long worked on the assumption that CCP clearing will be mandated in Europe – it was just a question of when.
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“Central clearing of OTC derivatives is an essential part of the regulatory reform to make this market sufficiently transparent and to allow supervisors and overseers to monitor the build-up of systemic risk effectively” Gertrude Tumpel-Gugerell, European Central Bank |
Indeed, just days after Pearson’s speech, European Central Bank executive board member Gertrude Tumpel-Gugerell commented: “Central clearing of OTC derivatives is an essential part of the regulatory reform to make this market sufficiently transparent and to allow supervisors and overseers to monitor the build-up of systemic risk effectively.” She added that 80% to 90% of OTC trades could be centrally cleared.
The question is therefore: what was the highly eloquent Pearson trying to say?
In addition to questioning whether central clearing reduces counterparty risk, he suggested that exchange trading of OTC derivatives might not necessarily be adopted in Europe – something that has also been seen as almost inevitable given the regulators’ drive for transparency in this market.
Safety not guaranteed
“If we shift massive amounts of OTC derivatives onto an exchange – are they safe enough to manage the risk?” Pearson asked. “We don’t know. There are 13 clearing houses in Europe. If one defaulted there would likely be multiple defaults of clearing houses across the region. Just imagine how the markets would react.”
Pearson’s comments came on the eve of the G20 meeting in Toronto on the weekend of June 26 – one year on from the meeting at Pittsburgh where all members signed up to centrally clear and exchange trade OTC derivatives, where appropriate.
“Look at those words ‘where appropriate’,” Pearson warned. “Europe has not taken this decision. Jurisdictions will come up with different solutions.”
Pearson was speaking shortly after the European Commission issued its final public consultation paper on OTC derivatives reform. Michel Barnier, internal market services commissioner, is due to reveal the text of the proposed legislation later this summer.
Re-examination under way
There have certainly been suggestions that since Barnier replaced Charlie McCreevy in February, the EC might have been re-examining its position on central clearing. On May 4 this year Barnier announced that non-financial groups in Europe would not be required to clear OTC derivatives unless their positions posed a “systemic risk”.
In June the EC announced the establishment of a new pan-European supervisory agency – the European Securities and Markets Authority – to determine which OTC derivatives must be cleared and which need not be.
This question of what is a standardized derivative has bedevilled the process of regulatory reform in this market because of the inherently bespoke and illiquid nature of many bilateral trades. But if, as Tumpel-Gugerell suggests, 80% to 90% of OTC derivatives can be cleared, then the question of standardization needs to be addressed urgently.
As clear as custard
“When the G20 leaders met in Pittsburgh last year they said that all standardized OTC derivatives must be cleared through clearing houses,” said Pearson. “This is as clear as custard. It needs to be translated into regulation but there is no single definition of what standardized derivatives are.
“You need to get the process right to make sure that you come up with the right answer,” he continued. “In Europe, we will have a process to determine what a standardized derivative is and all our noses are facing in the right direction. Unlike the England football team we know where the goal is.” (Pearson was speaking shortly after the England football team’s dismal showing against Algeria in the World Cup.)
Pearson’s comments prompted some bemusement among the clearing houses. Not surprisingly some took issue with his statement that CCPs do not reduce risk but redistribute it – citing the margin that is posted against each trade – but dismissed any suggestion that the regulatory process could deviate significantly from its expected path. “This does seem to be a subtle shift from the tone of other recent pronouncements,” says Rory Cunningham, director public affairs at LCH.Clearnet in London. “But there is no doubt that the structure will be established to require mandatory clearing of OTC derivatives in Europe.”
Euromoney highlighted the potential pitfalls associated with central clearing of derivatives two years ago (see Credit default swaps: On dangerous ground Euromoney , August 2008).
