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Central Counterparty Clearing - Panacea or False Down

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To what extent is a Central Counter Party for Over- The-Counter derivatives a positive development for Investment Managers?

The 1st century B.C. Roman lawyer, orator and senator Marcus Tullius Cicero famously coined the phrase “cui bono?” meaning “to what benefit” applying it as a maxim during several celebrated legal cases as he sought transparency and clarity of purpose and outcome. 2000 years later, as we face clarion calls for a move to the Central Counterparty Clearing model for OTC derivatives, it is time to apply the axiom afresh with respect to the investment management community.

The single focus of the pro- posed moves is the regulation of the Credit Default Swap (CDS) market (at least for the time being). In essence, the proponents of Central Counter Party (CCP) are asserting that by moving the clearing of these instruments onto a common platform, systemic risk may be contained and the need to bail out individual market makers mitigated. This does seem to make the assumption that what works for exchange traded products also extends to the world of OTC. Exchange traded products are simpler and tend to have commonly agreed pricing models which are open and transparent to all. CDS, despite the volumes traded, can still not be considered as “commoditised” instruments. CDS pricing models are heterogeneous with each house believing that its model offers them a trading edge. This is exacerbated by the fact that each trading house will be performing complex credit analysis not only on the companies on which they offer CDS trading but also on their competitor banks. This work will feed into their pricing and enable them to accurately price the risk inherent in CDS. This form of analysis will be difficult for a CCP to replicate, capture and reconcile into a commonly agreed price. As a result, the CCP may well be in the position of mispricing risk. As events have shown pricing is not easy especially when the contracts themselves may not be terribly liquid. Further, during periods of market stress, pricing differences and anomalies are likely to be magnified. Clearly, this is a disadvantage to the CCP itself but also to the end price taker, the investment manager who will not benefit from the informational asymmetries offered within the current bilateral trading framework. The price would be transparent, but not necessarily accurate.

An adjunct to pricing is the collateral/margining process. The ability for CCP’s to calculate and call margin quickly and efficiently are, without question, an operational and risk mitigative advantage. However, from the investment manager’s perspective, many of the benefits can be captured through a strengthening of the existing investment and operational risk frameworks within each organisation. By placing investment risk at the core of the investment process, greater ex ante risk insight into market events and positional structures can be realised. By ensuring that the collateral process is robust and scalable, from negotiation of ISDA’s through to facilitating daily collateral calculation and movements, the investment manager takes advantage of a process and infrastructure which puts them in control to a far greater extent.

The proponents of CCP argue that there are significant benefits to be gained from the new structure. Banks will need to post less regulatory capital in a CCP environment as the CCP is deemed to be a Triple-A rated body. Further market makers will not be exposed to the balance sheets of other banks since trades will be against the CCP. Hence, credit lines will be freed up between banks. It is difficult to see how either of these is a benefit to the investment management community. Further it might be argued that reduced capital and credit line requirements might well encourage banks into further risk taking in other areas. Let us not forget that the CDS market was not the direct progenitor of the crisis. There is, as far as I am aware, no plan to move CDO and other forms of structured debt products onto the CCP model (not least because for the time being demand for them is non- existent). That is not to say that in time such instruments will not make a return. The absence of these products from the CCP process does nothing to minimise systemic risk.

There are advantages to the regulator that they will see quantitative and qualitative statistics and reporting on trading activity from the CCP which will help them to monitor activity. There is a great deal of truth in this. However, the market has already developed the same functionality (DTCC Trade Information Warehouse). It would be worth examining the possibility of ex- tending access to TIW or some subset by the regulators in order that they can have and be seen to have the required level of insight into the market mechanics and hence avoid costly duplication of developmental effort.

Investment managers will also have an operating model to cater for the both collateral for bilaterally-traded OTC’s as well as for CDS which are exchange cleared, following the initial and variation margins process. This splitting of process for OTC instruments will require further analysis and design and will impose cost on Investment Managers. Further, the fact that several organisations either have or are in the advanced stages of developing CCP offerings and the concomitant legal, jurisdictional and operational issues this presents are far from resolved. It is difficult to see a further fracturing of the operating model applying to Investment Managers as being an advantage, especially when the perceived benefits cover only CDS. In conclusion I would urge that investment managers take up the offer to speak to regulators. The governmental and regulatory response to create CCP’s for CDS has doubtless been well intentioned. However there are several major issues with the CCP concept which beg the question “cui bono?” Investment managers would do well to take up the opportunity to engage in the discussion and ensure our industry has a voice during the development of these potentially paradigm-shifting proposals.

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