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Reaction to CCP

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1. Introduction

In an article in the Autumn 2011 of the Chronicle we explored some of the issues likely to result from Central Counterparty Clearing (CCP). Since that article there has been some reaction to the establishment of CCP from central banks, regulators and the industry.

To paraphrase the article, we stated that buyside access to the CCP would come about through partnering with a Clearing Member or members, where this relationship would not be unlike that which exists with clearing brokers in the Exchange Traded Derivative world and that that with EMIR being likely to require CCP’s to have the ability to call and collect margin intraday from clearing members. It was likely therefore that clearing members would require daily collection of margin from buyside clients with a knock on effect on both the operating model underpinning derivatives trading and on the availability of acceptable collateral.

2. Central Bank Reaction

In the Spring of this year the Bank of England (BoE) published a report, ‘Thoughts on Determining Central Clearing Eligibility of OTC Derivatives.’ This report set out the BoEs suggestions on the type of OTC contracts that should be made eligible for central clearing as a means of reducing UK systemic risk in financial markets.

The BoE argues that when determining which contracts are eligible both product standardisation and market liquidity should be two critical factors. Like all data elements of any security, the more standard in the market, the more automated the processing is likely to be to control and transact these securities. Without such standards CCP is problematic. Market liquidity is essential to making OTC contracts eligible to CCP as less liquid markets make for less automated processing and more manual control. However, the BoE does suggest that CCPs may have to revise their own risk models to allow for the processing of less liquid OTC contracts which may mean more manual effort and therefore risk. Focusing on the more plain vanilla credit and rates contracts fulfils these criteria. Perhaps eventually the requirements will be rolled out to cover more esoteric and therefore less transparent products such as CDO’s and Mortgage-Backeds.

3. Regulatory Reaction

EMIR (European Market Infrastructure Regulation) is Europe’s driving force behind delivering centrally cleared OTC trading and in the Spring of 2012 The European Securities and Markets Authority ended its consultation on EMIR with regards to eligible products for clearing. EMIR was set up to increase stability within OTC derivative markets with a timetable for introduction at the end of 2012 with CCPs gaining the appropriate recognition within two years of this date. The final text of EMIR has been agreed by the European Parliament, the European Commission and the European Council on 9th February 2012. However, this still requires a formal vote by the European Council to enact EMIR and this is timetabled for 30 September 2012. The European Securities and Markets Authority who will oversee the regulation are now consulting on the technical standards.

4. Market Reaction

More recently Nasdaq OMX has advised the market that it intends to launch a new London-based interest rate derivatives platform. Nasdaq OMX obviously see an opportunity to break into the European derivatives market dominated by NYSE Euronext and Deutsche Borse through their Liffe and Eurex platforms respectively. The platform marketed by Nasdaq OMX called NLX and will clear transactions through LCH Clearnet. The press release from Nasdaq OMX advertises that by using LCH Clearnet the customer will be offered greater collateral efficiency by allowing the cross-margining or products traded on NLX. It is hoped that this form of cross-margining will permit users to post less collateral as required by EMIR. Currently market participants are concerned about the effects of EMIR and the requirement to post significant quantities of collateral and set aside margin to protect against counterparty default.

No doubt EMIR and the recognition of CCP is well conceived and may in time bring about more control and less risk when transacting OTC derivatives, but like all change it will be evolutionary. Central Banks and Regulators want to de- risk the trading of off-exchange contracts as soon as possible, as market participants and service providers are challenged to adapt and play catch up, whilst offering transparency and lower costs. Future events may also challenge the adoption of EMIR, Mitt Romney may win the US election and the Euro crisis may deepen. Romney has committed to a review of Dodd-Frank (the US equivalent of EMIR) and if this is repealed in the US, will the Euro area continue with EMIR in its current form if it makes them uncompetitive? Secondly, the Euro-crisis may gather further pace hindering the markets’ ability to gear up in time for January 2013. One school of thought suggests a delay in implementation until one or both of these events play out.

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