The Role of Clearinghouses in OTC Derivatives

By George Bollenbacher Senior Managing Consultant Knowledgent Group, Inc. george.bollenbacher@knowldegent.com The Dodd-Frank legislation has as one of its main objectives reducing the systemic risk involved in the market for OTC derivatives. To quote an excellent white paper by Skadden, Arps, Slate, Meagher & Flom: “The main mechanisms for achieving these goals are:

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to require that as many product types as possible be centrally cleared and traded on exchanges or comparable trading facilities; to subject swap dealers and major market participants to capital requirements and to margin requirements (to be imposed by clearinghouses for cleared swaps and by regulation for uncleared swaps); and to require the public reporting of transaction and pricing data on both cleared and uncleared swaps”1

While the business press and others have paid a lot of attention to the execution of trades on swap execution facilities (SEFs), much less attention has been paid to the role of clearinghouses in this marketplace. The CFTC has held hearings, and has requested public comments, on the implementation of the Dodd-Frank clearinghouse requirements, but most market participants may not be aware of how different OTC derivatives are from those instruments where clearinghouses work today, or just how clearinghouses would function in the new OTC derivative landscape. Clearinghouses in other markets Before looking at clearinghouses in OTC derivatives, it is useful to see how clearinghouses work in other markets, which may have been the intellectual model for the Dodd-Frank requirement. Most observers have started by looking at securities depositories like DTC and Euroclear, but those organizations and functions aren’t really a good basis for comparison. A much better basis is the true securities clearinghouses, like FICC or OCC. These entities deal primarily with transactions before settlement, as opposed to the depositories, which handle settlements and post-settlement positions. Why is that distinction important? Because the risk parameters of a securities transaction change when it settles. If I buy a stock or a bond, I am at risk for the security’s performance after I settle, but I am at risk for both the security’s performance and my counterparty’s performance before I settle. For typical securities trades that settle in three days or less, the counterparty risk is relatively small, but in longerdated trades, like forward trades in mortgage backed securities, the counterparty risk can both grow to large proportions and persist for months. Clearinghouses handle this counterparty risk in two ways: first, they collect margin deposits and contingency funds from all their members to ensure, as much as possible, the members’ financial performance; and second, they net out offsetting positions, so that the only settlements and the only pre-settlement counterparty risk is between net positionholders. Those two functions of the clearinghouses mandate that their membership be restricted, generally to marketmakers or their clearing agents. One reason is that any member must be willing to accept any other

the initial margin is returned to the member. Public participants in the market are not generally willing to accept that condition. and then mark each position to the market daily. and are not netted or margined by the clearinghouse itself. There are some fundamental differences between these instruments and any that we have discussed before: 1. the clearinghouse role becomes more important and more visible. and that exposure must be collateralized by either the underlying security or cash. a closing price for each contract. Securities and futures contracts are standardized instruments that can be traded on exchanges and listed in security master files. but nothing requires that this be true. so the two-sided counterparty risk remains throughout the life of the instrument. One final aspect of first level derivative clearinghouses is that their variation margining function. relies on the availability of end-of-day trade prices. no matter whom that member originally traded with. is not managed by the clearinghouse. but a one-directional counterparty risk remains after settlement. The variation margin movements within the clearinghouse should match margin movements between its members and their customers. Their positions. either doesn’t happen or it doesn’t have the same risk impact. OTC derivatives are bilateral agreements between two parties about future cash flow that are not standardized or listed in security master files. they collect initial good-faith margin from all members for each new position. and use the difference to determine variation margin movement for the day. As a result. their margin movements. as used in the securities sense. unless they go to expiration and are replaced by the underlying. When a position is closed out. Any dispute about the end-of-day price for a contract or its underlying severely impacts the margining and risk management machinery. each party to the trade views the clearinghouse as their true counterparty. which is at the crux of their counterparty risk management.member as a counterparty at any time. one aspect remains the same – clearinghouse membership is restricted to marketmakers and market insiders. This persistent counterparty risk means that futures clearinghouses now become true central counterparties (CCPs). In other words. not the clearinghouse itself. Securities are issued and paid for. In these instruments settlement. Thus the seller of an option has an exposure to the option buyer for as long as the option exists. As different as this arrangement looks from the securities world. sometimes called systemic risk. usually from an exchange. like futures or options. so we can see how the clearinghouse concept would apply to them. . and their counterparty risks are with the clearinghouse members. In all these events. are not issued and not paid for. like futures contracts. Thus the risk in the market as a whole. One reason is that settlement means something different here than it does in the underlying securities. 2. it only manages the risk between clearinghouse members. When we move to first-level derivatives. Cash variation margin is passed from the owing member through the clearinghouse to the receiving member each morning as a condition of doing business that day. and are treated as assets on the books of the owner. even if no trades were actually done with that counterparty. they assume the position of counterparty to every member. Every business day these clearinghouses obtain. OTC derivatives. and are not treated as assets or liabilities. and so aren’t members of these clearinghouses – their positions are carried by the clearinghouse members. Futures trades don’t settle at all in the securities sense. The public (including many financial institutions) are not members of the clearinghouse. They are bilateral agreements. compare that price to the previous day’s closing price. The nature of OTC derivatives Now we need to look at the nature of OTC derivatives. Option trades settle in the same way as trades in the underlying (the buyer pays the seller and receives an asset in return).

In the past. With one-off contracts the rule of the day. will that arrangement be any better than the current one? If the clearinghouse needs more control over public positions. What we need instead is an enlightened discussion about what clearing derivative transactions really means. Without that discussion. 2. the clearinghouse will have to establish a pricing methodology that will be acceptable to all members. and the members of any clearinghouse are likely to be the same large commercial banks. sometimes leading to outright rejections of ISDA agreements. and could last longer. these contracts last five years. The clearinghouse will have to manage both types of risk we have already mentioned. If the offsetting contract is very close to the original. let alone be an improvement over the current situation. 2) find another party to replace them in the contract. 4. 5. the clearinghouse may have to take action if the member’s credit quality deteriorates. or 3) enter into a matching. Even if the market hasn’t moved against a member’s positions. Much of the current discussion has been about the minimum capital requirements for members. the clearinghouse will have to manage risk throughout the life of the contract. but not identical (slightly different tenor. and it knows nothing about public positions. wants out. implementing Dodd-Frank won’t accomplish much. 4. with the consent of the original counterparty. Since most derivative contracts have some unique parameters (and many more will have them as dealers strive to keep their trades off the SEFs) there won’t be active daily markets in each of the specific instruments. Clearinghouses in OTC derivatives These fundamental differences have significant impacts on how a clearinghouse would operate in this market. how will membership be determined? All these implications will need to be worked out before derivatives clearinghouses can function at all. In many cases. A party to an OTC derivative contract who wants out can only: 1) close the position out with the original counterparty at a price agreeable with the original counterparty. Because model-based pricing is formulaic. which may be the least of the concerns before us. at the same time. he/she can close out the position by doing a trade with a party other than the original counterparty. pricing methodologies have been a widespread sticking point between market participants. which could result in large unexpected price movements and uncovered risks. offsetting derivative with another counterparty. and may make matters worse. . market risk and counterparty risk. someone will have to guard against algorithmic errors. the only clearinghouse control is over its members.3. As with futures contracts. If. one might well ask what we accomplish by moving the transactions to a clearinghouse. and how we can get it done in the foreseeable future. longer than any futures contract or forward settlement trade. as with the current clearinghouses. Some of these impacts: 1. When the owner of a security. or the holder of a futures position. So there may not be end-of-day prices for the clearinghouse to use in margining. 3. for example) the algorithm will have to allow for “pseudonetting” to reduce but not completely eliminate the counterparty risk. the clearinghouse will have to have a sophisticated algorithm for detecting and netting out offsets. Because the preferred method of closing out contracts will probably be establishing offsetting contracts with another counterparty. however. since that deterioration would impact the member’s ability to support market risk at some point in the future. If the primary originators of derivatives are the large commercial banks.

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