Central clearing of OTC derivatives raises questions

By Megan Hart

The financial crisis of 2008 put the spotlight on the massive but opaque market for over-the-counter swaps and other derivatives that blew up following the failure of Lehman Bros. and threatened a global financial collapse.

With Lehman’s demise, American Insurance Group was instantly on the hook to pay out billions of dollars in credit default swaps, insurance-like contracts, it had sold. Until that moment, few outside Wall Street had ever heard of the contracts.

Lawmakers passed the Dodd-Frank Act of financial reforms in 2010, a document 16 times the length of “Moby Dick” that put regulators on the hot seat to reign in risky OTC contracts and prevent such a collapse from ever happening again.

But four years and dozens of new regulations later, no one is entirely sure the law is having the intended effect.

So far, the Commodity Futures Trading Commission has crafted 74 regulations based on Dodd-Frank that apply to OTC derivatives. Chief among the new rules is the requirement that many previously bi-lateral trades be transacted through third-party clearing houses.

While this move has been embraced by international regulators, global banks and financial services companies have been slow to come to the table.

As of June, about 27 percent of credit default swaps worldwide were cleared by central counterparties. That’s an increase of only 4 percent since the end of last year, according to the Bank for International Settlements and largely reflects slow progress in Europe.

In the U.S., where central clearing of non-foreign exchange swaps is required, regulators such as Federal Reserve Board Governor Jerome Powell are optimistic that central clearing is the key to safety and security in the financial system.

“Post-crisis reforms and the rise of central clearing have started us down a path toward greater financial stability,” Powell said in a speech at the Federal Reserve Bank of Chicago in November.

Markets that were centrally cleared survived the 2008 financial crisis almost fully intact. Now-defunct Lehman had a big position at the Chicago Mercantile Exchange, but largely because of central clearing, the CME withstood Lehman’s default.

“That’s where everyone saw that central clearing worked,” said Rajeev Ranjan, the lead technical expert on financial markets at the Federal Reserve Bank of Chicago.

The industry’s largest clearing houses, like CME, ICE Clear and LCH.Clearnet, have been in the business for a long time – more than 100 years in the case of CME. Even so, there is mounting concern that central clearing may just be concentrating risk in the OTC derivatives market.

“There is a possibility that risk now moves from the firms where we saw it in the financial crisis to the clearing houses,” Ranjan said.

At the heart of that fear, Ranjan said, is the sheer size of the OTC derivatives market, which encompasses interest rate swaps, credit default swaps and commodity swaps that are actively used by corporations to manage interest rates and other risks to their global operations.

At $691 trillion of notional value as of June 30, it’s bigger than the stock market, bond market and futures market combined.

“The amount of notional money in the OTC market is so much more that it’s a different game altogether,” he said.

If the majority of the OTC derivatives market is split among a handful of central clearing outfits, the failure of just one could produce catastrophic consequences. For this reason, regulators are taking extra steps to ensure that OTC derivatives clearing houses are protected.

Some regulatory moves have been widely accepted, such as those mandating that clearing firms hold a certain level of ready cash, or liquidity, in the event of a crisis. Other requirements haven’t garnered the same unanimous support.

The main way that central clearing houses offset risk is by maintaining a guarantee fund that can be used in the event of a member’s failure to post margin. Clearing houses require members to contribute significant amounts to these guarantee funds, which typically hold the amount of capital needed to protect the clearing house if its two largest members were to default on the same day.

LCH.Clearnet, the world’s largest clearer of interest rate swaps, requires members to contribute a minimum of £10,000,000 to its guarantee fund, with larger members paying even more.

Recently, however, large clearing members have pushed for the clearing houses to put their own money on the line by contributing significantly to their own guarantee funds.

In a recent report by J.P. Morgan’s regulatory affairs office, the bank suggested that the clearing house itself should be the largest contributor to its guarantee fund, providing at least 10 percent of the fund’s total amount.

“Having a minimum level of ‘skin in the game’ would more appropriately align incentives amongst the [clearing house] and its members and ensure proper risk management and governance,” the report stated.

Major industry players like West coast investment firm Pimco, and multinational asset manager BlackRock, as well as the industry’s trade group International Swaps and Derivatives Association, have also recently released statements in favor of a “skin-in-the-game” requirement.

Kathleen Hagerty, chair of the department of finance at Northwestern University’s Kellogg School of Management, said that despite the popularity of the requirement among clearing members, she’s not sure that it’s a necessity.

“Everyone wants someone else to kick in the capital,” Hagerty said, adding that clearing houses have enough incentive to properly manage risk without having to contribute to their own guarantee funds.

In the European Union, clearing houses are required to subsidize 25 percent of their own guarantee funds. Fed Governor Powell said he’s unsure if a similar regulation will be enacted in the United States.

Another issue that’s still unresolved when it comes to OTC derivatives clearing is that of stress tests, or the simulation that financial institutions use to determine how successfully they’d be able to withstand an economic crisis.

The country’s largest banks, many of which required bail-outs during the financial crisis, are required to undergo stress tests annually. Since the crisis, these have been overseen by the Fed and the results have been made public.

While most major clearing houses currently participate in some form of stress testing, it’s very loosely regulated. There is no standardized test, results are not always made public and, unlike with the major banks, there’s no requirement in terms of frequency.

Some argue that standardized stress tests could serve as a key component of clearing house regulation. JPMorgan and ISDA both contend that conducting standardized stress tests, and publically releasing their results, will foster resiliency and transparency in the OTC derivatives market.

Powell said that regulators are working to make stress tests “robust, informative and appropriately comparable.” But, according to Ranjan, a standardized test is unlikely because different clearing houses have different risk profiles.

Despite the contention over the “skin-in-the-game” requirement and stress testing, most experts agree that central clearing is the best option regulators have for the OTC derivatives market.

“I don’t think it’s this crazy new thing,” Hagerty said. “There’s a long history of clearing houses.”

Michael Gorham, the director of the Center for Financial Innovation at the Illinois Institute of Technology, said central clearing has been a valuable tool for protecting many other markets, such as grain, livestock, energy and financial futures and options traded on derivatives exchanges in Chicago and elsewhere.

While regulators are banking on the success of central clearing, it’s important to note that not all OTC derivatives are subject to the requirement.

The clearing rule only applies to financial institutions that hold at least $10 billion in assets, and, for now, they’re only obligated to clear standardized contracts, like credit default and interest rate swaps.

Most small firms that are eligible for the exemption choose to forgo clearing, according to Ryan Henley who serves as head of financial institutions strategies at Sterne, Agee & Leach. Henley said smaller firms tend to prefer bilateral arrangements.

“This is due in large part to the cost,” Henley said. There are lots of costs associated with clearing, and Henley contends that most small financial institutions do not trade frequently enough to justify the price tag.

The clearing requirement, paired with low interest rates, has made the OTC derivatives industry less profitable for mid-level participants. Some, such as the Bank of New York Mellon, have announced that they plan to exit the derivatives market.

Derivatives are a zero-sum financial instrument, and if mid-level banks are the losers in the new regulatory scheme, Hagerty says exchanges that have begun trading OTC derivatives seem to be the winners.

For example, the Chicago Mercantile Exchange’s monthly trading volume was 7 percent higher this November than last, largely due to interest rate swaps. After the central clearing requirement was enacted in 2012, the CME Group added interest rate swaps to its repertoire. Last month, the CME Group cleared an average of $153 billion of interest rate swaps daily.

Ranjan said, however, that he’s not ready to name a winner or a loser when it comes to OTC derivatives clearing.

“It’s more a marathon than a sprint because the rules are still being written,” he said.