The Bank of International Settlements (BIS) has released an interesting research paper which looks at the incentives for various market participants to centrally clear bilateral OTC derivative trades.
Following the financial crisis, G20 leaders agreed that standardised over-the-counter (OTC) derivatives contracts were to be cleared through central counterparties (CCPs). A number of regulatory reforms have been introduced that affect the incentives for central clearing of these contracts. These reforms include requirements to exchange initial and variation margin for non-centrally cleared derivatives exposures, standards relating to the measurement of counterparty credit risk for derivatives contracts, and capital requirements for bank exposures to CCPs.
The paper found that:
Clearing member banks (ie those institutions that clear directly with CCPs) have incentives to clear centrally.
Whilst central clearing incentives for market participants that clear indirectly (ie that are not directly clearing members of a CCP but clear through an intermediary that is a clearing member of a CCP) are less obvious and could not be comprehensively analysed on the basis of the data received in the quantitative analysis.
However, given that clearing members account for the bulk of derivatives trading, the conclusion of the analysis – there are incentives for them to clear centrally – indicates that the G20 objective on OTC derivatives reforms has, for the most part, been achieved.
These “indirect clearers” do not constitute a homogeneous group. Instead, their trading and clearing patterns vary in a number of ways, such as trading frequency, portfolio composition and regulatory requirements. Some, but not all of them, are banks. This makes it difficult to draw any general conclusions on the effect of the reforms on indirect clearers’ incentives for central clearing. After the reforms have been introduced, some indirect clearers may have incentives to clear centrally, while others may not.
The paper found that to a large extent, the incentives to centrally clear OTC derivatives contracts depend on the relative cost of bilateral settlement and central clearing. Important components of these costs are driven by regulatory margining and capital requirements (including counterparty credit risk charges for default risk and credit valuation adjustment (CVA) risk).
BIS paper available here: An assessment of incentives to centrally clear
Table indicates the primary drivers of incentives to centrally clear
In this simple example, the main elements are:
1. Capital requirements for CVA volatility for bilateral trades
2. The quantity of initial margin posted to the CCP and the amount of bilateral initial margin exchanged between counterparties
3. The capital requirement for the default fund for central clearing
4. The capital requirements for counterparty credit risk for bilateral and centrally cleared trades
We touched on this in a previous post, when we looked at the incentives for client clearing. In Europe under European Market Infrastructure Regulation (EMIR), standardised OTC derivatives (covering rates, credits, FX, commodity and equity) will be required to be cleared through central counterparties (CCPs), and those that can’t be cleared will be subject to bilateral margining. In addition, the Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR) increase the capital requirements for both cleared and non-cleared OTC derivatives.
So, what exactly are the increased costs for capital requirements for non-cleared (bilateral) and cleared OTC derivatives, and who will bear those costs?
According to estimates from a study by Deloitte:
the additional annual cost of trading for the OTC derivatives market will be in the region of €15.5bn/year, with cleared transactions costing €2.5bn/year more, whilst non-cleared transactions will be far more expensive at €13.5bn/year.
The main elements of the additional costs incurred by OTC derivatives being: new margin requirements, new capital charges and compliance costs.
Table above contrasts the additional costs for cleared vs non-cleared OTC Derivative trades (Source: Deloitte)
This should lead to banks providing clients with the choice of cleared vs non-cleared pricing via their SDP. With tighter spreads for instruments that are designated for clearing, and much wider spreads for the same instrument that would remain as bilateral trades and not be cleared. Thus giving clients a choice, or perhaps for certain clients where credit is an issue, only offering cleared trading, which is better than having to stop trading with the client!
Above is an example of a trade tile showing both bilateral and cleared prices via Nasdaq clearing, with the cleared pricing in blue) showing narrower spreads, due to lower CVA and capital charges.
We will revisit this discussion when looking at new initiatives in FX around ‘client-clearing’, and look at how client-clearing model can enable banks and clients to maintain strong trading relationships, whilst mitigating both higher capital costs and counter-party credit concerns by immediately upon execution migrating (or novating) pre-designated trades from bilateral to cleared trades which would be subject to margining by the CCP.