The leading Asian economies have been active in their quest for more centralised clearing in the over-the-counter (OTC) derivatives markets. Japan and Singapore have taken the lead in setting up clearinghouses to deal with OTC derivatives such as credit default swaps and interest rate swaps, according to a new report, OTC Derivatives Reforms in Asia: Challenging for the Buy Side, from Celent, a Boston-based financial research and consulting firm.
The Asian central clearing model is slightly different than models in the US and Europe. In those markets, there are norms for the trading of standardised OTC products. There too, it is expected that trading will take place on regulated platforms and that CCPs will undertake the clearing for such trades. In Asia, however, there are no regulations governing the move of trading to regulated platforms, and trading is still expected to happen in a bilateral manner. In that context: “There are doubts over the sustainability and viability of central clearing in Asia, because there is a great deal of fragmentation,” says Anshuman Jaswal, Celent senior analyst and author of the report. “The existence of multiple jurisdictions could lead to regulatory arbitrage.”
The share of the Asian OTC derivatives market in global notional outstanding is around 15% for both OTC equity derivatives and interest rate swaps. It is only 2% for credit default swaps (which are not very popular in Asia) and 26% for OTC FX derivatives, with Japan contributing a majority of this volume.
Among the other findings of the report, it is clear that collateral and margin management will become more complex and expensive. One of the important changes will be the higher cost of collateral management. Right now, bilateral clearing allows the counterparties to decide on the necessary collateral. The mutual understanding and experience of trading with counterparties plays an important part in ensuring that the collateral requirements are not very high. However, it is expected that CCPs would be more conservative in their approach and set higher collateral and margin requirements going forward. Any cross-margining benefits that the larger participants currently derive from trading larger volumes might not carry into the new regime, and CCPs are expected to be more cautious in this regard.
The report also finds that central clearing would lead to significant IT and infrastructure costs. Market participants in leading Asian markets are expected to bear any increase in costs resulting from a move to central clearing. Certainly, connectivity requirements are going to increase and it is going to be difficult for the smaller buy side firms and regional banks to create and maintain the infrastructure required to trade in the OTC markets. “It is expected that the leading sell side firms will try to meet the buy side requirements by providing this infrastructure as an additional service that would resemble the connectivity they provide for exchange-based trading and post-trading services. Besides clearing, in most instances, connectivity would be required to the trade repositories that are expected to improve the post-trade transparency across these markets,” says the report.
Moreover, the report suggests that CCP clearing will invariably become a revenue-generating opportunity for clearinghouses and clearing brokers in the global markets. However, this might not be the case in Asian markets because the volumes in a number of these markets are not significant. There are also some doubts voiced in the report over the sustainability and viability of central clearing in Asia, because there is a great deal of fragmentation. One or two clearinghouses would be ideal for such a scenario, but the existence of different CCPs in each national market means higher costs for firms that are trading in more than one market because they have to create a separate infrastructure in each market.
The report mentions the obvious benefits of the introduction of central clearing, such as improved risk management and efficiency benefits. Once the infrastructure is ready and clearing is taking place on an ongoing basis, risk management and efficiency are going to improve for the OTC derivatives markets. Clearinghouses performed well during the financial crisis, and it is expected that central clearing will perform in a similar fashion. Additionally, Portability will be an important aspect of central clearing. A crucial aspect of the strategy to reduce systemic risk has to be the mechanism to cope with a clearing member's default. This can be done through portability, which allows a market participant to move their trades from a defaulting clearing member to another clearing member, thereby ensuring continuity and reducing systemic risk. While it plays a vital role, portability has complications. In markets where the mechanism has been provided, there would still be the added complication of ensuring it works even under stressful market conditions, such as a broker default.
There is, however, a possibility that regional and global players that operate across a number of markets would choose to move their OTC business to markets with the least regulation and lowest collateral and margin requirement costs. This would be undesirable for both the market that loses the business and the market that gains it. The market that loses business might not be able to sustain its CCP due to low volumes. The market that gains the business might have artificially high volumes and therefore would have more complex issues with regard to systemic risk in case of a default by a clearing member or even a CCP. Multiple markets with CCPs also mean that the jurisdictions will have to address extra-territoriality and interoperability issues that will arise.
It is a sensitive time for the OTC derivatives segment as it undergoes change. While volumes in the global OTC derivatives market have recovered from the lows of 2008, the move to central clearing is expected to lead to a dip in volumes globally for the next couple of years. Volumes are expected to fall in 2012 and 2013, with the recovery beginning in 2014.