Derivatives clearing makes markets safer, but not 100% safe

Almost seven years after the near collapse of the global financial system and four years after the Dodd-Frank Wall Street Reform and Consumer Protection Act passed, the derivatives market still has a long way to go before it is 100 percent safe, according to experts.

The U.S. Commodity Futures Trading Commission and the Securities and Exchange Commission began implementing new rules earlier this year that require over-the-counter derivatives, such as the credit default swaps that swamped the global financial system during the crisis, to be transacted through a clearinghouse, such as the CME Group Inc.’s ClearPort and IntercontinentalExchange Group, Inc.’s ICE Clear Credit.

“I can’t say if it’s safer or not,” said Rajeev Ranjan, policy specialist at the Federal Reserve Bank of Chicago. “It’s always a work in progress; there’s never going to be a time when I feel everything is settled.”

When Lehman Brothers Holdings Inc.’s filed for bankruptcy in 2008, American Insurance Group was left holding the bag on billions of dollars in credit default swaps it had sold on Lehman’s debt. AIG had promised it would pay out on the insurance-like contracts in the event of a default. At the time, CDSs were unregulated and sellers of those asset classes were not required to keep reserves adequate to protect them in the event of a pay-out.

Current regulationsDerivatives Clearing by Agency

Mandatory trade clearing began Feb. 15, just three days before trade reporting in Europe started. The CFTC, which oversees commodity-based swaps, has finished writing its portion of the clearing regulations, whereas new rules for security-based swaps coming from the SEC are not yet finalized.

According to Ranjan, this is part of the reason why some bilateral trades without a clearing third party still exist: clearinghouses are not yet fully equipped with sufficient platforms to clear all types of swaps, especially the more intricate or exotic products that span multiple asset classes.

Nonetheless, the number of swaps cleared has soared to about 75 percent of the U.S. market from just 16 percent in 2007.

New derivatives clearing rules require more collateralization of the derivatives market, since trading counterparties are required to post margin, or collateral, to guarantee a trade. Clearing members also pay a fee for each trade cleared.

Phil Matricardi, manager and OTC derivatives specialist at Sapient Global Markets, says there is a “competitive landscape” where clearinghouses are competing for more volumes of contracts cleared.

In terms of interest rate swaps, for which rules have been finalized, London-based LCH.Clearnet has the most volume among all clearinghouses, Matricardi said. “CME is trying to break into interest rate swaps, whereas [credit default swaps] have been captured by ICE.”

At the end of 2013, LCH.Clearnet’s SwapClear cleared $282.6 trillion in notional amount of interest rate swaps and $213 trillion in open interest, meaning all “open” contracts that weren’t directly sold or delivered to a buyer. In comparison, CME’s interest rate swaps notional amount was $15.1 trillion with $9.1 trillion open interest, significantly smaller than LCH volumes, but still a whopping $14.2 trillion increase from 2012.

ICE led the CDS clearing business in 2013, with $7.7 trillion in notional amount, a 25.3 percent jump from $6.1 trillion in 2012, and $900 billion in open interest.

Aside from operating clearinghouses that collect clearing fees, giants like CME and ICE also have their own swap execution facilities, where swaps are listed and traded. There is competition among them as well.

CME launched ClearPort in 2002 and cleared over trillion OTC derivatives in 2014 Annabelle Ju/MEDILL
CME launched ClearPort in 2002 and cleared over $32 trillion OTC derivatives in 2014
Annabelle Ju/MEDILL

“In the beginning, everybody wanted to be a swap execution facility,” said Mary Kopczynski, CEO of New York-based financial regulatory consulting firm 8of9, LLC. “Truthfully, there will be only four or five that make it because [operating a SEF] costs a lot of money; ICE, CME will be the ones that make it.”

Kopczynski works closely with banks that are clearing members of clearinghouses and advises them on how to understand and navigate the new regulatory landscape.

“There is regulatory change in management where the new regulations are designed so bankers can’t do anything [illegal] and if that happens, they’ll find out,” she said, in reference to the credit default swaps, which were established in 1994 and in just a little more than 10 years managed to take down the economy.

“The goal for these new regulations is building safety around these tools,” she said.

This is because Wall Street banks are always, or trying to be, “10 steps ahead of regulators,” according to Kopczynski. “Are there probably unbelievable transactions going on [at] banks? Absolutely. Do regulators know? Probably not.”

But these unforeseen and unknown activities that could potentially be a systemic risk to the derivatives market are exactly why these regulations are rolling out in the U.S. The Bank for International Settlements created a set of guidelines called Principles for Financial Market Infrastructures, which “strengthen the existing international standards for…central counterparties,” or clearinghouses, according to the BIS report from April 2012.

“The CFTC spent a fair amount of money implementing the Principles for Financial Market Infrastructures into clearing regulations to create the framework within which swaps are supposed to be trading,” said John McPartland, senior policy advisor on financial markets at the Federal Reserve Bank of Chicago.

The current international standard, as agreed upon in the G-20 Leaders’ Statement of the September 2009 Pittsburgh Summit, states that financial instruments should be centrally cleared, where appropriate, and trade on exchanges and electronic platforms, according to McPartland.

“The CFTC took that to mean it had a mandate to determine how swaps should change – in the U.S. at least,” he said.


Banks are more compliant than ever

Despite the traditional tension between banks and their regulators, the two sides aren’t necessarily having issues getting along under new post-financial-crisis regulations.

“[The new regulations] are definitely changing the way everybody does business,” Kopczynski said. “Banks are much more likely now to ask regulators in advance” before engaging in activities that could raise eyebrows.

She said she sees a lot more cooperation on both sides than before, as regulators realize the complex processes banks undergo to integrate new rules, and banks see the importance of adhering to market standards for transparency and stability, among other reasons.

“These regulations are effective in terms of making financial institutions look at their own models,” she said, which enables banks to recognize their own problems.

There is a learning curve banks are starting to see in light of these regulations.

“When Dodd-Frank passed, many wanted to get out [of the requirements], but realized they couldn’t,” said Bart Chilton, a former commissioner of the CFTC and current senior policy advisor at DLA Piper, LLP. “Overall, as regulations are being put in place, banks are complying – some quicker than others.”

Regulators seem to understand where the banks are coming from.

“No one likes a lot of rules,” Ranjan said. “Regulators are always open to listening from the private sector because it’s the one interacting every day in the markets. They know what is happening on the ground level, but that doesn’t mean we let them loose. We have to monitor them.”

In a speech at the Swap Execution Facilities Conference Nov. 12 in New York, CFTC Chairman Timothy G. Massad acknowledged the need to work cooperatively.

“We must create a regulatory framework that not only implements the statutory trading mandate, but that creates conditions in which participants wish to trade on SEFs,” Massad said.

Massad compared the Dodd-Frank clearing mandates to the Securities Exchange Act of 1934 that sought to regulate the stock markets. The legislation was considered “revolutionary” at the time, and people called it the “death knell of capitalism,” but it became a necessity for the financial markets since it passed. The new derivatives regulations face similar criticisms, but it probably will get widely accepted and welcomed over time, according to Massad.

Challenges to regulating clearinghouses

Many industry experts and banks are concerned with the credit risk of clearinghouses, according to Matricardi. Critics of Dodd-Frank question the assumption underlying the Act that major clearinghouses, like CME, are too big to fail.

In fact, at the Futures Industry Association’s annual expo last month in Chicago, one of the heated debates revolved around just how big a clearinghouse’s guarantee funds should be. Guarantee funds are designed to assure that clearinghouses have enough capital on hand to stay afloat if they have to assume the debt of a clearing member who defaults. There is, however, disagreement from all directions on what the funds should comprise and where they should be safely kept.

“There should be a credential authority or oversight and some form of a standardized framework” for guarantee funds, said Emily Portney, global head of agency clearing, collateral management and execution at J.P. Morgan & Co., during a panel discussion. “It is important that there is sufficient skin in the game so central clearing parties’ incentives are aligned with market constituents’.”

According to McPartland, predictability is what most clearing members, like banks, seem to want. Big investment firms, like West coast-based Pacific Investment Management Company, are the major clearing members and have a lot of capital. They want to put their money into big, stable organizations, Ranjan said, and these clearinghouses are a way of outsourcing risk management through collateral requirements in swaps trading.

“They don’t know exactly how the clearinghouses operate,” McPartland said. “They would like to know more so they’re more comfortable that their own money in the guarantee fund of the clearinghouses” is used for market safety.

On Nov. 18, trade associations and clearinghouses, including the Securities Industry and Futures Markets Association, the FIA and the World Federation of Exchanges, sent two letters to the Basel Committee on Banking Supervision in Switzerland, explaining why the Basel III framework for clearing regulations create systemic risks.

The letters point to the adverse consequences of Basel III’s proposals to make banks less risky by reducing the profitability of a broker dealer or futures merchant, McPartland said, which could discourage further clearing and reporting of derivative trades.

In one letter, SIFMA wrote that “Rules that disincentivize the clearing of derivatives run counter to G-20 commitments established in 2009,” stating Basel III’s proposals to increase collateral posted in a trade can drive clearing firms out of business and potentially make room for more uncollateralized swap trades.

Safer than before, but room to improveyears

Experts seemed to agree that markets are safer than they were prior to the Dodd-Frank regulations. They referred to the international standards, like the G-20 accord, and organizations such as the Principles for Financial Market Infrastructures working to ensure there are no loopholes in the financial system.

“Before these regulations, these markets were completely in the dark and nobody knew who would be potentially going down [in the event of a debt default],” Matricardi said. “Regulators didn’t even have a way to assess that.”

Now market participants must report and clear their swap trades and do their homework on their counterparties, or face fines and other penalties.

“People are going to be more cautious,” Ranjan said, “and whatever the next crash is, will not be the same because now we know what was unknown then.”

As these regulations continue to roll out in 2015, the next step is to watch the clearing organizations integrate them into their structures.

“Once they’re put in practice, they’ll have to invest in technology,” Matricardi said. “We need much more tech-savvy firms and internal restructuring.”

While there may be unknown activities posing risk or a new product like the CDS being developed that could potentially harm the markets, regulators are mostly concerned about people finding ways around the rules.

Panelists at the FIA expo agreed that the first step to preventing possible loopholes is establishing a firm international set of rules for clearing, which requires cooperation among the CFTC, Basel III and the European Securities and Markets Authority.

“If the U.S. and E.U., who together compromise 70 percent of all financial trading in the world, build solid regulatory rules,” Chilton said, “then the rest of the world will come.”

This means overcoming the disagreements, including Basel III proposals, and finding solutions to clear cross-regional products.

“That’s where we’re headed,” Chilton said. “Ultimately we will be safer.”