6:50 pm - Sunday July 23, 2017

OTC Derivatives’s Central Clearing – the focus

The introduction of legislation in the US and Europe to move settlement of some OTC derivative products through a Central Counter Party is the much talked about topic among leading bankers. The aim of this legislation is to bring in much needed transparency in the transactions and also to reduce the associated operational risk in manual systems and processes.

This post tries to capture some of the limitations of this legislation, key benefits that may finally accrue, major challenges to be tackled and the must have features to make this transition smooth and painless.

Limitations

– Derivative indexes and single name credit default swaps will be covered (initially?)
– More complex structures may be difficult to cover
– Multiple clearing houses may lead to increased collateral requirements
– Clearing houses can resort to cross margining only in the case of trades they can handle

Benefits

– Availability of Central Counter Party to manage Counterparty risk
– Reduced capital requirement to back trading through netting of transactions
– Increased transparency with reporting of prices, quantities and other transaction details

Challenges

– Potential valuation errors could be a major risk
– Errors could creep in while calculating initial collateral requirements
– Errors could also happen in the calculation of the size of margin calls
– Errors in the calculation of precise amounts of payments on the instruments
– Pricing could be a big challenge
– Reconciling pricing data from CCPs, independent valuers and trading desks could be an issue
– Technology challenge will be considerable (and of course, surmountable – I am from a fintech organization!)
– Reconciling discrepancies in valuations leading to margin calls differences could be an issue
– Handling massive and in subsequent upsurges in data
– Valuation of OTC contracts on a daily basis could be an issue
– Management of price tick data on risk management systems
– Complex net present value calculations could be an issue for the CCPs
– Collateral management for non standard contracts could be a major issue

Must have

– Straight Through Processing Capability
– Facility to handle all types of trades between different parties
– Golden copy of the trade details preferably from an automated system to ensure consistency
– Requirement of electronic affirmation and confirmation systems
– Investments may be needed in systems to manage risks
– CCPs to facilitate greater liquidity through standardization and transparency
– Independent third party to provide prices of OTC contracts for valuation at regular intervals
– Systems to manage large number of credit curves (of course, on a dynamic basis)
– Same systems to handle standard as well as complex contracts
– Systems to provide complete details of both cleared and not yet cleared contracts
– Procedures and controls for portfolio reconciliation and margin calls
– Automated reconciliation systems that can compare prices and valuations too
– Last but not the least, adequate legal documentation to protect all the parties including CCPs

Well. We all know any changes will always be resisted as they disturb our present comfortable way of doing things. Let us hope the proposed changes to move settlement of OTC derivatives through a Central Counter Party will be a very smooth affair!

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