Central Counterparties

The legislative and regulatory response to the perceived contribution of OTC derivatives to the financial crisis has focused on standardisation and transparency as key objectives, and seeks to reduce counterparty credit risk and improve the ability of regulators to perform their prudential oversight function.

A key aspect of both the Dodd-Frank Act in the US and the European Market Infrastructure Regulation (EMIR) is the requirement for OTC derivatives to be cleared through central counterparties. This in turn requires that OTC derivative instruments be standardised to make central clearing practicable. Institutions that wish to continue to use derivatives to implement strategies and hedge risks must therefore adapt to the new environment.

The timescales set by the regulators are aggressive, and a broad range of issues must be addressed, including:

• Legal documentation
• Clearing member requirements
• Capital requirements associated with centrally-cleared activities
• Scope of clearing services to clients
• Market/product access and connectivity
• Central counterparty margining requirements and collateral eligibility
• Reporting and disclosure

In addition, institutions must consider the impact of central clearing on their current business and operational processes. For example, the loss of netting benefits as products migrate to central counterparties suggests that in the short run at least, counterparty credit exposures may rise. The requirement to deliver initial margin and the conservative collateral eligibility requirements of the central counterparties must also be included in the evaluation of proposed trades. From an operations and technology perspective, the requirement for daily margining and the need to manage collateral and reporting processes demand attention.