Our first post in this series on the weaknesses within the OTC derivatives market
looked at the changes that are to be brought into effect following
the 2009 G-20 Summit.
The G-20 leaders agreed that to avoid a repeat of the US
Sub-prime catastrophe, the trading of OTC derivatives should move
away from the current bilateral arrangements between parties,
towards recognised exchanges or trading platforms where
appropriate.
They also agreed that all standardized OTC derivatives should be
cleared through a central counterparty should be reported to trade
repositories to reduce systemic risk and enhance transparency.
To achieve this, a number of stakeholders have to be brought
together. In this post, we'll look at the different players within
the CCP workflow and their roles.
Standardized OTC Derivatives: The Players
There are 5 key stakeholders in standardized OTC
derivatives:
Central Counterparty (CCP)
The CCP carries out two main processes:
- Clearing of market transactions(identifying
the obligations of the parties on either side of the
transaction)
- Settlement of market transactions(this happens
when the final transaction of securities and funds occur)
This intermediary role benefits both parties to a transaction
because the CCP bears most of the credit risk.
Currently, there are about a dozen CCPs clearing OTC derivatives
based on interest rates, credit, equity and commodities.
The CCP can be owned by participants or monitored by the
regulator and may differ on factors such as margin requirements,
infrastructure or the type of products cleared.
Affirmation Platform (AP)
The Affirmation Platform provides post-trade execution for
confirming and matching trade details.
Details of the trade are input by the party executing the trade
(e.g. banker or broker) and affirmed by the client. A single record
of the trade details then becomes the legal confirmation of the
trade and remains in the central repository.
In addition, they also enable trades to be sent to other
stakeholders such as CMs, CCP and Trade Repositories as
necessary.
Trade Repository (TR)
After the financial crisis highlighted the lack of transparency,
regulators set up the Trade Repositories to centrally collect and
maintain records of OTC derivatives' transactional data. This
enhances transparency and reduces systemic risk as regulators can
see a firm's underlying position and exposure from a central
vantage point.
Clearing Members (CM)
Due to strict membership rules, such as an initial capital
requirement, not all clients can become members of a clearing
house. Therefore, CMs act as intermediary between buyers and the
CCP for all post-trade functions.
Trading Venue
To comply with the new rules, all standardized instruments must
be traded electronically.
In Europe, a trading venue can be a regulated market (e.g.
London Stock Exchange), a multilateral trading facility (e.g.
BATS/Chi-X), or an organised trading facility.
In the US, the Swap Execution Facility (SEF) provides the
required platform for buyers and dealers to trade OTC cleared swaps
electronically. Currently, there are no approved SEFs for OTC
derivatives, but this is being reviewed.
The following diagram shows how all these stakeholders' roles
fit together.
Non-standardized OTC derivatives will also have to be reported
to trade repositories. But they will also be subject to risk
management procedures and frameworks to measure, monitor and
mitigate operational risk and counterparty credit risk.
So far we have seen why these stricter measures are necessary
and the parties that need to be involved to ensure they are adhered
to.
In our next post we will look at how these new regulations are
being adopted in the US and Europe.