Lynn Strongin Dodds looks at the forces behind central clearing and why the momentum will continue
Ever since the global financial crisis, central clearing has been one of the main responses to ensuring financial systems are healthy and secure. In the derivatives world, the plain vanilla, liquid instruments were the first candidates to go through the pipes but as markets continued to oscillate, the more complex varieties are being considered, according to a new report by Coalition Greenwich – The Buy-Side View’s of Derivatives.
The report, which conducted interviews with 210 derivatives professionals globally, shows a more or less a steady upward trajectory since 2008 with roughly 75% of interest rate derivatives cleared while the figure is 50% for security-based credit derivatives. This is mainly attributed to a swathe of regulations that hit the market in the post 2008 landscape. The most notable is Basel III and the uncleared margin rule (UMR) which was implemented in a phased approach, requiring OTC derivative traders to exchange initial margin (IM) and variation margin (VM) with each other.
Using Average Annual Notional Amount (AANA) calculation as a benchmark, the first waves kicked off in 2016 for the largest firms, followed by phase 4 began in 2019 with the last two stages closing in 2021 and 2022. They captured the biggest cohort at 1,089, according to the International Swaps and Derivatives Association which helps explain the surge in central clearing.
However, as the Coalition Greenwich report notes, the regulatory push may have been the initial impetus for central clearing of derivatives but there are other drivers today. For example, more than 80% of the buy-side market participants point to operational efficiency as an important reason to use central clearing. The issues with workflow automation have been well documented but market participants continue to grapple with several functionality issues despite the advances in technology. These range from data inaccuracies to the inability to handle new trading volumes and manual processes around confirmations and reconciliations.
“For some, despite existing operational challenges in exchange-traded derivatives (ETD), the operational efficiency that may come from trading and clearing derivatives is an important incentive. For others, the transparency of bilaterally agreed margin calculations can feel more operationally efficient, keeping some trades OTC,” the report added.
The other motivating force has been increased liquidity and price transparency. Traditionally, clearing was seen as a risk management mechanism, with regulators focusing on the counterparty credit and systemic risk reduction benefits. The report points out that this may no longer be the top priority for users, who seem to care more about market structure advantages including electronic trading and price transparency.
Moving to central clearing through has not been a panacea though. As the report notes, while the use of ETD and cleared swaps can improve automation in some parts of the derivatives transaction lifecycle, problems across all instrument types still exist. For example, 90% of respondents point to the processing of exchange fees as the biggest pain point followed by broker commissions and collateral management.
Unsurprisingly, fees remain the most important reason for choosing a clearing broker. Buy-side firms typically employ more executing than clearing brokers, but in many instances maintain more than one clearing relationship. The report recommends asset owners and managers to do their homework and look more closely at all implicit and explicit costs—margin, spreads, technology, data, as well as fees.
The problem though is that they will have little choice and perhaps there is not much distinction between the leading lights. The report found that in February 2024, the top three clearing brokers held nearly 50% of total customer funds, while the bottom three held just over 10%. Of the top 51 clearing brokers, 61% of customer funds are held at the five largest banks.
One the one hand, spreading clearing activity too thin can cause operational complexity, including more margin movements, the need to consume data in different formats, and less-effective cross margining. On the other hand, concentration is a risk in and of itself, compelling end users to get the right balance based on their strategies, products traded and operational capabilities, according to the report.
“Over the past few years, flow has been concentrated among fewer clearing brokers, engendering concerns about the overall clearing capacity in the industry,” the report said. “End users need to consider how and where they execute, whether their current panel of clearing brokers can support new instrument clearing easily and identify where cross-margining opportunities reside. These complexities may temporarily slow the growth of clearing instruments that are not mandated, but momentum will continue to sustain this transition.”
Related reading:
EMIR 3.0—Experts Explore Coming Changes
Clearing a Path for FX Derivatives Clearing, US. Treasuries and Repo
