In the immediate aftermath of the global financial crisis, the G20 quickly turned its attention to reforming the vast ‘over-the-counter’ (OTC) derivatives markets. The statement issued after the G20’s September 2009 meeting included the declaration that ‘[a]ll standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest.’
This was an ambitious use of political capital, with the objectives being to increase market resilience, tackle interconnectedness and promote transparency. In a recent paper I consider the implications of this reform program for the market infrastructure it co-opted. I focus on the legal processes underpinning central counterparties (CCPs), and consider the implications of the clearing mandate for this part of the financial market infrastructure. My paper finds that the clearing mandate risks complicating two of the core techniques (selective membership and the posting of margin or assets) that keep CCPs working safely. I argue that these complexities need to be addressed in order to safeguard the very functions that attracted regulators to CCP clearing in the first place.
When a contract is cleared, a CCP becomes buyer to every seller in the market and seller to every buyer. Market participants no longer bear counterparty credit risk because they face the CCP rather than another market participant. Moreover, a CCP facilitates multi-party netting and, should a participant fail, it acts as a ‘shock absorber’ for the market. The corollary of these benefits is that CCPs have to be robust enough to manage the risks that they assume, both in the ordinary course of events and in times of market stress. This role becomes more difficult and more systemically important once clearing certain products becomes mandatory.
In the EU, the clearing obligation is found in Article 4 of the 2012 Regulation known as the European Market Infrastructure Regulation, or EMIR. No classes of contract have yet been declared subject to the clearing obligation, though the clearing obligation procedure under Article 5 of EMIR has been triggered and is likely to result in the clearing obligation applying to certain classes of contract from next year.
When it arrives, the clearing obligation will sweep up a far broader range of financial and non-financial counterparties than are currently members of CCPs. It is onerous and expensive to become a member of a CCP, because screening members rigorously is one of the ways that a CCP ensures its own resilience. A review of published CCP membership lists, discussed in my paper, shows that the membership of UK CCPs is relatively small (18, 43, 81 and 98 for the four UK CCPs) and narrow, being dominated by ‘dealers’ or specialist financial institutions. There is therefore a potential mis-match between the entities that are currently members of CCPs and those which will need access in a world of compulsory clearing.
Assuming many market participants will be unable or unwilling to meet the high thresholds to become CCP members themselves, there are two main options: client clearing, where an entity contracts with a member to clear on its behalf, or indirect clearing, where an entity is one further step removed, i.e., it retains a client to clear through a member. As my paper explains, these options mitigate rather than solve the problem of access, because an entity may still find itself unable to find a route to clearing. One finding of the paper, therefore, is that the clearing mandate creates a tension between CCP autonomy and inclusiveness. Regulators presume access to CCPs is available, while also expecting CCPs to manage their own memberships safely and robustly.
Client and indirect clearing help to mitigate this membership dilemma, but they complicate a further important means of CCP risk management, namely, the provision of assets by participants in the clearing service to the CCP. The second half of my paper considers this process in some detail, showing the fundamental role played by assets in the clearing process, and the complexity caused by client and indirect clearing. The EU and UK rules are considered as a case study, but the message is of general application: the provision of client assets for the purposes of CCP clearing must be safeguarded by clear, consistent and robust rules. While we need to take on board lessons from the last crisis as regards OTC derivatives, we must also heed those on the potential vulnerability of clients’ assets.
Overall, my paper shows that while the new regulatory regime for OTC derivatives depends on safely functioning CCPs, CCPs depend on selecting their own members and requiring them to post assets, while both techniques are potentially complicated by the clearing mandate. As CCPs start to assume a greatly enhanced role in the OTC derivatives markets, this is just one of many implications for lawyers and law students to consider. Clearing may be a technical area but it is also rich in legal issues, not least because it involves property rights moving round networks of contracts between clients, indirect clients, clearing members and CCPs. As a result, there is a valuable role for lawyers to play in the current debates about how CCPs are to fulfill the systemically important role which regulators have chosen for them.
The preceding post comes to us from Jo Braithwaite, Associate Professor, Department of Law, London School of Economics. The post is based on her recent article, which is entitled “Legal Perspectives on Client Clearing” and available here.