Regulations Increased Confidence in Derivatives

Investors say central clearing has reduced systemic risk in the derivatives market, and there is an increasing interest in futures.

Eighty percent of institutional investors believe that mandatory central clearing of derivatives—including futures contracts, forward contracts, options and swaps—has reduced systemic risk in global financial markets, according to a Greenwich Associates report.

The Dodd-Frank Wall Street Reform and Consumer Protection Act and regulations issued by the Commodity Futures Trading Commission (CFTC) require that swaps be “cleared.” This means that the plan and swap dealer submit the swap contract to a clearing member (CM) and a central counterparty (CCP). The swap counterparties also give cash or liquid securities to the CM as margin. The CM acts as a guarantor to the swap. In the event one of the swap counterparties fails to meet its obligations, the CM is contractually obligated to the CCP to provide remedies to the CCP, and the CCP in turn is obligated to provide remedies to the non-defaulting counterparty. For example, the CM can use margin deposits to make the non-defaulting party whole or to otherwise engage in close-out and/or risk reducing transactions.

Almost 70% of institutional investors interviewed by Greenwich Associates believe the major clearinghouses have adequate financial resources to handle a major multiple bank default. That finding represents a strong vote of confidence in both the risk frameworks and the clearing firms operating them. Fewer than one in five say they have a clear understanding of the default management waterfalls at the CCPs that clear their trades.

“Investors recognize the many benefits of central clearing, including counterparty risk reduction, improved transparency, better mark-to-market pricing, and a more efficient OTC derivatives market,” says Kevin McPartland, head of Market Structure and Technology Research at Greenwich Associates.  “While major clearinghouses have been transparent about their stress testing and risk management procedures, there is an overall lack of understanding among market participants about clearinghouse default management processes.”

When asked what additional steps clearinghouses can take to further limit the possibility of a bank failure, the two most frequent suggestions from investors include: providing clearinghouses with access to central bank liquidity and requiring them to have more “skin-in-the-game.”

In the U.S., the major clearinghouses have been designated Systemically Important Financial Market Utilities (SIFMU), which while burdening them with additional regulatory oversight and capital requirements, also allows the U.S. Federal Reserve to provide them with liquidity in the event of a crisis.

Clearinghouse capital and “skin-in-the-game” requirements are more complicated issues, Greenwich Associates says. The cost of holding extra capital will ultimately be passed on to clearing members and their clients.  With the cost of clearing already a sore spot for institutional investors, a structural change like increasing “skin-in-the-game” requirements for CCPs must be examined carefully.

“Institutional investors should take the time to fully understand the risk management practices of central clearing in general and the competing clearinghouses in particular,” says McPartland. “Ensuring clearinghouses’ incentives are properly aligned with robust risk management practices is critical, but limited knowledge of individual default waterfalls could result in a push for market structure change that, over the long term, could prove detrimental to the derivatives market as a whole.”

Throughout 2014 Greenwich Associates interviewed 4,036 global fixed-income investors about their dealer relationships and use of various fixed-income products, including interest-rate derivatives.  In the fourth quarter of 2014, Greenwich Associates conducted an additional 72 interviews with key research participants to more deeply understand their views on systemic risk, the impacts of central clearing and their expectations for the interest-rate derivatives market.  These results are available in a new Greenwich Report (commissioned by LCH.Clearnet) entitled “Systemic Risk and the Impacts of Central Clearing.” Information about how to obtain a copy of the report is here

In a separate report, Greenwich Associates says futures products will gain traction among global investors in coming years at the expense of more standardized cleared swaps, according to new research.

“Our quantitative model used in this research identifies generally favorable liquidity cost dynamics for futures in many cases as the regulatory headwinds impacting the swaps market will not die down,” says Greenwich Associates Managing Director Andrew Awad.

According to the report, “Total Cost Analysis of Interest-Rate Swaps vs. Futures,” based on deep quantitative modeling and interviews with more than 40 U.S. market participants, Greenwich Associates found futures to be the least expensive alternative for expressing views on interest rates in nearly every scenario analyzed with liquidity costs as the largest contributor to the gap.

While the impact of higher margin requirements for swaps has had limited impact on product selection to date, it will move the needle in the coming years as clients have less eligible collateral on hand. In addition, the liquidity cost gap between swaps and futures demonstrated in the research will likely widen as banks find it more difficult to make money trading cleared swaps with new regulations.

However, the research also reveals that swaps, both cleared and bilateral, will continue to have their place and those markets will remain robust, albeit on a smaller scale than previously. “Many market participants are willing to pay up for customization that the swaps market allows and our models show that the cost differentials will benefit those in this camp,” McPartland says.