Key industry associations say central counterparty clearing for OTC derivatives will improve market efficiency and transparency.

Momentum is gathering behind the establishment of central counterparty clearing for OTC derivatives, and exchanges are well positioned to step into the frame. In Europe, exchanges are lining up to offer clearing services, while in the US a debate is taking place about how much of the OTC derivatives trading life cycle should come under exchange-type controls.

In November, a proposal for a Derivatives Trading Integrity Act was introduced in the US which would bring the OTC derivatives market under federal regulation and would require OTC derivatives to be traded on an exchange. The bill was condemned by the International Swaps and Derivatives Association (ISDA), and the Securities Industry and Financial Markets Association (SIFMA). According to ISDA, if businesses and investors cannot use these products, their ability to manage risks and weather tough market conditions would be undermined.

Kevin McPartland, a Senior Analyst at US-based financial research and advisory firm TABB Group, says it is logical for exchanges to be involved in OTC derivatives, but not all OTC derivatives should be traded on exchanges. “There are some instruments for which it makes sense, such as vanilla products and standard index CDS type products,” he points out. “These are the more straightforward products and therefore the easiest place to start.”

The London-based Wholesale Market Brokers’ Association (WMBA) endorses the efforts of US and European regulators to encourage central counterparty clearing in OTC markets such as credit derivatives in order to mitigate counterparty risk. However, the WMBA stresses that several OTC markets are already fully compatible with central counterparty facility operations. For example, OTC products such as US treasuries, European interest rate swaps, OTC equities, spot foreign exchange and carbon emissions have been executed OTC and cleared centrally for some time.

The WMBA further notes that the most recent, on-the-run US treasuries trade OTC and fully electronically, but they clear centrally through the DTCC. US energy derivatives trade OTC via voice brokers and electronically, but they are also centrally cleared through ICE or NYMEX/CME. Similarly, this applies to the operation of CLS in foreign exchange markets. These have proven to be effective mechanisms and such structures can be duplicated elsewhere in the OTC world.

McPartland says it is no accident that the four main parties vying for a place as a CDS central counterparty – ICE, CME, NYSE Euronext and Eurex – are all exchanges. “The exchanges already have central clearing for other products and it will be much easier, from an operational point of view, to tweak their existing environment and use their existing knowledge to create central clearing for OTC instruments.”

Focusing on OTC interest rate swaps, NASDAQ OMX has also entered the OTC derivatives clearing space with an 80% stake in International Derivatives Clearing Group (IDCG), which cleared and settled its first US dollar interest rate swap futures contract in January 2009.

Kevin Rideout, Global Head of Market Infrastructures at Citi Global Transaction Services, says exchanges can play a vital role in bringing transparency to the OTC market. Straight through processing and risk management are the name of the game when it comes to clearing and settlement of OTC derivatives. “In any asset class where a bilateral trade takes place, there is a role for a central counterparty,” he notes. “A safe house where trades are netted, recorded and novated and margin is collected as protection in conjunction with default funds is an absolute must.”

Bob Greifeld, CEO of NASDAQ OMX Group, agrees that centralized clearing is fundamental and also believes re-regulation is necessary. “The objective should not be more or less regulation. It should be smarter and more efficient re-regulation. We need new rules on the books, reflective of the world that exists today, not the world that existed in the 1930s. Regulated exchanges have a natural role to play in the new regulatory landscape.”

Kevin Rideout, Global Head of
Market Infrastructures,
Citi Global Transaction
Services

By HEATHER MCKENZIE