Central counterparty clearing of OTC derivatives could reduce firms' collateral costs and banks' risk-based capital obligations.

THE FINANCIAL SERVICES industry and regulators are debating the merits of establishing central counterparty (CCP) clearing of OTC derivatives. In addition to improving transparency, such a move would also improve the accounting process.

Clearing member firms are required to post initial and variation margin against their positions, and many clearinghouses permit members to post margin based on their net open positions. When a clearinghouse accepts a trade from a member firm, it is obligated to settle that trade even if one party defaults.

OTC DERIVATIVES are treated differently. Firms that trade interest rate swaps, for example, typically have International Swaps and Derivatives Association (ISDA) agreements in place with their counterparties. These bilateral agreements include default clauses that specify a loss threshold – usually US $10 million. If the unrealized loss on the position exceeds US $10 million, the counterparty must pledge collateral. The agreement also establishes whether netting is or is not allowed if the position must be unwound in the event of default.

Therefore, even if a firm has a net flat position on its trading book, it still has to pledge collateral when individual positions show an unrealized loss, and that is expensive for an institution with hundreds of open positions. For some firms, collateral management is a profitable business because they earn a small spread on collateral by taking a float day and by not paying interest on the pledge.

“A clearinghouse solves this problem,” says Peter Strandell, Treasurer of NASDAQ OMX. “You don’t have to pledge any collateral as long as you’re in a net positive position.”

Ron Hassen, Controller at NASDAQ OMX adds that international banking regulations treat exchange traded, centrally cleared products more favorably than OTC products. “The risk-based capital provisions in the Basel II Accord take into account that exchange traded products are secured by variation and initial margin and the clearinghouse assumes the counterparty risk. Banks do not have to put up capital to support the market valuations of on balance sheet products, so they have more money to lend.”

Novation reduces transaction costs and strengthens markets. Standardized, liquid contracts can be recorded and marked-to-market more easily. Transparency attracts more participants, and the ability to net exposures reduces the amount of capital required to support open positions.

TO ASSUME THE OBLIGATIONS of both counterparties, the clearinghouse must model and price the trade and calculate the appropriate margin requirements. Some OTC derivatives are one-off products, so novation is not always efficient. “There are plenty of OTC instruments that are potentially suitable for central counterparty clearing, but there also are a good number that would not be,” says Frank Moore, President, Frank D. Moore and Associates.

Novation provides certainty

The accounting benefits of CCP for OTC derivatives are compelling. Banks can net their positions to reduce their collateral costs and potentially reduce their risk-based capital obligations. The challenge lies in identifying which products are good candidates.Trades between clearing members (and trades cleared through a clearing member) are “novated” when a clearinghouse accepts them. Frank Moore, President of Frank D. Moore and Associates, a consultancy firm with offices in New York and Alabama, explains. “This means that the clearinghouse assumes the seller’s obligations to the buyer and the buyer’s obligations to the seller. Each remains bound to perform fully under the contract, but the clearinghouse must complete and settle the trade even if one of the parties defaults.”

By Sherree DeCovny, photo Getty Images