OTC Derivatives Clearing
The clearinghouses and dealers are revamping their back offices and risk methodologies in order to be ready for OTC derivatives clearing in 2012.
Why It's Important: Despite the slow pace of finalizing rules, central clearing is coming to the $600-trillion OTC derivatives market in 2012. "This enormous universe of trades will be forced into a clearinghouse," says Kevin McPartland, a principal and director of fixed-income research at Tabb Group. As the 2008 credit crisis indicated, the primary benefit of central clearing is to reduce counterparty risk and provide transparency into the exposures of dealers, customers, member firms and even regulators. The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in July 2010, requires that standardized contracts are traded through exchanges or swap execution facilities (SEFs) and cleared through central counterparties (CCPs) to prevent systemic risk. Aside from the regulatory mandate, volatile markets are driving the shift from bilaterally traded to centrally cleared OTC derivatives, according to a recent Tabb Group report.
Where the Industry Is Now: The Commodity Futures Trading Commission (CTFC) was scheduled to vote on the clearing rules at press time (Oct. 18). "The clearinghouses are a year ahead of last year in defining their margining methodology and building out capacity and risk management technology," observes McPartland, who notes that most of the buy side is counting on the brokers to connect trading systems with the clearinghouses. Though few buy-side firms and hedge funds have moved over to central clearing already, most have tested to make sure the mechanics work, according to McPartland. "They're sorting out who their clearing broker will be, while the clearing brokers are figuring out how they will offer the services and how it will tie in with the trading side," he says, pointing to collateralization and calculating margin payments as examples of details that need to be worked out.
Focus In 2012: Once the final rules are approved by the CFTC, central clearing will be mandated next year. If regulators finish the rules at the end of 2012's first quarter, dealers will have 90 days from that date to be compliant; everyone else will have another 90 days, though the more complex buy-side firms will have an additional 90 days to submit their derivatives trades to clearinghouses, according to McPartland. "Even if the mandates don't take effect until Q3 2012, once we have clarity in the rules -- which should occur by the end of the first quarter -- people are going to make changes in their technology," says the analyst.
Industry Leaders: The major exchanges stand to benefit from the shift to exchange-traded and centrally cleared OTC derivatives. The main players are the InterContinental Exchange, the CME, Eurex (whose proposed merger with NYSE Euronext is still pending) and LCH.Clearnet. NYSE Euronext owns NYSE Liffe Clearing and part of New York Portfolio Clearing, a joint venture with DTCC related to margin offsets between treasuries and futures. And in October, the London Stock Exchange was in exclusive talks to acquire LCH.Clearnet, the largest interest-rate swaps clearer, which launched derivatives clearing for U.S. buy-side clients in March 2011.
Technology Providers: Calypso and Murex are two of the biggest clearing technology providers. SunGard Capital Markets also has technology solutions to address derivatives clearing. Cinnober also provides clearing systems to exchanges. Middleware providers MarkitSERV and ICE Link will handle all of the post-trade processing and worfklow, connecting all of the data that helps firms get from execution to clearing and confirmations. Electronic trading platforms -- including Bloomberg, MarketAxess and Tradeweb -- that plan to become SEFs will have to establish direct links with clearinghouses.
Price Tag: Industry participants already have spent more than $12 billion on clearing-related technology in 2011, with OTC derivatives accounting for the biggest piece of the pie, Tabb Group reports. Because the scope of the regulations is so vast, the firm estimates that the sell side's expenditures on clearing technology in 2012 will be split evenly between third-party providers (47 percent) and internal development and resources (53 percent). Buy-side firms will spend about 36 percent on internal resources versus 64 percent on external solutions, while CCPs will tap internal IT for 44 percent of the back-office spend and external solutions for 56 percent, Tabb said.