Welcome to Futures Industry
Will Acworth
Published 6/20/2012

The race is on. Clearinghouses are scrambling to roll out clearing services for over-the-counter derivatives. Clients are poring over the details of various offerings, analyzing default structures, calculating margin requirements, and testing the operational details. While the vast majority of OTC trades are still conducted bilaterally, in recent months the number of trades that have been submitted to clearinghouses has picked up noticeably.

Three clearinghouses—LCH.Clearnet, CME Group and Singapore Exchange—have already launched clearing services for interest rate swaps in various Asian currencies and are beginning to see meaningful volumes of cleared trades. LCH.Clearnet continues to be well ahead of the rest, thanks to its long head start and strong dealer support, but CME's addition of Japanese yen and Australian dollar swaps this spring immediately attracted some business, and SGX continues to see meaningful increases in the volume of interest rate swaps that it clears.

Meanwhile a large number of other clearinghouses in the region are preparing to offer clearing for OTC interest rate swaps, the largest segment of the overall market. Clearinghouses in Japan, Hong Kong, Korea, Australia, India and China are at various stages of readiness, with Japan, Hong Kong and Korea the closest to launch.

This is proving to be no simple project, however. Several clearinghouses have been forced to delay the timetable for their plans, either because the necessary changes to local laws have not been finalized or because the financial and operational details are still being worked out in consultation with the financial institutions that might become their clearing members.

In fact, in some jurisdictions, the local clearing solution may not be available until well after the year-end deadline set by the Group of 20 leaders in November 2009. All of the signatories to that agreement—including a number of countries in the Asia-Pacific region—pledged to require clearing for all standardized OTC derivatives by the end of 2012, a goal that has proven to be difficult to achieve even in the U.S. and Europe.

In a previous article, Futures Industry described progress towards OTC clearing in Japan, Singapore and Hong Kong (see "OTC Clearing in Asia: Under Construction" in the March 2012 issue). This article covers three more jurisdictions: Australia, Korea and India. Each of the three is taking a different approach, highlighting the fragmented nature of the clearing landscape in Asia-Pacific. Australia is relying on market forces to drive the adoption of clearing, at least for now. Two global clearinghouses—LCH.Clearnet and CME Group—are already clearing trades for Australian financial institutions, and the domestic exchange may also enter the race. Korea has drafted laws that will mandate clearing through an onshore clearinghouse, but a snag in the legislative process has delayed the Korea Exchange's plans to launch clearing for Korean won-denominated interest rate swaps. And in India, there is no mandate for clearing as of yet, but the local government securities clearinghouse is developing plans to offer clearing for interest rate swaps denominated in rupees.

Australia: Industry-Led Solutions

In contrast to the approach taken in most other jurisdictions around the world, the Australian regulators have agreed to let the market take the lead in driving the adoption of central clearing. In a consultation paper released on April 14, Australia's Council of Financial Regulators said that "industry-led solutions" should be the preferred route. The regulators explained that financial institutions will have powerful economic incentives to move their OTC trades into clearinghouses.

For example, new capital charges and margin requirements for uncleared derivatives will send a "price signal" to all market participants, especially the larger market participants, the regulators said. And once a critical mass of large market participants begins central clearing, they expect the "network externalities" of clearing will make it likely that the practice will spread.

What explains the decision to avoid a mandate, at least for now? For one thing, the regulators recognized that the Australian OTC derivatives market is relatively small and very cross-border in nature. Both of those characteristics would pose a "challenge" to the success of any domestic regulatory initiative, they said. The regulators also recognized that the transition to central clearing will require significant changes to market practices and organizational structures. For example, a host of changes to legal and operational arrangements will be needed, and larger amounts of collateral have to be posted and received.

For this reason, it makes sense to give financial institutions sufficient time to make the necessary adjustments, they said. "Allowing time for the work-through of changed price signals will permit the financial system to reconfigure itself in an organic way, with scope for regulatory guidance or intervention as necessary."

Despite the market-friendly approach, the regulators have not ruled out introducing a mandate at a later stage, cautioned Dale Rayner, a lawyer in the Sydney office of Clifford Chance. The government is in the process of drafting a legislative framework that will authorize the Australian Securities and Investment Commission to require clearing and is now assessing feedback from market participants. "The regulators have taken the view that market forces will drive the adoption of clearing among Australian financial institutions, but they want to retain the ability to mandate a solution if the pace of change is not sufficient," Rayner said.

Extensive consultation with local and international financial institutions played a key role in the regulators' decision to adopt this approach, according to David Love, director, policy and international affairs at the Australian Financial Markets Association. Love said that although the Australian regulators are committed to the objectives of the G-20 derivatives reforms, they realized that the reforms should be carefully calibrated to the specific context of the Australian OTC market.

One of the key features of that market is that swaps are traded on a global basis. Large international banks are major players in the Australian market, and trades that originate in Australia may be booked in London, New York or Hong Kong. "It's a very open market, and we said to the regulators that it is very important to avoid fragmenting liquidity and tiering the market," he said.

Still another factor is that the market is beginning to offer better pricing for counterparties willing to clear their swaps. One bank executive said swap desks are starting to use two pricing curves, with better terms for cleared than for uncleared trades. This reflects the capital costs anticipated for uncleared derivatives, he explained, adding that clients are weighing this price differential against the costs of funding the market requirements.

Love noted that the major dealers in the Australian market—both local and international—are anticipating that they will be subject to the clearing mandate in Dodd-Frank as well as the higher capital requirements that will be established under the Basel 3 standards. Cross-currency swaps are a big business, and several major Australian banks have entered into client clearing relationships with members of the main global clearinghouses such as LCH.Clearnet and CME Group.

"All the major Australian banks accept that they have to clear," Love said. "They are closely monitoring the implementation of the Dodd-Frank Act, and they also recognize that Basel 3 is coming down the track." He added that Australian banks raise approximately 50% of their capital offshore and then use swaps to convert the proceeds into Australian dollars. As a result, there is a good chance that some of their swap transactions with offshore counterparties will come under the mandatory clearing requirements of Dodd-Frank, especially if the CFTC takes an expansive interpretation of its application to non-U.S. entities.

Global Clearing

In fact, a number of local banks and other financial institutions have already begun to clear their trades. Officials at several international clearing firms said they have clients in Australia who have gone live at both LCH.Clearnet and CME and have cleared swaps denominated in U.S. dollars and euros as well as Australian dollars.

Steve Mahoney, global head of OTC clearing at Credit Suisse, said that his bank has cleared several interest rate swaps with Australian counterparties during local hours. The significance, Mahoney explained, is that this shows trades can be executed and cleared at any time around the globe. "It doesn't matter where the clearinghouse is located," he said. "All you need is the technology to route the trades and process the trades for clearing."

LCH.Clearnet offers clearing for the widest range of Australian dollar interest rate swaps, including zero coupon swaps, single currency basis swaps and compounding swaps, and is prepared to accept for clearing swaps with maturities of up to 30 years. As of May 31, the notional value of the outstanding amount of cleared swaps was A$ 3,473 billion (US$ 3,452 billion), and it has been estimated that LCH.Clearnet is clearing approximately half of the dealer-to-dealer market for Australian dollar interest rate swaps.

CME joined the race only recently, adding Australian dollar interest rate swaps to its clearing offering in mid-April. Even so, the Chicago-based clearinghouse has found some success, particularly with the buy-side. As of May 31, the notional value of the outstanding positions was A$ 1 billion (US$ 994 million), and CME officials said that the majority of those positions were dealer-to-client trades. In contrast, LCH.Clearnet's total included just A$ 497.5 million (US$ 494.5 million) in notional value of dealer-to-client trades.

"We continue to see more and more interest in clearing from a broad range of market participants in Asia, in particular banks and asset managers," said Laurent Paulhac, head of OTC products and services at CME. Paulhac added that the addition of Australian dollar and Japanese yen swaps to its offering had a noticeable impact.

"When we added the two Asian currencies in April, we originally thought that U.S. institutions would be the main clients, but as the volume picked up, we discovered that institutions in Australia and Japan were also interested. So we geared up our infrastructure in those time zones and made the necessary adjustments so that our services would easily be consumable by clients in the Asia-Pacific region as well as Europe."

These are still early days. Only a small number of Australian financial institutions have actually begun clearing. But officials at several banks said clients are interested in using both clearinghouses. A number of factors drive the decision on which to use, including existing relationships and familiarity with the legal environment. Looking ahead, cross-margining will be a key issue affecting the choice of clearinghouse, according to Credit Suisse's Mahoney.

"That's the battleground for clearinghouses around the world," he commented. "Capital efficiency is on every client's wish list. The more you can bring products together and cross-margin them, the more it will resemble what they pay today, with one margin call across a whole portfolio of positions."

A Local Solution?

But what about ASX? As the operator of Australia's futures market, ASX can offer substantial margin offsets between interest rate futures and interest rate swaps. ASX officials have spoken publicly about their interest in offering a domestic clearing solution, but AFMA's Love said it's not clear that there is enough demand to support the cost of building such a service. "There is ongoing discussion about a possible local clearing solution, but questions remain about how it would work in practice and whether it could be economically viable."

ASX has not formally announced the details of its plans, but several industry sources said the exchange has formed a working group with industry representatives to explore how the clearing solution would work. The expectation is that the service will be provided by the clearinghouse now used for the exchange's futures market, but it will be backed by a stand-alone default fund. Cross-margining with futures is a key objective; ASX has the largest fixed income futures market in the Asia-Pacific region, with annual turnover in fiscal 2011 of more than A$ 45.18 trillion (US$ 44.91 trillion) in notional value.

The industry sources also said ASX is consulting with the Singapore Exchange, which already offers clearing for interest rate swaps and non-deliverable forwards. SGX has signed up nearly a dozen banks for its OTC derivatives clearing service and has cleared S$ 264.6 billion (US$ 207 billion) in notional value of interest rates swaps since the launch of the service in November 2010. SGX's offering is limited to dealer-to-dealer trades, however, and the exchange's futures market does not offer the same potential for cross-margining.

Meanwhile ASX is pushing ahead with a more limited project—offering clearing for OTC equity derivatives. The new service gives users the flexibility to specify maturity, type of option, exercise price and exercise type. In addition, the positions can be offset with the exchange's listed options, and trades can be entered into with one counterparty and exited via another.

The equity derivatives offering comes at a good time, according to Ian Nissen, Citi's head of futures, OTC clearing and prime finance sales for Australia and New Zealand. "There's been a pick-up in the use of options strategies among investment managers that are looking to improve their returns," he explained. "By booking more of their options positions into clearinghouses, they can reduce their counterparty risk and free up their balance sheet for the really tailored OTC products," he added.

Phase one, which was launched in May, covers options on 19 stocks as well as the S&P ASX 200 index, the main benchmark for the Australian equity market. Phase two, which is scheduled for early next year, will cover all classes of options listed on the exchange and will cover options expiring as far out as four years.

Korea: December Target

As a member of the G-20, Korea has been very focused on meeting the timetable for derivatives reforms. The government has drafted the legislation necessary to amend the local laws and provide legal certainty for the clearing of OTC derivatives. In contrast to the Australian approach, the Korean government intends to require all dealers in swaps, including branches of foreign banks, to clear their trades, and has designated the Korea Exchange to serve as the clearinghouse for the Korean OTC market.

Last December KRX officials circulated white papers outlining their plans to offer clearing, including clearing rules and operational procedures. The exchange intends to start with plain vanilla fixed-for-floating interest rate swaps denominated in Korean won, with a maturity of up to 10 years. The clearing service will be supported by a default fund supported by contributions from clearing members as well as the "settlement reserve fund" that draws on the exchange's own financial resources.

Jae-Joon Lim, a director of business development in the exchange's derivatives market division, explained that the potential market for its clearing service consists of the 79 banks and securities firms that are licensed to act as dealers in OTC derivatives. The membership requirements have not been finalized yet, he said, but KRX is studying the examples set by CME and SGX. KRX also is talking to Markit, the platform that many of the large international dealers use to process their OTC trades, so that trades confirmed on this platform can be routed to the KRX clearinghouse.

Initially the goal was to launch the service in July, but the timetable has been delayed by a snag in the legislative process. The Financial Services Commission, Korea's markets regulator, submitted amendments to the National Assembly last year that will lay the legal foundation for the clearing service. Those amendments were part of a larger package of financial reform measures that bogged down in disputes over other, unrelated issues, according to several lawyers familiar with the status of the legislation.

KRX expects that the legislation will be reintroduced by September, Lim said. Other sources agreed the clearing-related amendments are a high priority for the government, which wants to meet the G-20 schedule, but warned that there continues to be opposition to other provisions of the legislation that will encourage the creation of investment banks. They predicted that even the new KRX timetable, which envisions the launch of clearing services in November or December of this year, may prove to be too optimistic.

Paget Dare Bryan, a partner in the Hong Kong office of Clifford Chance, added that there is another issue that needs to be addressed. It's not completely clear, he said, how the rules and the law will permit client clearing "portability," meaning the transfer of positions and assets from one clearing member to another in case of a default of that clearing member. That raises the concern that a transfer might fail to work as expected or be challenged in court.

This is especially an issue for banks using client clearing, he added, because it would affect the capital charge on their cleared positions. Basel 3 proposals offer very low capital charges for risk exposures to clearinghouses, but only if it is highly likely that positions can be ported to another clearing member in case of default. Otherwise the exposure has to be treated as a risk exposure to the clearing member, rather than the clearinghouse.

Lim emphasized, however, that central clearing ultimately should result in more participation in the Korean swap market, rather than less. Currently the market is dominated by banks, but by reducing counterparty credit risk, clearing will increase the volume traded by securities firms. "The securities firms are not major players today, but with clearing they will be able to become more active," he predicted.

India: Cautious Approach

In some respects, India is farther ahead than either Australia or Korea in the implementation of the G-20 reforms. The Reserve Bank of India, the country's central bank and the principal regulator of India's OTC derivatives markets, began implementing a trade reporting requirement for interest rate swaps and forward rate agreements in August 2007, well in advance of the financial crisis that prompted the G-20 reforms. In March 2012, the central bank extended that reporting requirement to cover all interest rate and foreign exchange derivatives, and expanded the scope to include not only interbank trades but also client trades.

The repository for these trade reports—the Clearing Corporation of India—is now developing a plan to offer clearing for these trades. CCIL was established in 2001 at the instigation of central bank for the purpose of improving trade processing and reducing settlement risk in the government securities market. Since then it has expanded into the settlement of foreign exchange trades and a wider range of market infrastructure services. CCIL's primary owners are the leading Indian banks, but foreign banks are also represented in the ownership structure.

Siddhartha Roy, CCIL's chief risk officer, said the company is preparing to launch clearing for interest rate swaps. Initially the service will target rupee-denominated overnight index swaps that reference the Mumbai Interbank Offered Rate, a widely used overnight money market index. This type of swap accounts for the bulk of the interest rate swap market in India, according to the data collected by CCIL through its repository.

CCIL expects that the 20 banks that are the most active participants in the market will be the most likely to join the service, at least during the initial stages, Roy said. Clearing will be limited to members, so there will be no provision for porting client trades to another clearing member.

The original target for launch was June, but Roy said this had to be put off after the RBI decided to take a closer look at the details of the clearing service to make sure that they were in line with international standards. In particular, the central bank is examining the "principles for financial market infrastructures" that were set out in April by the Committee on Payment and Settlement Systems, an organization representing central banks, and the International Organization of Securities Commissions. These principles are designed to ensure international convergence among the many central clearing solutions emerging around the world, and regulators are expected to begin implementing the standards this year.

Although CCIL does not provide clearing services for exchange-traded futures and options, it does have experience in post-trade processing and settlement for a wide range of other financial instruments, including OTC derivatives.

In March, CCIL conducted its second portfolio compression exercise for interest rate swaps. The purpose was to reduce the overall notional value and the number of outstanding contracts by identifying economically redundant trades for early termination, freeing up capital for market participants and reducing the overall level of risk. CCIL said 21 banks participated in the exercise, including several large foreign banks, and more than 17,000 trades were terminated, leading to a reduction in notional value of 8.954 trillion rupees (US$ 162.6 billion).

Will Acworth is the editor of Futures Industry magazine.
 
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