A clearing obligation exemption to incentivise post-trade risk reduction

Andy Brindle, a derivatives, securities and structured products veteran with more than 25 years of experience in the equity, credit and interest rate marketplaces, and currently a principal at Valere Capital Partners LLP as well as a P.R.I.M.E. Finance expert, discusses the recent publication of a white paper in which it is proposed that EMIR is amended to allow transactions that result from post-trade risk reduction services to be exempted from the clearing obligation.

Original News

The International Swaps and Derivatives Association (ISDA), the European Banking Federation (EBF), the International Capital Market Association (ICMA) and the International Securities Lending Association (ISLA) (the Associations) have published a whitepaper 'EMIR REFIT: Incentivising Post-trade Risk Reduction' in which they propose amending the European Market Infrastructure Regulation (EU) 648/2012 (EMIR) to allow transactions that result from post-trade risk reduction services such as portfolio compression and counterparty rebalancing to be exempted from the clearing obligation. Post-trade risk reduction administrative transactions are exempt from the trading obligation under the Markets in Financial Instruments Regulation (EU) 600/2014 (MiFIR) but there is currently no corresponding exemption from the EMIR clearing obligation.

Why have the industry associations decided to publish the white paper?

The very nature of derivatives means that some form of counterparty exposure, whether to a clearing house or another market participant, is inevitable and can be substantial. Market participants and regulators alike are motivated to reduce these exposures to the greatest extent possible. Regulators have incentivized exposure reduction by implementing risk based capital charges and using proxies for risk such as gross notional in these calculations. SA-CCR, SIMM and Cleared Margin all take us a step closer to risk based charges.

Historically, an effective way to reduce operational and counterparty risk in the bilateral OTC derivatives space was through programmatic use of thoughtful combinations of compression and terminations.

With the advent of mandatory clearing for interest rate derivatives, risk based calculations were now introduced to the most liquid instruments in the majority of the asset class in the form of cleared margins.

Mandatory clearing requirements has shifted a substantial portion of historically bilateral exposure to central clearing houses which has significantly benefited the marketplace from the perspective of operational and systematic risks. The remaining bilateral and uncleared portfolio of derivatives, however, still represents a significant capital constraint under new guidelines.

The industry associations have been alerted by their members to various issues with respect to their ability to effectively reduce counterparty risk in their derivative portfolios under the current regulations which has prompted significant dialogue resulting in this white paper.

In order to effectively reduce systematic risk and the associated charges of this uncleared portfolio on a post trade basis banks require the ability to execute market risk neutral trades with each other on a multi-lateral basis which is currently prohibited.

What are the key amendments that the associations think should be made to EMIR as part of the Regulatory Fitness and Performance program (REFIT)?

In order to allow for effective post-trade risk reduction programs the associations are attempting to designate a set of current mandatorily cleared instruments for exemption from this requirement. They have proposed a set of criterion that will clearly distinguish trades in these instruments for the purposes of capital efficiency from regular trades where the objective is to buy or sell market risk.

The called for amendment would allow trades meeting these criterion i.e. being transacted purely to reduce systematic risk and collateral as opposed to taking a directional view on the market to be excluded from the mandatory clearing and certain execution requirements.

In April of 2016 the Market Risk Advisory Committee of the CFTC invited four experts in the field to speak to expanding the definition of portfolio compression to include risk reduction. More than one member of the Committee spoke to the need for such exemptions to ensure the health and liquidity of the market.

How does post-trade risk reduction work?

There are several versions of post trade compression techniques ranging from simple termination programs to sophisticated algorithms where banks will submit their portfolio of trades to a central facilitator along with objectives (such as reduction in leverage ratios, capital or net collateral postings) and constraints (such as the maximum number of days a future cash flow may be moved, the maximum number of new resulting trades etc.) and the facilitator will utilize various algorithms to calculated an optimum result. These facilitators only provide analytical services and are not themselves market participants and liquidity providers. This set of proposed terminations and/or new trades retain the same market risk characteristics but reduce counterparty risk and its associated charges.

What benefits are likely if these amendments are made?

Post trade counterparty risk reduction on a portfolio and multilateral basis is a vital part of an efficient and effective market for derivatives. It allows participants to continue to provide liquidity to the marketplace without excessive exposure to each other and minimizes the potential impact of failure of a large dealer.

By way of example, the foreign exchange market is not currently subject to mandatory clearing and its market participants actively and routinely seek to compress their books via multilateral compression with companies like World Bank sponsored LMRKTS. LMRKTS have facilitated over 20,000 multilateral compression trades resulting in a reduction of almost $6 trillion in notional equivalent contracts a $500 billion reduction of counterparty exposures in the FX markets - a testament to the effectiveness of these techniques.

In contrast is the world of interest rate swap options where currently the product is bilaterally traded but the interest rate swap hedges are subject to the clearing requirement. This can result in a significant amount of counterparty exposure as the interest rate market moves and with no clear mechanism available to mitigate these risks. The proposed amendments would allow major dealers to be able to execute bilateral uncleared interest rate swaps with each other for the purposes of managing this counterparty risk which would significantly reduce overall systematic risk and lower the associated charges currently assessed on the dealers.

Interviewed by Emma Millington.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

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