Wider clearing scope will create risk, warns Goldman exec

If clearing mandates are expanded to include less-liquid products, the market will struggle to provide hedges in the event of a dealer default, conference is told

Regulators will create systemic risk if they expand the range of over-the-counter derivatives that is required to centrally clear, according to Oliver Frankel, managing director for derivatives risk at Goldman Sachs. The smaller pool of dealers that trade less-liquid products may not be able to absorb the risk resulting from the default of a rival, he argued at yesterday's Quant Congress Europe conference in London.

"Clearing products beyond which the market can provide hedging liquidity for in the event of a default will compromise the systemic safety of central clearing," said Frankel.

Clearing mandates took effect in the US last year, affecting two of the OTC market's most liquid product sets – interest rate swaps and index credit default swaps (CDSs). Europe's corresponding rules may take effect at the end of this year and are widely expected to cover the same products.

Single-name CDSs can be cleared on a voluntary basis, and central counterparties (CCPs) are trying to expand their services to cover swaptions, inflation swaps and total return swaps. Frankel argued these products should not be accompanied by a sweeping regulatory mandate.

"Derivatives that are suitable for clearing have already begun clearing. Those products that remain are generally not suitable for clearing on an unlimited basis. There just isn't sufficient market capacity in a time of stress to provide the hedges needed to close out a default. I'm even concerned about clearing for single-name CDSs that are already cleared – specifically, whether there is sufficient market capacity for closing out a defaulted member's portfolio," he said.

Derivatives that are suitable for clearing have already begun clearing. Those products that remain are generally not suitable for clearing on an unlimited basis

In the event of a clearing member collapse, other CCP members are required to take part in the default management process – which involves valuing and bidding on the defaulted member's portfolio. As an initial step, the CCP would also seek to staunch losses in the portfolio by using the defaulted member's initial margin to pay for hedges. This process of hedging and auctioning could fall down for products that are not currently cleared, Frankel said.

Non-cleared trades will be subject to rules requiring larger derivatives users to collect initial margin on a bilateral basis – a first for the OTC market. The regime was finalised by the Working Group on Margining Requirements (WGMR) last year, and Frankel was critical of the outcome.

Despite a heated lobbying effort, the International Swaps and Derivatives Association has agreed to develop a standard initial margin model (Simm) to work out the collateral requirements for uncleared trades. This is an attempt to avoid the lengthy regulatory approval process that would result if every bank had its own model, while also cutting down on counterparty disputes. Frankel co-chairs the Isda committee that is working on the Simm.

Isda's analysis suggests the WGMR rules may require anything from $1.7 trillion to $10.2 trillion of collateral in initial margin, with rehypothecation only possible under tight restrictions. Initial margin will have to be segregated from the assets of the collector, and immediately made available in the event of a counterparty default. Chains of rehypothecation would also be banned – collateral could only be reused once by its collector. Frankel said the process would prove too restrictive to be useful.

Locking up so much collateral will force wholesale changes on derivatives users, Frankel argued, with the most obvious effect being a reduction in non-cleared derivatives – something that will have real-world consequences, he said.

"As we've pointed out to regulators, that would have the negative effect of increasing the risks and costs of the key financial services that non-cleared derivatives support – and they are key financial services: cross-currency swaps; swaptions for fixed-rate mortgages; single-name CDSs used to manage corporate loan and bond risk; and enterprise risks with specific tailored solutions, which aren't clearable," he said.

Another response might see dealers moving market risk that existed between them into clearing, Frankel said. Giving the example of two counterparties seeking to redress outstanding interest rate risk, Frankel suggested firms could calculate their DV01 – the per-basis-point sensitivity to rate movements – and create a pair of offsetting DV01 trades, which would be clearable.

"The two counterparties haven't really changed the risk between them, but they've allowed the risk that was there to be cleared. That would reduce the amount of margin required. It also has the benefit of moving the remaining risk into clearing – but not the trades – which I think is probably the better interpretation of what the Group of 20 nations asked the WGMR to do anyway," he said.

The initial margin component of the WGMR rules will be subject to a phase-in, starting with firms that have the largest outstanding gross notionals of non-cleared derivatives. Covered entities with gross notionals above €3 trillion – roughly 30 dealers, said Frankel – will be subject to the regime from December 2015.

Another 75 will be caught in 2016, and a further 100 to 150 over the following two years. But the vast majority of covered entities – some 3,500 firms – will not come into scope until December 2019, meaning the full impact of the rules won't be felt until the end of the decade, Frankel argued. At that point, all of the end-users caught by the regime would be compelled to collect initial margin from the relatively small pool of dealer counterparties.

Responding to questions, Frankel argued it was highly unlikely that CCPs themselves would converge on a single initial margin calculation model, as dealers are now seeking to do.

"CCPs need models that provide margin coverage for a given close-out period to at least a 99% confidence interval at all times. There's no capital that CCPs have to fall back on – at least, that's not the intention. We couldn't do the same for bilateral trades as it would create huge procyclicality. So instead we're interpreting the rules – as was hopefully originally intended – as providing 99% certainty of coverage over a specific reference period. So the Simm will be very, very different to a CCP model," he said.