OTC Derivatives Central Clearning & Dodd – Frank

Ready or Not ? Here it comes

Lot of Hedge funds and Investment banks have started publishing the margin FAQ’s after the Credit crisis. As part of Dodd-Frank, by the end of 2012, all standardised over-the-counter derivatives will have to be cleared through central counterparties.

That’s the biggest challenge for the market as OTC derivatives account for almost 95% of the derivatives markets. In June 2011, the notional value of outstanding OTC derivatives was around $707 trillion or €540 trillion. The OTC derivatives market comprises a wide variety of product types across several asset classes (interest rates, credit, equity, foreign exchange (FX) and commodities) with widely differing characteristics and levels of standardisation. OTC derivatives are used in a variety of ways, including for purposes of hedging, investing, and speculating. Contrary to derivatives traded on exchanges, OTC derivatives are not automatically cleared through Central Clearing Parties.

let’s try to define what Central Clearing Parties (CCP) are,a CCP is an entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer. A CCP’s main purpose is to manage the risk that could arise if one counterparty is not able to make the required payments when they are due –i.e. defaults on the deal.

I have tried to put of the definitions for the most important factor:-
Imagine the market for $707 trillion and that has to be cleared through CCP. When a CCP comes in between margins are required to put up. Just to quote an example when Silver was fluctuating too much commodity exchange (CME)hiked silver margins 5 times in a row) silver market is tiny by comparison to OTC it is easy to be pushed around, and thus exchanges can easily represent the illusion that they are in control of counterparty risk
Nothing could be further from the truth: where exchanges are truly at risk is when it comes to mitigating the threat of counterparty default for participants in a market that is millions of times bigger than the silver market: the interest rate and credit default swap markets.

So the 14 Dealers that dominate derivatives trading includes major banks will soon need to post billions in initial margin, and as a brand new BIS report indicates, will likely need significant extra cash to be in compliance with regulatory requirements.

The Topic is vast will continue in my next post.

9 thoughts on “OTC Derivatives Central Clearning & Dodd – Frank

  1. The overall impact of regulation in the OTC Derivatives markets is likely to be very positive. But much of the concern is about the lack of flexibility that is in some of the current rulings for market transactions, and the timeframes for implementation.

    With the impact of SEF’s, Central Clearing, increased Margin / Collateral requirements, more rigorous reporting and the “push-out” provisions, there is a considerable amount of effort needed within the swaps dealers and major swaps participants.

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    1. Agree with you Kola but I think there is a tug of war going on between the Law makers and the derivative lobby who has been controlling the derivatives market since inception .. but you know not all rules are full proof

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    2. I am afraid that the impact of these types of regulations on the activities of non-financial corporations is most certainly NOT positive. Sadly regulators have rarely heard of the ‘law of unintended consequences’

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  2. I don’t understand how ‘tailor made’ OTC derivatives will survive ?! I know many banks who use derivatives to hedge their risk from loans that are structured. Initial nominal might be 102 220 555 EUR or USD, then amortised in a non linear way. Will CCP make these non plian vanilla deals disappear ? Will banks have to hedge partially using 100M falt deals ?

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    1. Hello David, its a genuine concern even I do not know the road ahead, for them but it is for sure the CDS markets will not be so lucrative . . In the time to come

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  3. The idea to move to a CCP is good. But the question is how are CCP’s going to manage risks. It will be leading to once again concentration of risks with the CCPs. How will margins be computed on the open positions. Will you have intra day margin call ! What will be contribution to the Settlement guarantee fund ! how will initial margin be computed !

    More importantly will there be position limits for players based on their capital and collateral posted with the CCP. There are a host of issues which need to be clarified.

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