Regulatory reform of over-the-counter derivatives: an assessment of incentives to clear centrally

In 2009, the G20 Leaders agreed that standardised over-the-counter (OTC) derivatives contracts should be cleared through central counterparties (CCPs). Since that time, global standard-setting bodies have advanced a number of regulatory reforms that are likely to affect the incentives for central clearing of these contracts. These reforms include requirements to exchange initial and variation margin for non-centrally cleared derivatives exposures, standards relating to the measurement of counterparty credit risk for derivatives contracts, and capital requirements for bank exposures to CCPs.

In view of these changes, an OTC Derivatives Coordination Group was formed comprised of the chairs of the Financial Stability Board (FSB), the Basel Committee on Banking Supervision (BCBS), the Committee on the Global Financial System (CGFS), the International Organization of Securities Commissions (IOSCO) and the Committee on Payments and Market Infrastructures (CPMI). The group commissioned an assessment of the incentives for central clearing of OTC derivatives, recognising that misaligned incentives in this area - as compared to those for bilateral transactions - could lead market participants to take actions that could undermine the regulatory reforms (eg by customising their derivatives trades to avoid mandatory clearing of standardised OTC derivatives contracts). The OTC Derivatives Assessment Team (OTC DAT) was charged with bringing forward this work.

The OTC DAT initiated its assessment by developing a stylised framework for examining the main financial costs of central clearing compared to trading OTC derivatives contracts on a bilateral basis. The framework served as the basis for discussion at an industry workshop held in April 2013, where participants were asked to comment on the appropriateness of the framework for assessing incentives in this area. Insights gained from the workshop informed the development of a quantitative analysis that was conducted during the second half of 2013. The results of the quantitative analysis helped the OTC Derivatives Coordination Group and global standard-setting bodies to better understand the combined impacts of the regulatory reforms on OTC derivatives contracts. It also provided supporting evidence to finalise and approve some key decisions related to proposed regulatory reforms that had not yet been finalised, specifically the revised framework for bank exposures to CCPs and the revised standardised approach for measuring counterparty credit risk (SA-CCR).

The results of the quantitative analysis indicate that clearing member banks (ie those institutions that clear directly with CCPs) have incentives to clear centrally. Central clearing incentives for market participants that clear indirectly (ie that are not directly clearing members of a CCP but clear through an intermediary that is a clearing member of a CCP) are less obvious and could not be comprehensively analysed on the basis of the data received in the quantitative analysis. These "indirect clearers" do not constitute a homogeneous group. Instead, their trading and clearing patterns vary in a number of ways, such as trading frequency, portfolio composition and regulatory requirements. Some, but not all of them, are banks. This makes it difficult to draw any general conclusions on the effect of the reforms on indirect clearers' incentives for central clearing. After the reforms have been introduced, some indirect clearers may have incentives to clear centrally, while others may not. However, given that clearing members account for the bulk of derivatives trading, the conclusion of this analysis - there are incentives for them to clear centrally - indicates that the G20 objective on OTC derivatives reforms has, for the most part, been achieved.