The global financial crisis drew attention to the serious risk that the over-the-counter (OTC) derivatives market presented to the broader economy. Following the financial crisis, regulators across the world made concerted efforts to improve the transparency and risks associated with the OTC derivatives market.  The challenge has been to balance this with preserving the benefits they offer to the market.

The Dodd Frank Act and the European Market Infrastructure Regulation (EMIR) are behind the move towards central clearing in the OTC industry, driven by global leaders and policy makers. EMIR requires that anyone who has entered into a derivatives contract must report and risk-manage their derivative positions. The most important aspect of these regulations regarding risk is the introduction of Central Counterparties (CCPs). Central clearing mitigates counterparty credit and operational risks by managing a transaction after order matching and before settlement. A CCP manages the risk that could arise if the counterparty is not able to make the required payment when due.

A CCP is responsible for the following:

• ·         Clearing trades
• ·         Collecting and maintaining margin
• ·         Overseeing delivery and trade settlement
• ·         Reporting trade data

The timelines associated with these regulations keep getting pushed back and within the buy-side community, there is still a great deal of uncertainty about what their obligations will be. European authorities are now expected to approve the full legal framework of EMIR in February 2013 with the likely adoption and application of the rules in April 2013.

The costs involved for buy-side firms could be very high, as moving OTC contracts to CCPs requires that collateral be posted for every contract cleared. Another challenge for dealers will be the increased number of intra-day margin calls required as part of the CCP process.

There is also a debate as to whether CCPs will indeed reduce risk as they are intended to, or if they will instead concentrate risk leading to systemic consequences if the CCP were to become stressed and collapse.

CCPs reduce counterparty credit risk and increase market transparency. They reduce systemic risk partly by netting transactions across multiple counterparties. CCPs can also reduce the potential knock-on effect of a major counterparty failing, as the failure would be absorbed by the CCP’s default protections.  However, the CCPs can also concentrate and spread risk through their policies if they become stressed, so they must therefore be effectively regulated and have strict risk management procedures in place. Multiple CCPs will be required to support the regulations and local jurisdiction. In addition, trading across multiple asset classes requires different CCPs for each, introducing further complexity and risk.

This may lead to managers of smaller funds to hedge less risk or utilize futures more, particularly given the increased cost of hedging with CCPs. This may not increase the level of uncertainty present in the market place—systematically or otherwise—but it could shift it towards non-clearable OTCs.

The creation of CCPs will go some way towards mitigating systemic risk and restoring confidence in the financial markets. Despite initial reservations, the market now seems to be generally in favour of CCPs. The CCPs will be responsible for getting potential customers to adopt a more holistic view of risk management so that they can understand the value proposition and make informed decisions about which clearing strategies they should adopt.