Central clearing - putting a square peg in a round hole

The concept of centrally clearing all OTC derivatives - both standardized and complex derivatives - is flawed. The current regulatory expectation for institutional investors is to go through a central clearing party for an expanded range of products. Compounding this requirement is that derivatives will need to be reported through trade repositories. This means that derivative products have to be cleared through a central counterparty, but not every derivative instrument fits this model.

Surprising to me is that many financial institutions haven’t given this much consideration. While some may currently rely on a counterparty valuation, this is likely to change in the future. My view is that these products will have to be valued on a more frequent basis - ideally daily. This is because institutions will require a fair value for their collateral and regulation purposes, which means they will need to remove reliance on a valuation that is coming from a party that is linked to the transaction.

My silver bullet to tackling the central clearing of exotic OTC derivatives comes down to transparency.  Institutions need to understand from an independent third party how the valuation and component elements of a transaction were arrived at in terms of its market data, assumptions, calibration and modelling. While these transactions are collateralised and financial institutions may assume that the counterparty risk element is therefore mitigated, a regular valuation of that derivative is necessary. Meaning that as the value of the OTC changes, the collateral needs to be continually adjusted in line with the valuation.  I have seen one large European institution that has recently moved from monthly to weekly mark to market to satisfy a more regular valuation on their non-vanilla OTCs.  I expect more institutions will follow suit to ensure their complex derivative transactions remain fully collateralized. 

While central clearing parties provide a solution for the valuation of standardized OTCs, it is the complex products that are not processed in central clearing. They require additional transparency or they will be valued on a less frequent basis.

But that’s not all. Many products are still going to be bilaterally agreed upon and bilaterally settled. Basel III requirements have indicated that these products are going to need higher levels of capital adequacy requirements, creating the need to collateralise the trades to compensate for this fact. The irony is that the intent of central clearing is to take some of the risk out of the equation. Going down the bilateral route means that institutions will have to compensate for this risk by setting aside more capital. This is an example of trying to force a square peg into a round hole by making one concept fit for all types of derivatives - food for thought for many institutional investors.