However, over the last few years, the scale and complexity of the G20 ambition has become clear. The number and variety of end-user clients creates a massive challenge for clearing houses and client-clearers. The regulatory landscape is fragmented across multiple jurisdictions. The structure and capitalization of the central clearing house industry itself is proving contentious, and questions have arisen over the potential operational and systemic risks of the large scale move to central clearing.
2012-13 is likely to be a decisive period. The nature and timing of many vital regulations will be clarified, including Dodd-Frank, CPSS-IOSCO, Basel III, and EMIR. These regulations and the responses to them will determine whether central clearing remains a credible and beneficial near-term goal at the scale currently envisaged.
Policymakers’ choices on the detail of regulation will be vital, and these choices are by their nature complex. We offer four core pieces of advice to policymakers:
- Keep safety and simplicity as first principles. In any move of this nature, the risks of unintended consequences are significant. Phased timing and a conservative approach to the change is appropriate. Linked to this, some areas of regulation would benefit from simplification – particularly the initial target product scope, and the extent of the push towards exchange-like market-making and price discovery that is often bundled with clearing regulation.
- Ensure adequate incentives for central OTC derivatives clearing. If large parts of the OTC derivatives markets are to be smoothly transferred to central clearing, market participants will need realistic economic incentives in addition to legal requirements. We see a risk today that these incentives will either be insufficient or even negative, potentially resulting in damage to liquidity or a migration to non-standardized products/jurisdictions. This is most notable in the Basel proposals for capitalization of exposures to clearing house default funds, and capital rules for “client-clearer” banks. These proposals in our view strike the wrong balance between “safety” and “adequate incentives” by adding capital to the system but adding it in the wrong place and in the wrong structure.
- Seek more transatlantic consistency, and adjust the ambition in smaller G20 markets. Although the FSB is attempting to ensure that G20 members have a level of consistency here, we see three issues to be addressed. First, we still see inconsistencies between EMIR and Dodd Frank that should be addressed. Second, the timing of Basel implementation remains a major transatlantic inconsistency. Third, many G20 members outside the EU and US have yet to decide on how to implement the central clearing mandate (and indeed it is unclear whether central clearing would be of benefit in smaller markets); we see a need for more realism in the G20/FSB ambitions here.
- Strengthen clearinghouse risk management requirements. While the CPSSIOSCO requirements for central counterparties are a useful starting point, more is needed to ensure a safe and secure clearinghouse industry. The current requirements risk acting as a ‘bare minimum’ in key areas, and therefore risk creating a race to the bottom in terms of margining/collateral/default fund policies. Particularly in an environment where the major central counterparties (CCP) will be too big to fail – either de facto or de jure – we see a need for stronger global guidelines in these areas.