The Commodities Futures Trading Commission (CFTC), a regulator of OTC derivatives in the United States, has mandated the initial implementation of “central clearing” of certain classes of Interest Rate Swaps and Credit Default Swaps. An OTC derivative trade is considered centrally cleared when it is cleared through a clearinghouse, instead of directly between two counterparties, and both counterparties effectively assume credit risk exposure to the clearinghouse. When trades are cleared through a clearinghouse, the counterparties are required to post initial margin and daily maintenance margin, and settle all future cashflows with the clearinghouse instead of each other.
OTC Derivatives Subject to Mandatory Central Clearing
In its final ruling on central clearing of OTC derivatives, the CFTC decided to first focus on clearing OTC swaps that have a large market share, and those that are capable of having a significant market impact. Additionally, the CFTC also decided to focus on those derivatives that were already centrally cleared widely through a central clearinghouse on a voluntary basis by market participants.
Based on the above considerations, Interest Rate Swaps and Credit Default Swaps were determined to be the best suited for the initial clearing requirement.
INTEREST RATE SWAPS (IRS)
Initially, only the simplest interest rate swaps would be subject to mandatory central clearing. IRS with optionality, dual currencies, or conditional notional amounts are excluded from theinitial clearing requirement.
Types of Interest Rate Swaps Required to Centrally Clear:
Interest Rate swaps in four major currencies (USD, EUR, GBP, JPY) on major indices, and in four distinct classes:
- Fixed-to-Floating Swaps
- Basis Swaps
- Forward Rate Agreements
- Overnight Index Swaps (OIS)
Available DCOs for Interest Rate Swaps:
1. LCH.Clearnet SwapClear (LCH): Largest DCO for Interest Rate Swaps. Currently clears 50% of all OTC interest rate swaps (i.e. both bi-lateral and centrally cleared) globally. Of the centrally cleared interest rate swaps, LCH accounts for 95% of all cleared trades.
2. CME Group
CREDIT DEFAULT SWAPS (CDS)
As with interest rate swaps, only the simplest CDS trades referencing the major market indices have been determined to require central clearing. Single name CDS’s on a specific reference entity and “tranched” CDSs are not required to centrally clear.
Types of Credit DefaultSwaps Required to Centrally Clear:
- North American Untranched CDS Indices on the Markit CDX family of indices
- European Untranched CDS Indices on the iTraxx Europe family of indices
Available DCOS for Credit Default Swaps:
- IntercontinentalExchange (ICE): Largest clearinghouse for CDS trades. ICE Clear Credit clears North American CDS; ICE Clear Europe clears European CDS.
- CME Group (CME): Started clearing CDS trades in 2009. CME currently only clears CDS on North American indices.
Over time, the Commission plans to increase the derivative classes covered by including more CDS and Interest Rate Swaps, and adding other OTC swaps such as energy swaps and equity index swaps.
IMPLEMENTATION CALENDAR FOR DIFFERENT CATEGORIES OF ENTITIES
The CFTC has decided to require compliance with these rules to be phased-in in three stages depending on the category of the trading entity. From December 13, 2012, the date of announcement of these rules, Category 1 Entities will have 90 days, Category 2 Entities will have 180 days, and Category 3 entities will have 270 days to implement clearing of specified IRS and CDS’s through approved DCOs. The “end-user” clearing exception applies to counterparties that are not financial entities. Trades by “end-users” are not subject to mandatory central clearing.
KEY BENEFITS OF CENTRAL CLEARING
- Standardizes Counterparty Credit Risk – credit risk transfers to the DCO from the traded counterparty as the DCO assumes the risk of default non-payment and guarantees future cash flows.
- Reduces Operational and Trading Costs – standardization of contracts leads to standardized trading and clearing procedures, and potentially reduces legal costs of reviewing bespoke contracts.
- Capital Efficiency – standardizing margin and collateral requirements by the DCO, levels the playing field for buy-side firms and smaller entities with their swap dealers. Standard margin settlement process for all firms and netting and compression benefits has the potential to significantly reduce margin requirements.
- Consistent Valuation and Mark-to-Market – consistent valuation methodology and frequent mark-to-market by an independent DCO instead of differing and potentially biased valuation methods by each swap dealer.
