Bank of England lays down guidelines on OTC derivatives

The Bank of England has set out its suggestions on how to determine which OTC derivatives can be made eligible for central clearing, as part of the government’s G20 commitment to reducing systemic risk in financial markets.

The Bank of England has set out its suggestions on which OTC derivatives should be made eligible for central clearing, as part of the UK government’s Group of 20's commitment to reducing systemic risk in financial markets.

Published in a report, 'Thoughts on determining central clearing eligibility of OTC derivatives', the Bank of England argued that suitability for mandatory central clearing depends first on product and process standardisation and secondly on market liquidity. Key considerations identified are usage of standard legal terms, use of straight-through processing and electronic confirmation and accessible measures of liquidity.

Less liquid products, or products for which operational processes remain less automated, are unlikely to be suitable for central clearing, according to the report. Despite this, it also suggests that central counterparties (CCPs) may need to modify risk management models developed for more liquid products, to accommodate the less liquid OTC products.

In addition, the paper suggests that the industry may need more specific guidance from the authorities as to which OTC derivatives should be centrally cleared. The Bank of England acknowledges that this would likely need close and coordinated engagement with CCPs, as well as the main dealers.

“There is an urgent need to develop precise and timely metrics to monitor central clearing progress, work which was highlighted as a priority in the October 2011 Financial Stability Board progress report,” said the paper.

The G20 nations mandated a reform of the structure and transparency of OTC derivatives following the financial crisis. Reforming the sector was seen as a key means to reduce systemic risk, since many of the products that contributed to the collapse of certain large financial institutions were complex OTC instruments.

In Europe, the proposed European market infrastructure regulation (EMIR) seeks to transfer as large a proportion of current OTC trading as possible onto centrally cleared platforms. The European Securities and Markets Authority ended its consultation on EMIR – including which products are eligible for clearing – last week.

Market participants will be forced to post collateral and set aside margin to be used in the event of a default of one of the parties to a transaction. This process is intended to reduce the possibility that the default of one institution could have a catastrophic knock-on effect on financial markets. Implementation of EMIR is currently scheduled for the start of next year.