OTC derivatives reforms may risk "wasting" a scarce commodity by causing collateral to be posted across multiple central counterparties (CCPs), according to Manmohan Singh, senior economist, International Monetary Fund.
Speaking in a personal capacity, Singh said the large number of jurisdictions looking to establish domestic clearing houses to clear OTC derivatives in competition with international CCPs could fragment collateral over 20-25 entities globally, with the result that "netting efficiencies are destroyed".
"It's important not to waste a good commodity that is getting scarcer: collateral", he told delegates at an Economist Group event in London yesterday.
Central clearing of standardised OTC derivatives - primarily interest rate swaps and credit default swaps - is being mandated across Group of 20 countries to reduce systemic risk in response to the financial crisis of 2008.
Singh has persistently warned that restrictions on the ability of market participants to re-use collateral is a key factor in addressing concerns about a widening gap between demand and supply as OTC derivatives migrate to central clearing.
Simon Gleeson, partner, Clifford Chance, said new rules being implemented to shore up financial markets stability were making it "impossible" for institutions to re-use collateral. "An astonishingly smaller percentage of collateral is available for use … and a lot of the rules are not even in place yet," he said, noting the rolling deadlines set out by the Basel Committee on Banking Supervision for higher capital requirements for high-risk activities, such as trading non-cleared OTC derivatives trades.
Singh added that asking clearing houses to take on risk in the OTC derivatives market only served to create another tranche or financial institutions - alongside global investment banks - that are too big to fail. Furthermore, central clearing did not address the key issue of under-collateralisation of transactions.
"Everyone with skin in the game is not posting their fair share of collateral …It's ironic that a lot of the people who don't post sufficient collateral are still exempt [under the new regulatory framework]."
Gleeson agreed that, however unlikely, the question of CCP failure had to be addressed by regulators. At present, he said, the choice seemed to lie between unlimited liability for clearing members or the assumption of public sector rescue. "Both are unacceptable, but they seem the only choices we have," he said. Singh said a further taxpayer bailout for the financial markets would prove the post-Lehman crisis reforms to have been to have achieved little other than to fragment netting opportunities.
According to Nadine Chakar, executive vice president, global collateral services, BNY Mellon, financial institutions are working with CCPs to widen the range and increase the availability of assets eligible to be posted for margin purposes - through services such as collateral transformation - to meet growing demand as implementation of new OTC derivatives rules nears.
Noting upcoming US deadlines for categories of institutional investors to start clearing OTC derivatives in June and September, Chakar suggested that "stress on the system may not be felt until late 2014 and into 2015", but insisted that the buy-side needed to "step up" their efforts to prepare for the new regulatory framework. "Better risk management for underlying investors is something we're not seeing a lot of," she added.
Clearing houses are open to accepting a more diversified portfolio of acceptable collateral to offset the expected shortfall in supply, said Bryan Durkin, chief operating officer, CME Group. But he asserted, "We will not reduce our commitment to prudent risk management."