OTC Derivatives Regulator Group Reports on Cross-Border Clearing
Commentary by Steven Lofchie
The Over the Counter ("OTC") Derivatives Regulators Group ("ODRG") updated G20 leaders on continuing efforts to identify and resolve cross-border issues associated with the implementation of the G20 OTC derivatives reform agenda. The ODRG Report focused on the recognition of clearing agencies settling cross-border transactions, and thus being subject to the potential exercise of jurisdiction by the regulator of each participant to the trade, as well as the clearing corporation's home regulator.
The ODRG lists to a number of agreements signed between different regulators allowing market participants in the relevant jurisdictions to clear and trade. Notably, the European Securities and Markets Association ("ESMA") has entered into agreements with Australia, Hong Kong, Japan and Singapore, with the result that ESMA has recognized eleven CCPs established in these four countries. The CFTC has granted conditional recognition to two clearing houses in two countries.
Commentary
The big message of the report is "deference"; i.e., at the end of the day, any national regulator that wants to enable its financial institutions to do business in another major financial center is going to be required to recognize the major clearing corporations of that jurisdiction.
The concept of deference adds political risk to the other systemic risks created by mandated central clearing. In the pre-Dodd-Frank world, if a bank believed that another bank (in a different jurisdiction by way of example) was weak financially, the first bank could either negotiate better collateral terms going forward or else avoid the second bank entirely. In the mandatory clearing world going forward, that option is not going to be possible. If the first bank believes that the clearing system in another country is weak, perhaps threatened by a weakened banking system or by an endangered clearing member, there is simply nowhere else to go: the only path to "safety" would be to pull out of the country entirely. Obviously, this is a decision that a bank will be much more reluctant to make than simply stopping, or limiting, business with a single other counterparty.
Put differently, mandated global central clearing adds political risk to economic risk: one can not merely walk away from Bank X; one must now walk away from Country X. Conversely, what will happen if the clearing house in Country X gets into trouble, perhaps because of problems with local clearing members, and then starts to demand more collateral from banks in other jurisdictions, albeit in a manner that is consistent with the local clearing house rules?
Bottom line, it does not appear that U.S. regulators have fully considered the risks that mandated global central clearing creates in terms of added political risk and increased interconnectedness through the clearing corporations. This is to say nothing of the risks of clearing house failures which they have identified, and the risks of a liquidity drain.