The extensive focus of the Dodd-Frank Act (DFA) on over the counter (OTC) derivatives is a reflection of the asset class' contribution to the recent financial crisis, and the complexity of these instruments and the associated trading and clearing processes. Proposed reforms are comprehensive and unless completely emasculated in the rules writing process, should dramatically change how a significant proportion of such instruments are traded and cleared. Uppermost in these reforms is achieving transparency in what has largely been an opaque market, and interposing exchanges and central clearing between the parties to what has been an OTC bilateral trading arrangement. Futures markets have apparently served as a model. While appropriately aggressive and reasonable, our concern is that the proposed reforms may not be entirely operationally feasible, particularly when the most tailored and potentially most problematic structures are involved. Unique swap structures are less likely to be listed by exchanges or cleared by clearinghouses yet it was such tailored structures that were at the core of the swaps related problems during the financial crisis. A cursory examination of AIG’s swaps portfolio at the onset of the crisis supports this.
Swaps processing current and expectedPrior to discussing concerns, the current processing of swaps trades and any potential changes to this system by the DFA need to be reviewed. Regardless of the effectiveness of the new regulations, it will necessitate substantial retooling for market participants. The precise nature of such changes will depend on the rules currently being written, but the overall direction and objectives of these reforms is apparent from the act.
Currently the swaps trading process, outlined in diagrams 1 and 2, depends on whether the trades are conducted OTC or via an exchange. Before discussing these diagrams an important distinction relating to how a trade is cleared needs to be made. In the most basic sense clearing refers to the counterparties to a trade agreeing to the terms of the trade and confirming those terms. DFA goes a step further and specifies clearinghouse involvement where possible. To interpose a clearinghouse means that the trade is not only cleared in the basic sense but is also guaranteed by the clearinghouse. This process is referred to as centralized clearing. This is an important distinction that will be referred to later on in this discussion.
Diagram 1 illustrates the most common way that swaps are traded and cleared. The counterparties to the trade enter into a bilateral trade agreement, the details of which can be conveyed either manually or electronically. When conveyed electronically the details are often routed to a trade processing facility (eg MarkitSERV) where the trade details are confirmed and the formal clearing of the trade is conducted. The more manual paper-based approach is likely to be cleared through direct communication of the counterparties' operations departments. In either case the trade information will be retained in a data warehouse, administered by a clearing facility or by the counterparties themselves depending on how the trade is cleared.
In Diagram 2 we illustrate the process when the swap is exchange traded, a growing but still small part of the overall trading activity in swaps. Rather than a bilateral agreement, the counterparties convey their bids and offers to an exchange where the trade is consummated. Trade information is then sent to the exchange associated clearinghouse where it is cleared. Once cleared the clearinghouse stands between the counter parties guaranteeing both sides of the trade. Because of that fiduciary arrangement, access to a clearinghouse is restricted to clearing members who have satisfied particular financial requirements. Therefore a non-clearing house member wishing to trade on an exchange must have an arrangement with a clearinghouse member to represent their trades to the clearinghouse.
To better understand the interaction among swaps markets participants as envisioned by the DFA consider Diagram 3 below. Standardized swaps will be traded on exchanges or on Swap Execution Facilities (left undefined in DFA, but will likely include many of the current electronic trading platforms in addition to new entrants to the market). Once the trade is completed it must be cleared, which for exchange traded swaps means that it will be centrally cleared at a clearinghouse in the same way that exchange traded swaps are currently cleared. A clearinghouse could also clear swaps trades executed on a Swap Execution Facility when such arrangements are established. Alternatively such swaps could be cleared in much the same way as an OTC trade is cleared. By comparison the portion of the market represented by non-standardized swaps will be traded and cleared in a way that is largely unchanged from current practice. The right side of Diagram 3 represents OTC trades after the DFA, which looks much like Diagram 1 above.
Margining processKey to the financial viability of a clearinghouse is the margining process whereby the counterparty to a trade, whose initial margin falls below the maintenance level, is the recipient of a margin call. Failing to satisfy the call is likely to result in involuntary liquidation of the position with losses absorbed by the residual margin left in the counterparty’s account. To the extent that the loss exceeds the margin on deposit, the clearing member is liable to make up the loss. If however, the clearing member is insolvent, the clearinghouse must draw on its own resources. This process has worked surprisingly well throughout the history of futures exchanges. Although the instrument itself has occasionally been the subject of criticism, as a facilitator of speculation, the operation of exchanges and their clearinghouses has generally been above reproach.
For the exchange and clearinghouse arrangements to work as well as they have requires that futures contracts satisfy several conditions. Futures contracts need to be sufficiently liquid so that a market determined independent price is generally available. Pricing is important for establishing both initial and variation margin and properly administering variation margin. Margin levels are set in direct relationship to the recent price behavior of the instrument to insure that risk is properly managed. Moreover, the process of margining is dependent on a closing market price. Liquidity is also important because it provides confidence that positions can be liquidated without disrupting the market and at minimal, if any, loss to the liquidator.
Clearing members form a community abiding by a given set of rules and requirements that are enforced by the clearinghouse. Because the clearinghouse is in effect the guarantor of all cleared trades, the identity of counterparties to a trade is irrelevant and reversing the trade with the original counterparties is not required. Now that most exchanges and clearinghouses are part of public entities there are also demands from shareholders that they perform profitably and within the constraints of prudent risk taking.
New role of clearing houseSwaps began to trade over the counter because they were tailored to the particular requirements of the counterparties, mostly for hedging cash flows. (Prior to the financial crisis 98 per cent of Fortune 500 companies used swaps, which outside of the swaps dealers on the list is largely explained by hedging activities.) These characteristics facilitated hedging but their uniqueness also ensured illiquidity where prices had to be calculated rather than market-determined. Although a clearinghouse’s infrastructure can be applied to clear such an instrument, no clearinghouse would willingly guarantee such a trade. The DFA recognizes this possibility and allows such instruments to be traded and cleared largely as they are now with the critical caveat that they are margined and a capital charge, which is greater than that applied to an exchange traded instrument, is implemented. . Hedging transactions will receive advantageous treatment, which implies less stringent capital and margining requirements than will be applicable to the outright trading of tailored swaps. Recognizing the economic value of swaps and not implementing barriers to such hedging activity is appropriate; however as with much else pertaining to tailored swaps significant difficulties could arise from enforcement.
Changes in regulatory oversightRegulatory oversight of OTC swaps will have to include setting margin, determining collateral requirements and marking positions to market. Although the dealers will be doing the actual implementation the regulators will have to take an intrusive role in the process to ensure compliance and actions are consistent with the objectives of the act. This is a complex task potentially applied to a very large number of swaps that will require the attention of well-trained and experienced supervisory staff. Moreover, if swaps applied to hedging situations are to be treated differently, there will also need to be regulatory determination of what constitutes a swap. The simplistic application of offsetting a cash exposure with a swap appears easy enough to identify; however not all hedges are constructed in that way. Also hedges can quickly become speculative positions if the initial exposure is liquidated.
ConclusionMany of the proposed reforms will have a beneficial effect on the swaps market. The regulatory community will also be tested when it comes to those swaps that are tailored and therefore less likely to be traded on exchanges or SEFs and cleared by clearinghouses. It will take sensitive fine tuning to set margin requirements and capital requirements that curtail socially undesirable risk taking while supporting legitimate hedging applications in OTC swaps activity. It will be an extremely difficult challenge for the regulatory community to allocate sufficient and adequately trained resources to oversee this significant portion of the swaps market. Standardized swaps have been migrating to exchanges since at least 2008, and although the proposed reforms will likely speed up the transition, it is the swaps that are inherently not exchange or clearinghouse compatible that will remain a cause for concern.
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