Compulsory Central Clearing of OTC Derivatives: The Changing Face of the Provision of Collateral

Abstract

New regulation brought in as a result of the global financial crisis mean that more reliance than ever is being placed on collateral, not just as mitigation of credit risk in bilateral financing transactions, but as one of the main techniques supporting the architecture of the regulated capital markets. This is particularly true in the derivatives market, where, for transactions which meet a specified degree of standardisation, compulsory clearing through central counterparties is being introduced pursuant to the decision taken at the G20 summit in Pittsburgh in September 2009. The Regulation introducing compulsory central clearing in Europe (‘EMIR’),takes an ambivalent attitude towards collateral. On one hand, it makes the provision of collateral to central counterparties (‘CCPs’) compulsory,in order to protect CCPs from credit risk if their counterparties default. On the other hand, it mandates particular collateral holding models, in order to protect counterparties from the risk of CCP insolvency, and to protect clients from the risk of their clearing broker’s insolvency.Both these requirements result in vastly increased demand for quality collateral.For many market participants this is only achievable at considerable cost. There is every incentive for the market to develop ways of reducing the amount of collateral that is required to be posted, and to enable the available collateral to ‘go further’. The chief technique used is netting of transactions: the more netting there is, the less exposure and therefore the less collateral is required. One of the benefits of central clearing is reduction of exposure through multilateral netting. However, netting at lower levels brings its own costs and difficulties. The market challenge has been to produce a range of collateral holding models so that participants can choose the particular balance of risks and costs which suits them. The purpose of this paper is to examine the new structure in relation to central clearing,as well as some of the market solutions, to analyse the legal position of each under English law and the resulting mix of risks and protections offered by each technique.