Charta is on Google Play: practise on the go. Get the app
Charta

Describe the regulatory initiatives that have targeted OTC derivatives and what they mean for central clearing.

FRM® Part I · Financial Markets and Products · Central Clearing · FRM1.FM.6.d

The idea

After the 2008 crisis the G20 leaders meeting in Pittsburgh in 2009 agreed that standardised OTC derivatives should be cleared through CCPs, traded on exchanges or electronic platforms where appropriate and reported to trade repositories. Contracts left uncleared should carry higher capital requirements. National laws followed, notably Dodd-Frank in the United States and EMIR in the European Union. Basel III added capital charges that make uncleared trades dearer than trades with a qualifying CCP. The BCBS-IOSCO framework requires initial and variation margin on uncleared derivatives between covered entities. Reporting applies to all OTC derivatives, but the clearing obligation covers only eligible standardised ones. Exam point: regulation pushes standardised trades into clearing and makes the remaining bilateral trades more costly through margin and capital.

A practice question

From the question bank, with the reason each wrong option is wrong.

Which of the following was a commitment made by the G20 leaders at their 2009 Pittsburgh summit regarding OTC derivatives?

  1. All OTC derivatives, including bespoke ones, must be traded only on exchangesWhy not: Overstates the commitment; exchange or electronic trading applies where appropriate, and bespoke trades are not forced onto exchanges.
  2. Standardised OTC derivatives should be cleared through CCPs and reported - correct
  3. OTC derivatives must be abolished in favour of futuresWhy not: No such commitment was made; the reforms were designed to make OTC markets safer, not to eliminate them.
  4. Capital requirements on uncleared derivatives should be lowered to encourage bilateral tradingWhy not: Reverses the commitment; non-centrally cleared contracts were to face higher capital requirements.

The G20 agreed that standardised OTC derivatives should be centrally cleared, traded on exchanges or electronic platforms where appropriate and reported to trade repositories, and that uncleared contracts should carry higher capital.

A harder one

How do the Basel III capital rules support the policy goal of central clearing?

  1. They impose the same capital on cleared and uncleared trades so that firms choose on price aloneWhy not: Basel III deliberately differentiates; equal treatment would remove the incentive to clear.
  2. They ban banks from holding any exposure to a CCPWhy not: Banks are encouraged to clear; exposures to qualifying CCPs are allowed with lower capital.
  3. They apply higher capital to cleared trades because CCPs concentrate riskWhy not: Concentration is addressed through CCP standards and default fund charges; trade exposures to qualifying CCPs get favourable treatment.
  4. They charge far less capital on exposures to qualifying CCPs than on bilateral ones - correct

Basel III gives trade exposures to qualifying CCPs a low risk weight and exempts them from the CVA charge, while uncleared trades attract higher capital. The differential is intended to push standardised trades into clearing.

The hardest tier

A bank holds trade exposures to a CCP that previously met the international standards for qualifying status. The CCP loses qualifying status because it no longer complies with the CPMI-IOSCO principles for financial market infrastructures. What is the most likely effect on the bank?

  1. Its capital charges fall because the exposures are now treated as bilateral and nettedWhy not: Reverses the effect; loss of qualifying status removes the favourable treatment and increases capital.
  2. Its capital charges are unchanged because status affects only the CCP's own regulatorWhy not: Capital relief for banks depends on the CCP's qualifying status, so the status change does directly affect the bank.
  3. Its capital charges rise because the favourable qualifying-CCP treatment ends - correct
  4. Its trades are automatically cancelled and replaced by trades with a different CCPWhy not: Nothing in the rules cancels trades automatically; the effect is higher capital, not forced novation.

Basel capital relief depends on the CCP being a qualifying CCP, meaning it is supervised and meets the CPMI-IOSCO principles. Losing the status removes the reduced risk weights, so the bank holds more capital.

In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.

Start free →

More in Central Clearing