Ex-Isda risk chief: ditch gross notional thresholds for clearing

10 years on, David Murphy says mandate should be rebased to exempt less risky firms

The decade-old swaps clearing mandate is not fit for purpose in an era when clearing is concentrated in the hands of a few central counterparties (CCPs) and mediated by only a handful of big banks, a prominent derivatives industry figure has claimed.

In forthcoming research, David Murphy, a visiting professor at the London School of Economics and former head of risk at the International Swaps and Derivatives Association, calls for the over-the-counter clearing mandate to be based on a firm’s total margin obligations, rather than the notional size of their derivatives exposures – a radical overhaul that would remove hundreds of smaller and, he argues, less risky clients from clearing.

Murphy believes the move is necessary to preserve systemic stability in the event of a major default. In a paper due to be published shortly in the Journal of Financial Market Infrastructures, he examines the consequences of the failure of a major clearing member. The event, he argues, would have far greater ramifications for systemic risk than the mandate’s architects may have expected in the era in which it was drawn up, given how concentrated over-the-counter derivatives clearing has become at both the CCP and clearing member levels.

Murphy says: “At that point in time, there was significantly less concentration, certainly among clearing members, and there wasn’t this phenomenon of a single dominant CCP in an asset class that there now is in some areas of the cleared OTC derivatives market. One can never know what was in people’s minds, but my guess would be: no, they did not anticipate this phenomenon.”

Most clearing mandates for eligible swap transactions have been phased in over the last decade sequentially, according to the size of in-scope counterparties’ total derivatives exposures, with exceptions. In Europe, for instance, a complex and piecemeal series of exemptions exist for certain counterparties whose exposures fall below an €8 billion ($9.4 billion) threshold. Raising the bar Similarly, the mandate to bilaterally exchange margin on non-cleared derivatives will eventually roll down to firms whose notional derivatives exposures exceed$8 billion. Many have called for that threshold to be raised significantly, in effect removing the mandate from roughly 1,000 smaller firms. Research from the UK’s Financial Conduct Authority, based on UK-reporting entities, suggests a threshold of \$50 billion would catch 2.4% of all entities in scope of the rules – but represent 97.1% of all derivatives activity they sought to capture.

Murphy makes a similar argument for clearing-eligible trades, calling for the abandonment of gross notional tracking in favour of a rolling three-monthly or annual assessment of a firm’s margin obligations – a more risk-sensitive measure of the counterparty risk they pose, he argues. Small clients could be discouraged from clearing by keeping the minimum threshold relatively high, Murphy suggests.

Some attempt at harmony with the non-cleared margin threshold should be made, he adds.

It turns out that clearing members are much more concerned about having enough margin for their client positions than they are about the cost of funding their house IM

David Murphy, LSE and ex-Isda

“Ideally, a calibration exercise would be done to determine each threshold. I don’t have a strong sense whether they should be the same number, or whether the clearing threshold should be materially higher than the margin one, but clearly the answer should depend on the systemic risk reduction benefits of each approach,” says Murphy.

In risk terms – measured by their initial margin (IM) requirements – the clients at a typical CCP follow “a fairly sharp power law”, he says. At one end of the curve is a small number of very large clients with high IM requirements. Below them is a larger number of medium-sized, ‘medium-risk‘ clients. And then there is a long tail of clients whose portfolios, risk levels and IM requirements are all very small.

The smallest clients of each clearing member represent minimal systemic threat – but, Murphy argues, they pose a problem in another sense: they still require due diligence and other operational resources to onboard and maintain. Collectively, it would need a significant effort in the event of clearing member failure if they are to be ported to a surviving clearing member or their portfolios wound down.

This is effort that would be diverted away from dealing with larger, more systemically important stricken clients, he writes: “They all have operational requirements, but few if any individually will be profitable enough for a clearing member to prioritise their porting in.”

Margin obligations were initially considered as a basis of calculation when the mandate was being drawn up, Murphy points out – but regulators feared margin requirements could be subject to gaming, and kept artificially low via a race to the bottom among CCPs competing by offering low margin requirements.

However, experience since the mandate came in has shown that fears of a race to the bottom for OTC margin were overblown.

“In fact, there’s been a race to the top. It turns out that clearing members are much more concerned about having enough margin for their client positions than they are about the cost of funding their house IM. CCPs have tended to pass higher levels of margin of safety than competition, not lower levels – but that phenomenon was certainly not understood at the time the rules were being written,” comments Murphy.

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