Profile: CLS Bank's Bozian on regulatory co-ops and CCP settlement risk

Clearly settled

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Reform of the over-the-counter derivatives market is still being finalised, but a new world – built around mandatory clearing, electronic execution and reporting – is beginning to take shape. These measures will help limit systemic counterparty risks, regulators hope, either by mitigating it directly or by shining a light into the previously opaque OTC market so exposures are not allowed to reach dangerous concentrations.

But national interests are making the realisation of this vision difficult. Supervisors want to oversee central counterparties (CCPs) serving their domestic banks and also insist on guaranteed access to information from trade repositories – something they might not get if infrastructure is based in another jurisdiction. Market participants warn that a host of CCPs and trade repositories will fragment netting sets and data, undermining the supposed benefits of the new regime and – in the case of reduced netting efficiency, at least – increasing overall levels of exposure (Risk April 2011, pages 38–41).

One solution could be for regulators to embrace the precedent set by New York-based CLS Bank, which undertakes settlement in the global forex market. The firm is overseen by a co-operative of 22 central banks – a model supervisors are now seeking to apply to big, systemically important infrastructure providers in the OTC derivatives market. But if regulators decide they want a centralised, jointly regulated data warehouse, CLS Bank’s New York-based chief executive and president, Alan Bozian, believes some fundamental questions need to be answered first.

“Some of the key questions are around whetheer the repository will be global or regional in nature. If global, who will take the lead in oversight responsibility? How much information will central banks be willing to share with each other? For instance, do European authorities want US regulators to see data from all the activities of the European banks, or only data from the activities that concern US regulators directly and vice versa?” he asks. Answering these questions will be crucial if global regulators decide to adopt a model akin to CLS Bank’s oversight committee, Bozian says.

He also says some regulatory expectations could be over-inflated – having a single global repository gathering counterparty exposures and risk concentrations in real time is a long way off, he argues. “From the specifications released so far I believe repositories are expected to provide a round-the-clock, real-time system that gives regulators a window into mark-to-market exposures, counterparty positions and risk concentrations from all over the world. However, I don’t know how practical that is. It will certainly take a lot of money and a lot of time to set up,” he says.

That's the sticking point with using co-operative oversight on CCPs - at some point, someone needs to take ownership and provide a monetary backstop

In the case of CCPs, a co-operative system of supervisors may also seem sensible at first, but Bozian warns the reality could be more difficult. For one thing, it would be unclear which country would pick up the tab if a global CCP were in financial distress. “That’s the sticking point with using a co-operative arrangement for CCPs – at some point, someone needs to take ownership,” he says.

With CCPs set to clear the lion’s share of the $600 trillion notional OTC market, that backstop will need to be credible. For many, only central banks could provide it, but that apparently uncontroversial stance is fraught with difficulties. In June, the European Central Bank proposed that any CCP clearing euro-denominated products would need to be located within the eurozone to ensure access to central bank liquidity – a prospect that alarmed the UK Treasury enough to file a lawsuit. Forcing multi-currency CCPs – such as the UK’s LCH.Clearnet – to have a presence in the country of the currency being cleared would tear them to pieces. One alternative would be for central banks to agree bilateral swap lines that would be used to tap foreign currency liquidity in the event of a CCP failure – but some central bankers have privately indicated they don’t like that idea. They might also object to having shared responsibility, warns CLS Bank’s Bozian.

“In a co-operative system, a lot of central banks will not want to be responsible for providing emergency liquidity without full and undisputed control over the institution in question. It is not yet clear whether a co-operative can solve this problem,” he says.

CLS Bank was born in 1997 in an attempt to mitigate settlement risk in the forex market – an exposure sometimes dubbed ‘Herstatt risk’, after the Cologne-based Bankhaus Herstatt that collapsed in 1974 before it had been able to deliver on its side of some large foreign exchange transactions. Since 2002, CLS has enabled forex transactions to be settled on a payment-versus-payment basis, meaning the accounts of member banks are simultaneously credited or debited with currencies bought and sold. CLS Bank guarantees the principal on transactions that are cleared through it, virtually eliminating settlement risk.

The US Federal Reserve Board is first among equals as the lead regulator of the institution, although the other 21 central banks that sit on the CLS oversight committee can meet CLS Bank individually and make additional information requests independently of each other.

Although regulators and central bankers are at loggerheads over OTC derivatives oversight, Bozian says that has not affected oversight of CLS. The Fed’s role as a lead regulator, in particular, has helped to ensure CLS Bank has a clear idea of what is expected, he says. “There has to be active co-operation between the regulators to make CLS work, with the need for a lead regulator widely recognised. If you had 22 central banks trying to play the lead role, we would struggle to get anything done. The Federal Reserve is an active lead regulator. CLS is a strategically important part of the forex market infrastructure and, as such, is subject to the same level of supervision that regulators would give to a global, systemically important bank,” says Bozian.

The role CLS currently performs could expand as some forex derivatives trades move into a centrally cleared environment. Some regulators have called for CCPs to provide certainty of settlement as well as guarding against counterparty exposure – but that would be challenging in trades such as forex options, which can require big exchanges of cash when triggered. CLS, or something like it, may be called on to help solve the problem.

CLS Bank has already had numerous discussions with regulators, banks and other market participants on the topic, Bozian says. “Regulators have mandated clearing to reduce counterparty risk. However, CCPs do not mitigate settlement risk. The settlement service provided by CLS was designed to do that and already has robust regulatory oversight in place. Whatever the solution is for forex clearing, cleared trades still need to be settled so settlement risk is not reintroduced,” he says.

One idea that has been mooted is for CCPs to create their own payment-versus-payment systems, but this would present a major technical challenge. Unsurprisingly, Bozian believes it would be simpler to involve CLS Bank.

“We have informed CCPs that until the overall model has been agreed between the CCP and the relevant regulators, it would be premature to determine how CCPs may connect to CLS to mitigate settlement risk. However, the regulatory community has created CLS, and we hope that they are envisioning a solution that incorporates CLS in some way” he says.

Bozian says the firm is eager to help in other areas of the OTC derivatives market too. The International Swaps and Derivatives Association is working with market participants to develop a new standard credit support annex (CSA), which governs the posting of collateral between counterparties in an OTC derivatives trade. The move comes in response to the degree of optionality granted by existing CSAs, allowing each counterparty a choice of collateral types and currencies it can post – with each different currency implying the use of a different overnight indexed swap (OIS) rate to discount the trade. The pricing challenges that generates has resulted in frequent disputes and the death of pricing consensus (Risk September 2011, pages 24–27).

Dealers say Isda’s new standardised CSA will include five collateral buckets, corresponding to currencies with the most liquid OIS curves – US dollar, euro, sterling, yen and Swiss franc. Individual trades would be allocated to one of the five buckets, and could no longer be netted off against each other, resulting in an increase in the frequency of collateral payments between the counterparties – and a jump in settlement risks. Collateral is exchanged on a daily basis under the terms of a CSA, and although same-day settlement is currently beyond the capabilities of CLS Bank, some market participants have suggested a similar system could be used to buttress the new standard CSA in the future.

CLS Bank has yet to receive the call, however. “We have not been involved in discussions with Isda on standardised CSAs. We believe that we could contribute to the conversation. However, at the moment we have plenty to keep us busy in the forex space,” says Bozian.

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