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ISDA, the International Swaps and Derivatives Association, recently published a report that said transparency of OTC derivatives is on the rise. Global Custodian spoke to Karel Engelen, director and global head of technology solutions at ISDA, about the report — which touted the benefits of central clearing for OTC derivatives.
GC: How feasible is standardization and central clearing in the OTC derivatives space?
KE: Centralization is something we have been working on for several years. Its a development we continue to put a lot of emphasis on. If you look at an asset class, such as credit derivatives, we have reached a high degree of standardization, and at the same time there is always a need for customized transactions that will allow a client to precisely hedge the risks that they have. If you want to link standardization and central clearing, its very important to keep in mind that in addition to standardization you also need liquidity. A contract, in order for it to go into central clearing, there is a need for a certain level of centralization. At the same time there needs to be enough liquidity so the clearing houses can get on a daily basis prices on the contracts, and they are able to manage the risks of the contract. So standardization is something that is happening. We are moving toward that. We are also moving toward central clearing. Its something the industry is working on and putting lots of effort into. However, standardization as such is not enough. You certainly also need to look at liquidity of the contracts.
GC: Are CCPs for OTC derivatives a good thing?
KE: The use of CCPs in OTC derivatives we certainly think is a very positive development. As mentioned before, there is a lot of work that goes into this, and the industry is working to move the different asset classes to central clearing. It is important to keep in mind again that not all contracts are suitable for central clearing. So the standardized very liquid contracts, they certainly are able to go into central clearing, and for those contracts the use of a central clearinghouse is a great tool to manage counterparty risk. However, for the less-liquid contracts, there would be concerns if they mandatorily would be pushed into central clearing, because they are not always well suited for central clearing. And the end result is that you would increase risk in the financial system, rather than reduce risk.
GC: How do you respond to claims from people in the industry who say concentrating risk through the use of CCPs actually increases risk?
KE: A central clearinghouse manages counterparty disk. There are different ways in which you can manage counterparty risk. One is through central clearing. You certainly get a concentration of risk in the central clearing house, which is a positive and a negative. It is positive in the sense that you know where the counterparty risk resides. And if the central clearing house is a very well-managed institution that has the right checks and balances in place, then that should not be a problem. However, if you would force contracts into central clearing that are not suited for central clearing you could increase the risk.
Christopher Gohlke