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Exchange clearing of OTC derivatives likely to reduce counterparty risks for hedge funds

Date: Tuesday, May 1, 2012
Author: Margie Lindsay, Hedge Funds Review

The move to more standardised OTC derivatives as products go to exchange clearing could reduce counterparty risk but may also hit hedge fund strategies reliant on customised vehicles.

Many issues are still outstanding in the EU's attempts to move to exchange clearing of OTC derivatives. Having started somewhat behind the US, the EU is now playing catch-up.

One of the biggest issues is the expected huge demand for collateral. According to Marcus Zickwollf, executive vice president of Eurex Clearing and chairman of the European Association of CCP Clearing Houses, discussions centre on "which collateral can be accepted and how buy-side customers can exchange their collateral and transfer that collateral into CCP-eligible collateral".

Another concern for some is the divergence between the US and EU on the approach to legislation on this topic. "Dodd-Frank regulates trading and clearing in one regulation. In Europe there is a different approach because with Emir [European market infrastructure regulation], we regulate the clearing player, and with Mifid [markets in financial instruments directive] and Mifir [markets in financial instruments regulation], we regulate the trading players. So we have to wait for Mifid and Mifir to see what the differences are," says Zickwollf.

There are also outstanding issues still be debated on Emir. Zickwollf says discussion centres on tactical implementation. "We expect the consultation for this technical implementation requirements in June this year. It's about the clearing obligations, how Esma [European Securities and Markets Authority] will report or define what has to be cleared. It's also about the requirements of the CCPs, how robust the CCPs have to be."

One thing is clear: the European rules will mean "huge investments" for CCPs. "They need more capital. They need more robust risk management. They have to increase their efforts in risk management and develop services for products which were not cleared so far," notes Zickwollf.

Once rules are in place, Zickwollf expects more trading of OTC derivatives products on swap execution facilities in Europe. "I expect more standardisation of products and less customised ones," he says.

Looking at how this will affect the hedge fund industry, Zickwollf thinks the biggest difference will be a reduction in counterparty risk. "It think there will be more use of standardised products and so maybe not every strategy which needs very customised derivatives will function in the future. But we will see how standardised products will be able to replace that," he adds.