Derivatives traders pressured to use central clearing

With uncertainty looming around the shape of new legislation aimed at curbing risks in over-the-counter derivatives markets, regulators will on Thursday press derivatives dealers to route an ever-growing proportion of trades through central clearing houses.

A group of 15 large derivatives dealers, including Bank of America Merrill Lynch, Barclays Capital, Citigroup, Deutsche Bank, Goldman Sachs, JPMorgan and Morgan Stanley, has been meeting every several months at the Federal Reserve Bank of New York as efforts have stepped up to reduce systemic contagion risks in the derivatives markets that came to light after the default of Lehman Brothers and the near-collapse of AIG in 2008.

Last year the group agreed to clear most new interest rate and credit default swap index trades through central counterparties. However, so far, derivatives that are cleared are in the minority of contracts outstanding. In a paper published last week, the New York Fed said 35 per cent, or $202,000bn, of the gross notional outstanding in the OTC interest-rate derivatives market was cleared at the end of 2009.

Regulators are expected to demand higher clearing targets at Thursday’s meeting. The desire to get banks to sign up for ambitious targets reflects concerns that some could opt to use centralised clearing for only a small number of trades.

“Dealers should further increase the fractions of their derivatives trades that are cleared,” the Fed paper said. “In 2010, regulators should demand an increase in the suite of clearing-eligible products.”

The efforts come as uncertainty continues to hang over the future of the derivatives industry. Regulators and lawmakers are trying to agree on new legislation. Proposals range from some that could vastly reduce the scale of the derivatives market, such as demanding that all contracts are traded on exchanges, to others that are less controversial to the industry, such as the growing use of clearing for widely used derivatives.

The Federal Reserve Bank of New York, the arm of the Fed most involved in tracking Wall Street’s capital markets, said it did not regard OTC derivatives as the central cause of the credit crisis, the origins of which are now being scrutinised by a Congressional Commission.

“Weakness in the infrastructure of derivatives markets did exacerbate the crisis,” the Fed said in its recent paper. “As a result of failures of risk management, corporate governance and management supervision, some market participants took excessive risks using these instruments.” It added that, “used responsibly”, there were benefits to the financial system of OTC derivatives.

But central clearing houses themselves can become a source of systemic risk, an issue regulators are also trying to tackle.