Last week, Nasdaq OMX became the first infrastructure provider to be authorised as a Central Counterparty (CCP) under the European Markets Infrastructure Regulation (EMIR). The decision sent waves of mild panic rippling through the OTC markets, putting the focus back on an issue that was already predicted to pose problems for European banks and their customers – namely frontloading.
Frontloading is a term that describes the obligation to centrally clear an OTC derivatives contract retrospectively. It arises because there is a gap between the time that a CCP is authorised under EMIR and ESMA’s decision to mandate central clearing of certain derivatives.
For example, Nasdaq OMX has been authorised under EMIR to provide central clearing services for a range of derivatives, including interest rate swaps, forward rate agreements and options, and OTC-traded equity index futures, forwards and options (all covering a range of benchmarks and tenors). However, the decision on which of those instruments will have to be centrally cleared under EMIR will not come for at least another six months. Once that decision is made, market participants will need to retroactively clear the contracts deemed eligible for mandated CCP clearing that were entered into since 18 March (the day Nasdaq OMX was authorised).
The reason this timing discrepancy poses such a problem is because it can end up having serious commercial implications. Trades that are centrally cleared are subject to different cost structures from those that are not. If those costs were known up-front, dealers would be able to factor in the CCP cost model into the way they currently price their swaps. But given the uncertainty over which derivatives will be mandated for central clearing, dealers cannot price their trades accurately.
Consequently, as of 18 March, dealers trading in contracts that Nasdaq OMX has been authorised to clear face new risks in how they price their contracts. Ignore those risks and it could send otherwise profitable trades into the red, once the frontloading requirement is determined. Equally, being too cautious could be bad for business. By factoring in additional costs that are not guaranteed to materialise, dealers could end up pricing themselves out of the market. In any event, customers will be faced with a choice between paying a premium up front or additional costs later to cover either the potential costs of clearing the trade or, finally, the true cost of executing the trade.
Ideally, there would be some market consensus around these issues. But that’s not what we have discovered in our discussions with industry players. Instead, JWG has captured a number of key concerns relating to:
- The fact that frontloading can make some trades uneconomic
- Uncertainty as to how to price the (frontloading) risk
- Lack of consistency as to how all brokers are going to approach the requirement (i.e., pass on / absorb)
- The withdrawal of some dealers from some platforms in the face of uncertainty
- The potential impact on market liquidity.
Whether or not clarity can be brought to alleviate those concerns remains to be seen. ISDA and the FIA have written to ESMA with an urgent plea for clarification but, given the rush the European Parliament is in to meet G20 commitments and head to the polls, it might not be possible for ESMA to give the industry the answers it wants. In the absence of further explanation (and technical standards) from regulators, perhaps industry consensus is the best we can hope for. But, given that commercial interests are at stake, and competitive forces prevail, even industry consensus will be hard to establish. So for the time being, all that can be said for certain is that frontloading poses some clear and present dangers to the way swaps are priced. And those dangers are set to escalate once other European CCPs are authorised under EMIR – a process that has been going on for quite some time … Stay tuned.