Regulators Urged to Include Product Suitability Standards for Derivatives Clearing in PFMIs

Standard-setting bodies are urged to include product suitability standards for derivatives clearing in the Principles for Financial Market Infrastructures ("PFMIs") as the market enters the post-mandatory clearing phase, a conference has heard. 

At the Asia Securities Industry & Financial Markets Association ("ASIFMA") annual conference held in Singapore in mid-November, Jenny Cosco, co-head of government affairs, Asia-Pacific at Goldman Sachs, who spoke on the panel on recovery and resolution plans for clearing houses, said the economics of clearing has changed following the global implementation of mandatory clearing and that of margin rules for non-centrally cleared derivatives. 

"With respect to that we are seeing potentially more products being pushed to clearing houses and in some respects that makes a lot of sense. In other respect, highly illiquid products make less sense," she told the conference.

Product Suitability and Governance Standards

Cosco said regulators could bring the PFMIs one step further by providing further detail on product suitability standards, particularly on governance standards developed by the Committee on Payments and Market Infrastructures/International Organisation of Securities Commissions ("CPMI/IOSCO"). 

Agnes Koh, chief risk officer at the Singapore Exchange Limited ("SGX") who sat on the same panel, said that clearing houses traditionally clear mostly standardised products for which they are able to manage potential default. She said it is important to the SGX that its operations remain undisrupted even if it clears a product that goes into a default. 

Benefits of Mandatory Clearing

The SGX was asked to clear a product a few years ago which was deemed fairly complex and lacked liquidity. It eventually decided that it could not clear that product as it had to depend on market participants to provide the liquidity in times of stress, according to Koh. 

"You would find that the benefits of mandatory clearing is really pushing [for] more standardisation of products across the board and this could make the market a little less complex and that may not be a bad thing overall for the financial market," she told delegates. 

Exposing Clearing Member to New Risk

Another panelist, Rogier Van Kempen, executive director, clearing house risk at JPMorgan, said the regulatory environment has sometimes made it difficult for market participants and clearing houses alike. He said market participants sometimes tried to push for certain new derivative instruments to be cleared which would mean new business to CCPs, but could potentially expose clearing members to new risk even if the latter may not be interested in trading in those new products. 

"The sheer fact by saying: 'we are not interested, go ahead and introduce it' doesn't mean that we as a [clearing] member are not exposed to the risk. That is a problem and that's just the way CCPs work. [That is] possibly [something] that may require a bit more attention as well," he said. 

Kishore Ramakrishnan, director of consulting at PwC in Hong Kong, who moderated the session, noted that although regulators have not mandated central clearing for certain products, some CCPs took a proactive approach and cleared them. 

He asked the panelists what their concerns were when such products were offered for clearing even though clearing them have not been made mandatory. He also asked the clearing houses what they would like to put in place to mitigate the risk associated with products that have not been mandated for clearing but were still cleared by CCPs.

Cosco said there is a difference between a product that has been offered for clearing and making it mandatory to clear a product. A product that can be appropriately risk managed by CCP is appropriate to clear and that, she said, should be the most important consideration.

Cosco pointed out an ongoing tension between products with liquidity issues, when there is need to clear certain products and when products are made mandatory to clear. 

"From clearing members' perspective, one thing that has been suggested is: is there a way to have some kind of risk threshold for clearing members where clearing members can share with CCPs how much risk they can safely clear in times of market stress so that people can get comfortable with clearing these products where there is low level of liquidity and with some demand?" she said.

The most important question clearing members and clearing houses need to ask themselves is whether in the event of a default, they are able to risk manage products that are illiquid and yet are demanded by the market, Cosco said. Product suitability and all the safeguards for risk management purposes are the best solution against CCP resolution, she said. 

Van Kempen said new instruments are welcomed as long as they have sufficient liquidity and their risk can be properly managed.

"But we should also continue to look at [the fact that] even if it [a new instrument] is liquid, how many members are actually interested in clearing it because if you have a big segment with 20 members and only five members are interested in clearing [the new instrument], you are exposing the rest of the 15 members to the risk as well, which may not be fair," he said.


Patricia Lee is a South-East Asia editor at Thomson Reuters Regulatory Intelligence in Singapore. She also has responsibility for covering wider G20 regulatory policy initiatives as they affect Asia.