Since the world economic crisis finance gurus have been systematically reducing systemic risk in the OTC Derivatives Market. Since the public doesn’t want a repeat of the crisis, we have been tuning into how they try to reduce risk. One of the most agreed upon methods is to using clearing houses for clearing derivative trades.
The main mechanisms to reduce system risk are:
- Require that as many product types are possible are centrally cleared and traded on exchanges or similar trading facilities
- Subject swap dealers and large market participants to capital and margin requirements (which are imposed by clearing houses)
- Require the public reporting of transaction and pricing data on uncleared and cleared swaps
What Are Clearing Houses?
Before we take a look at how clearing houses are applicable to the other-the-counter (OTC) derivatives market, it’s important that we understand the basic concept of a clearing house.
A clearing house is a middleman between sellers and buyers and assumes the opposite position of each side of the trade. Once two parties agree on a transaction such as interest rate Swaps, the clearing house will ensure the smooth functioning of the financial transaction. For example, if you agreed to sell 150 shares of your company to John for £10,000, the clearing house will guarantee that John receives his shares and you receive your payment.
Without clearing houses, fewer transactions would take place as sellers and buyers would be weary about the counter-party.
One of the primary goals of the reforms after the crisis is to reduce the risk for clients trading derivatives such as Interest Rate Swap Claims. Clearing for Interest Rate Derivatives has been underway for sometime. There has been an increased amount of pressure placed on traders of OTC derivatives to make their trades on an open exchange with the clearing house to prevent defaults.
The clearing house would use their mechanisms such as default guarantee funds, background checks, financial monitoring of their parties and margins to prevent trades from collapsing.
The clearing requirement notion that has been introduced since the global crisis on OTC trades requires that a clearing house clear all eligible derivatives. The clearing house will provide critical risk mitigation by mutualizing the losses from a clearing members failure to pay up on their end of the deal and they will also require that all parties have collateral. Clearing houses provide trade reporting and transparency to the OTC derivatives market including prices, position data, etc.
Therefore, the clearing house remove the opacity in the OTC derivatives market to make it safer not only for their direct participants but its potential domino effect on the smaller financial transactions and even the individual.
A clearing house aims to change the OTC derivatives market from one that is tremendously opaque and vulnerable to losses to one that is safer for every party.