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Central Clearing: The Global Regulatory Landscape

The current state of regulatory-imposed financial reform has been the subject of many articles, client alerts, and implementation advice covering a broad range of activities from policy and structural alignment, to the requisite automation required by regulatory reform.

What is missing, however, is a forward-looking strategic harmonization of future best practices that are being prompted by regulatory change compared with any strategic implementation conducted because of regulatory change. Process and automation reconfiguration should be inspired by business drivers, and not purely as a result of the threat of regulatory sanctions.

Conjecture, opinion and speculation within the context of identifying, implementing and managing substantive regulatory readiness necessarily involves a narrower and more concise explanation in the form of concrete and particularized value, compared to a generic description of industry and regulatory buzzwords.

Within the realm of central clearing, covered activities must necessarily be well articulated from an enterprise perspective. For instance, most regulations have enjoined market participants to comprehend risk and exposure at an enterprise level. The enterprise level, often referred to as a “consolidated,” refers to the internalization of a systemic view of activities. This is noticeably different compared to the autonomous view that existed previously.

For example, the Dodd-Frank Act (DFA) generally requires market participants to maintain a system of risk and exposure management procedures designed to monitor and manage the risks from an integrated perspective, including the consolidation of entities, affiliates and other guaranteed risks.

Drilling into the next level of detail, capital charges, which are attributable to banks and bank-dealer subsidiaries as a result of the consolidation requirements described above, are an example of activities migrating into different structural paradigms and necessarily supported by automation.

These capital charges, which incentivize the clearing of derivatives through qualifying central counterparties (QCCPs), attach lower capital charges and as a result enable significant business and operational advantages compared to non-qualified central counterparties.

Another area of strategic harmonization concerns the segregation of collateral. The legally segregated with operational commingling model (LSOC) is a new regulatory-imposed method of protecting and accounting for customer funds. LSOC provides a fundamental change in how futures commission merchants (FCMs) must manage customer margin collateral.

By default, LSOC generally provides for the complete segregation of client funds. However, LSOC does not expressly prohibit a cleared swaps customer from affirmatively granting a lien or security interest on its own margin collateral held by the FCM, nor does the rule prohibit the FCM from taking action to induce the cleared swaps customer’s grant of such a lien. Hence in this instance, contractual agreements concerning the use of the margin collateral may supersede the rules.

The examples described above, including the consolidated risk perspective, the use of qualified CCPs and the segregation modeling, substantially change market operations. In the end, it is necessary to reconfigure automation justified and inspired by business drivers, and not as a single-focused compliance exercise.


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