The approval of the first central counterparties under the European Market Infrastructure Regulation has focused attention on how a clearing determination will be applied across the European Union. This paper outlines the composition of the equity derivatives market and the extent of central clearing today, as well as the criteria that should be assessed when determining whether a clearing mandate should apply in the EU. In addition, the paper examines whether the liquidity of the underlying reference share – proposed by ESMA as a possible method of defining a class of product – is appropriate for clearing mandate determinations.
The Conclusion of the study states:
The equity derivatives market is uniquely varied in terms of the factors that influence investment and hedging decisions. It is important to understand the different product characteristics, as well as how standardized, exchange-traded futures and options contracts differ from the highly customized contracts traded in the OTC market.
The vast majority of the equity derivatives market is already cleared, including all listed futures and options contracts and the more flexible products offered by services like Bclear. A nascent clearing service for OTC CFDs has also recently emerged. This capability is likely to continue to naturally increase over time, capturing those products with the most standardized product terms, in the most popular maturities and referenced to the most liquid stocks and indices.
However, the broad availability of clearing for OTC equity derivatives products will not develop overnight and is likely to remain limited in the near future, largely because of the highly tailored nature of these instruments, and the complex, non-standard adjustment events such as corporate actions that are negotiated between counterparties. While demand for clearing is likely to gradually build for more standardized/commoditized OTC products, it will be challenging to develop clearing solutions in the near future for OTC products such as equity swaps, OTC single-name options and exotic equity products.
These contracts meet an important need, as they allow non-financial counterparties, asset managers, pension funds and other end-users, as well as banks, to meet their investment objectives and hedge very specific, business-critical risks. The size of the OTC market, despite the existence of a listed, standardized and clearable equity derivatives market, proves these instruments continue to have an important role in the equity derivatives market.
European legislators recognized there is a place for customized, non-clearable OTC contracts that enable end-users to manage risk and achieve their investment objectives, and draft regulatory technical standards on risk mitigation techniques for non-cleared OTC derivatives were recently jointly published by ESMA and other supervisory authorities. As well as mandatory reporting and higher capital, these rules will mean non-cleared trades will be subject to margin requirements to mitigate associated risks – although calibration of these requirements will be important to ensure the continued availability of these products, given the absence of cleared substitutes.
As clearing availability develops for sufficiently liquid OTC equity derivatives, however, any clearing obligation decision should consider the unique features of listed and OTC instruments, as well as the specificities of individual products. The cleared futures contracts available on Bclear, for instance, are very different from OTC equity forwards and swaps. Under current rules, they would all be captured under the same bucket, potentially leading to circumstances where a clearing mandate is applied to that entire ‘class’, despite an absence of demand for clearing and no existing clearing service for OTC equity swaps. An overly broad clearing mandate based on underlying, product type or settlement currency – for example, options on European equities – would also be disruptive, potentially capturing contracts for which no clearing service exists.
A granular approach to evaluating whether products should be cleared, including a detailed product taxonomy, a comprehensive review of liquidity and analysis of product standardization is vital to the process. This will ensure additional operational hazards are not introduced to the market, and CCPs do not have the opportunity to improperly benefit from a clearing monopoly in certain products.