Thoughts on Determining Central Clearing Eligibility of OTC Derivatives

In response to the events of 2007–09, the G20 has mandated a comprehensive reform of the structure and transparency of over-the-counter (OTC) derivatives markets, which will result insignificant changes in the trading, clearing and reporting of transactions. This article explains which criteria are important when determining the eligibility for central clearing of OTC derivatives products. Suitability for mandatory central clearing is likely to depend on product and process standardization, but also on market liquidity. Liquidity is an important constraint and may require central counterparties (CCPs) to modify risk management models. Further, systemic risk reduction benefits associated with central clearing can only be achieved when CCPs have robust risk management processes. Novation to CCPs is unlikely to be practical where operational processes are not automated, while risk modelling and default management become particularly challenging when products are illiquid. Therefore, there may be a natural boundary for the central clearing obligation, with less liquid products, or products for which operational process remain bespoke and less-automated, unlikely to be suitable for a central clearing obligation