If you believe that central clearing means safety in derivatives trading, then Canada's over-the-counter derivatives market is about to get a lot less risky.
The Bank of Canada's Financial System review, in a look at clearing and margin requirements in derivatives, finds that about one-third of the $17-trillion in notional over-the-country derivatives outstanding at big Canadian banks are centrally cleared these days. Most of that is in the interest-rate derivatives business, which is the biggest. For other asset classes (equity derivatives, foreign exchange), central clearing barely registers. The breakdown between what is cleared and what is not roughly mirrors the global experience. That balance is set to shift dramatically, in Canada and globally. But the shift in Canada will be larger.
The bank found that, based on survey responses, the market for non-centrally cleared OTC derivatives in Canada will plunge "to around $3-trillion in Canada (about a 65-per-cent decline). The contraction will be driven by higher capital and margin requirements and the resulting incentives to centrally clear." Globally, the drop will be more like 45 per cent, the bank found.
This part of the Financial System Review didn't get much press. No surprise, as it's not nearly as sexy as the central bank's look at the mortgage market or the Bank of Canada's decision to lower its estimate of economic risk in Canada to DefCon 2.
The numbers are important, though, given the international and domestic effort put into central clearing in the wake of the financial crisis. They show that regulators are getting what they wanted when they pledged to increase central clearing and margins as an antidote to some of the systemic risks posed by derivatives.
However, there is a school of thought that central clearing houses could be a locus for another crisis, an idea that John Gubert at Global Custodian wrote about recently.
There are a number of forces that may be concentrating risk in what has traditionally been a sector that has managed risk well.
One of those, Mr. Gubert writes, is the number of instruments that are now being cleared. In the past, only the most liquid instruments were cleared, and those with long histories that enable central counterparties to understand how they will behave in all types of market environments.
"Such a prudent approach is, I sense, being challenged both by competitive forces but also, more significantly, by the regulatory thrust for ever more central clearing. The problem with many of the new instruments is both their esoteric nature, appeal to specialized segments of the marketplace and narrow base of truly committed market makers. The risk is that, in times of turmoil, they may become illiquid. The probability is that, in times of stress, many will become one-way markets. A CCP [central counterparty] will only be low-risk if it can unwind its positions and realize collateral to compensate for any shortfall with immediacy."
So the good news is that more instruments are being cleared. The bad news is that more instruments are being cleared.