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Central Clearing in the Equity Derivatives
An ISDA Study
The approval of the first central counterparty (CCP) under the European Market Infrastructure
Regulation (EMIR) – Sweden’s Nasdaq OMX on March 18 – has focused attention on how a
clearing determination will be applied across the European Union (EU). Alongside an assortment
of interest rate derivatives, Nasdaq OMX was authorised to clear several single-name, basket and equity index futures and options, kick-starting a six-month process by the European Securities and Markets Authority (ESMA) to determine whether a clearing obligation should apply for those classes of derivatives.
Given this process is now under way, ISDA and its members believe the criteria used to determine a clearing obligation, as proposed in an ESMA discussion paper published on July 12, 2013 1, must be carefully considered. In particular, the criteria used to define a ‘class’ of equity derivatives for the purposes of determining a clearing mandate should be highly granular, taking into account both the specificities of the equity derivatives market, as well as the important differences between exchange-traded and over-the-counter (OTC) instruments. An overly broad definition for an equity derivatives class could mean certain products unsuitable for clearing end up being captured by a clearing mandate, which would ultimately be detrimental for market participants that rely on those instruments for investment and risk management purposes.
There is already a well-developed cleared business for exchange-traded contracts, which make up the vast majority of the overall equity derivatives market, and this has proved to be highly responsive to client demand. Where there has been a need for greater standardisation, exchangetraded, cleared contracts have emerged – and this trend is expected to continue in the future. A number of OTC products are becoming increasingly standardised, and may migrate to exchange trading and clearing over time as customer need for these services grows.
Despite the size of the cleared exchange-traded market, however, there continues to be strong demand for the flexibility and customisation offered by non-cleared OTC products. These instruments exist because they allow market participants to meet unique, tailored hedging and investment needs – demands that cannot be met by using more standardised contracts. An overly broad clearing mandate could leave end-users unable to access customised instruments that meet their specific objectives, resulting either in an increase in risk in the system or a restriction in investment choices by market participants.
As recognised in EMIR, and by ESMA in its joint draft regulatory technical standards on risk mitigation techniques for non-cleared derivatives 2, there is a role for tailored OTC contracts that meet end-user risk management needs, but which aren’t suitable for clearing. Those customised, non-cleared trades are subject to mandatory reporting, and capital and margin requirements will be applied to mitigate other potential risks.
http://www.esma.europa.eu/system/files/2013-925_discussion_paper_the_clearing_obligation_under_emir_0.pdf https://www.eba.europa.eu/documents/10180/655149/JC+CP+2014+03+%28CP+on+risk+mitigation+for+OTC+der ivatives%29.pdf 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. The important distinctions between listed and OTC products are highlighted, alongside key product, market and underlier features that must be considered when determining whether an equity derivatives instrument is suitable for mandatory clearing. 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.
BACKGROUNDUnder EMIR, ESMA is required to determine whether a clearing obligation should apply once a CCP has been authorised by a national competent authority to clear certain classes of OTC derivatives. As part of this process, ESMA has six months to conduct a consultation and draw up separate regulatory technical standards for each class of derivatives authorised for clearing.
In its discussion paper on the clearing obligation under EMIR, ESMA identifies several
characteristics for the purposes of defining an equity derivatives class:
• Product type – for instance, vanilla, dividend or volatility
• Product sub-type – for instance, basket, index or single name
• Transaction type – for instance, option, contract for difference (CFD) or forward/swap
• Settlement currency, which could be grouped by geographic zone
• Maturity ESMA also states that equity derivatives contracts traded on multilateral trading facilities (MTFs), such as futures and options, are classified as OTC derivatives under EMIR.
Furthermore, products that are known as ‘futures’ by market participants, but which don’t trade on regulated markets – such as the flexible futures contracts available on services such as Bclear, described later in this paper – are categorised by ESMA as ‘forward/swap’ to avoid confusion with exchange-traded contracts.
The approach for defining a class of index product is considered to be relatively straightforward, but the ESMA discussion paper acknowledges the definition of single-name classes is more complex. A variety of options are proposed, including reference to an entity identifier, reference to membership of a specific index, cross-reference to a list of liquid shares as defined under the Markets in Financial Instruments Directive (MIFID), and reference to an unspecified set of criteria. The advantages and disadvantages of each option are briefly outlined by ESMA.
ESMA writes that it will consider a variety of factors when determining whether to apply a clearing obligation for any class of derivatives product, including the degree of standardisation of contract terms, the volume and liquidity of the relevant class of OTC derivatives, and the availability of fair, reliable and generally accepted pricing information.
EQUITY DERIVATIVES MARKET CHARACTERISTICSThe equity derivatives market can loosely be divided into three segments: exchange-traded and centrally-cleared standard contracts; centrally-cleared but privately-negotiated ‘flexible’ exchange-like contracts; and OTC contracts. While instruments with similar features can exist in each grouping (for instance, referencing the same underlying share or index and/or denominated in the same currency), they can be very different in terms of their characteristics, their uses, the level of standardisation, and their suitability for clearing.
This section briefly describes the three groupings and their main characteristics.
Exchange-traded contracts This segment primarily comprises single-name futures and options and index futures and options. These contracts reference a particular underlier (for example, the Euro Stoxx 50 index) and may include secondary characteristics, such as volatility or dividends (for instance, Euro Stoxx 50 index dividend futures contracts). These products are highly standardised in terms of maturity/expiry, strike and contract size, and in how they are modified to take account of adjustment events and corporate actions.
The contracts can be executed via an order book, but many exchanges also allow participants to originate standard trades over-the-counter before submitting them to the exchange. Eurex, for instance, reports that 88% of standard single-name futures contracts were executed via its EurexOTC block trade facility in 2013.
All exchange-traded equity derivatives products are cleared through CCPs. Eurex clears through Eurex Clearing, and NYSE-Liffe clears via ICE Clear Europe for transactions executed in London and LCH.Clearnet SA for trades conducted via its continental European platforms. Other clearing houses active in this space include BME Clearing in Spain, CC&G in Italy, Holland Clearing House and Nasdaq OMX.
- Index contracts There are hundreds of index futures and options listed on European exchanges, with the majority of trading activity occurring on Eurex and NYSE-Liffe. According to data compiled by the Bank for International Settlements (BIS) 3, open interest in exchange-traded equity index futures totalled $1.48 trillion at the end of December 2013, with roughly 38% coming from Europe.
Turnover in that product during the whole of 2013 hit $30.43 trillion in Europe versus $26.82 trillion in 2012.
Meanwhile, open interest in exchange-traded equity index options reached $5.76 trillion at the end of 2013, with 27% originating in Europe. Over the course of 2013, $15.45 trillion worth of equity index options contracts traded in Europe versus $13.04 trillion in 2012 (see Table 1).
In terms of number of contracts, 19% of the 39.7 million outstanding equity index futures and 25% of the 142 million outstanding equity index options contracts at the end of 2013 were located in Europe (see Table 2).
Despite the size of the market, trading volume is very concentrated on a relatively few indices.
For example, trading in the top 20 most popular index futures contracts by value on Eurex between April 2013 and March 2014 represented close to 100% of total index futures trading volume over the 12-month period. The top five most-traded contracts comprised 98% of total volume, while the most popular product – the Euro Stoxx 50 index futures – accounted for 53% of volume over the April 2013-March 2014 period. Similarly, trading in the most popular index options contract on Eurex as of March 2014 – Euro Stoxx 50 index options – comprised 58% of total volume in index options on that exchange over the prior 12 months (see Appendix 3 and 5).
- Single-name contracts There are thousands of single-name futures and options contracts listed in Europe, with most of the trading activity again centred on Eurex and NYSE-Liffe. Eurex alone listed 1,187 singlename futures and 508 single-name options contracts as of March 2014.
The BIS does not report open interest and number of contracts traded for single-name contracts, but the World Federation of Exchanges reports 951 million and 3.97 billion single-name futures and options contracts, respectively, were traded in 2013 4.
Similar to index contracts, trading volume tends to be concentrated on a relatively small number of names. An analysis of single-name futures trading on Eurex between April 2013 and March 2014 found the top 20 most popular futures by value represented 78% of total single-name futures volume traded over the entire 12-month period. Trading of single-name options are slightly more dispersed, with the top 20 most-traded contracts representing 67% of total volume over the prior 12 months (see Appendix 3 and 5).
Cleared, flexible exchange-like contracts Cleared, flexible exchange-like contracts closely resemble exchange-traded products, except that market participants are able to bilaterally negotiate a limited number of terms, such as contract maturity, exercise price and settlement method. Once the terms are agreed, the contracts are sent to an exchange or CCP for confirmation, processing and clearing.
The largest provider of these products is NYSE-Euronext’s Bclear platform, which lists 2,419 unique flexible single-name futures, 2,410 flexible single-name options and 16 flexible index options. The flexible single-name futures contracts include 168 dividend-adjusted single-name futures, launched in November 2013 to give users the ability to trade an instrument that is adjusted for both ordinary and special dividend payments, as opposed to just special dividends.
Following the acquisition of Bclear parent NYSE Euronext by ICE, all Bclear contracts are now cleared through ICE Clear Europe.
Like exchange-traded contracts, Bclear trading volume is highly concentrated, with the top 20 most-traded flexible single-name futures contracts by value accounting for 85% of total singlename volume over the April 2013-March 2014 period.
Single-name options are again more dispersed, with the top 20 most-traded names in March 2014 comprising 36% of total single-name option volume over the prior 12 months (see Appendix 4 and 5).
http://www.world-exchanges.org/files/2013_WFE_Market_Highlights.pdf OTC instruments OTC instruments are highly customisable, bilaterally negotiated contracts that allow counterparties the flexibility to negotiate terms relating to underlier, size and tenor. Participants can also agree how risk will be allocated between the parties with regards to dividend treatment, corporate actions and other similar events, as well as possible disruptions to the underlying market, including inconvertibility and market disruption events.
The products are used by end-users for a variety of purposes, including the hedging of employee stock option programmes, risk-managing retail guaranteed investment products, reducing risk related to strategic initiatives such as mergers and acquisitions or capital raising, and hedging or monetising existing stock holdings. In each case, the contracts are customised to meet the specific needs of the user, and so are, by definition, non-standard.
Despite the existence of a large exchange-traded futures and options market, OTC contracts continue to make up an important part of the overall equity derivatives universe, proving there is demand for customisation that the listed market is unable to satisfy.
According to a semiannual study of OTC derivatives markets by the BIS 5, the notional amount outstanding of equity derivatives contracts fell from $6.82 trillion as of June 2013 to $6.56 trillion at the end of that year, a decline of 4%.