In remarks to the Society of Worldwide Interbank Finance in Ontario on Monday, the Bank of Canada’s Deputy Governor Tim Lane outlined the pros and cons of using large global clearing houses to trade OTC derivatives. While large offshore central counterparties (“CCPs”) can bring costs down through economies of scale, Lane points out that the undue concentration of risk in the hands of a few institutions might counteract the very reforms that regulators are trying to implement.
Canada, like many countries, is in the midst of creating and implementing financial reform legislation. As a member of the G-20, it is further obligated to specifically address OTC derivatives clearing, exchange-trading and data reporting. The country has already begun work on a new CCP specifically for repo loans and fixed-income transactions. However, says Lane, “fulfilling the G-20 commitments on OTC derivatives is a more complex task, requiring coordination among many stakeholders, with a wide range of possible outcomes.”
The Bank of Canada has two primary directions it can steer the reform of Canada’s $9 trillion OTC derivatives market. Either it can encourage Canadian firms to trade on large offshore CCPs, via clearing members, or it can create its own national clearing service. Using global CCPs is appealing on the surface, but Lane fears the concentration of so much risk in so few hands. Clearing member or institutional failure, or market abuse by the larger firms, could undo any benefits created by clearing requirements. In order to avoid these scenarios, the Deputy Governor says that “direct access has to be broadened.”
The alternative, creating a Canadian CCP to clear OTC Canadian-dollar interest rate derivatives, has a few advantages. It would be easier for Canadian regulators to oversee its activity, and might insulate (or at least cushion) Canada in the event of another global financial crisis. However, the creation of many national CCPs fragments the market and all but ignores the G-20’s call for international harmony.
Lane says that the Bank of Canada is still weighing its options: “In assessing the best clearing strategy for Canadian OTC derivatives, [we] are working with our domestic and international counterparts to ensure that global CCPs, particularly those of systemic importance to Canada, are able to deliver the intended benefits of financial stability. Second, we are actively exploring the possibility of developing a Canadian-domiciled CCP, in collaboration with the financial industry and other public policy institutions. We must choose the arrangements that best support the stability and efficiency of Canada’s financial system.”