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OTC Derivative Clearing

Summary

Making Great Ideas Become Reality”

+OTC Derivatives – What has Changed?2

The recent financial crisis, with the failure of major broker-dealers plus the near failure of amajor insurance company has triggered the regulation of the OTC derivatives market. Thecredit default swaps (CDS) market (part of the OTC derivatives market) has taken centerstage in the financial difficulties as the counter party risk involved in this largely bilaterallycleared market to materialize. These risks most specifically were in the areas such as non-transparency,and Inherent counter party risk.Since 2009, there has been a growing interest among international regulators, investors, broker-dealers,clearing members, clearing houses and exchanges for the development of a CCP (Central CounterParty) or a CCH (Central Clearing House) for CDS (Credit Default Swaps) and other OTC derivatives.The CCH assumes the credit risk liability of all the trades that are submitted by its members. Using a CCHto which trades are submitted will:- reduce systemic risk- increase transparency- reduce counter party risk- increase efficiencies in operational processes through accurate integration of trading, risk and operations- support a robust default management process to manage the default of any clearing member.

The primary purpose of regulated OTC derivatives CCPs is to reduce counter party risk among broker-dealers and to minimize the systemic risk associated with counter party failure. Despite the benefits inmoving to a central clearing of OTC derivatives, there are still many challenges that the industry will face.

+CMA Analysis of OTC DerivativesCMA has performed an analysis of the developments in the OTC derivatives market and thekey findings are as follows: Expansion of the OTC derivatives market – The market size has increased dramatically in recent years and is now significantly larger than that of exchange-traded derivatives. One of the key differences between these markets are that while exchange-traded derivatives are fully transparent in terms of positions, prices, exposures and counter party risk reduction; OTC derivatives are largely unregulated with respect to the disclosure of information, and information available to market participants. Risk Management for OTC Derivatives – The OTC market has historically dealt with counter party risk through a variety of methods, ranging from simple counter party credit limits to collateral or margin, margin “calls”, and bilateral netting agreements. However, the financial crisis highlighted many weaknesses in the bilateral OTC derivatives market, such as non-transparency, inherent counter party risks and the danger of systemic risk. The Use of CCP Clearing – CCP clearing (clearing, execution, collateral management, valuation and servicing) is an immediate way of addressing the limitations. This will be accomplished by creating more robust management of counter party risk, increased transparency and a reduction in a variety of other associated risks for the OTC derivatives market, remove trade-by-trade counter party risk by acting as the central hub and facilitator of every trade, protect against default through margin requirements, reduce operations risk by standardizing, centralizing and creating automated trade processing through a single entity, reduce capital requirements, facilitate multilateral netting helping to reduce average exposure, and create positions that are market-to-market.

+CMA Analysis of OTC Derivatives (cont)

OTC Derivatives Regulation – Worldwide regulators increasingly favor a move towards cleared contracts. Central clearing has been shown to increase transparency and reduce a variety of risks for OTC derivatives markets. Legislation is therefore underway to mandate the central clearing of all suitable products. Some of the areas covered by the new regulations include; scope of derivatives covered, clearing and trading requirements, trade repositories, capital and margin requirements and position limits.

There are a number of challenges associated with establishing this new OTC derivatives market includingthe costs associated with developing and maintaining a large number of dynamic exchange feeds, theoperational risk costs, reconciling the collateral calls and margins, creating a new link between productcontrol and finance, implementing default management, provisions of balance sheet reporting, creatingnew reconciliation requirements, providing full transparency around collateral, updating and extendingsystem integration, margining and reporting.

Our Conclusion – The regulatory pressure to move to a centralized clearing of OTC derivatives is being encouraged by a number of key considerations such as the need for transparency, liquidity and lower counter party risk. Counter party risk is now far more important than ti was prior to 2008 and we see a definite need to address the lack of transparency that pervades OTC derivatives markets. The use of CCPs alone is not enough to ensure that the OTC derivatives markets operate accurately and remain resilient. It is important to complement the CCPs with improvements in trading and settlement infrastructure. With respect to the implementation of the new OTC derivatives regulations, ‘Harmony and Consistency’ across the different jurisdictions around the world is a key condition to avoid participants from exploiting weaknesses of the new reforms.

+How CMA can HelpOur resources cover all aspects of the forthcoming reforms, OTC derivatives market and theImpact of using a central counter party (CCP). Our resources consider the benefits andbusiness opportunities associated with OTC clearing, as well as the implications of the reforms on IT systems, risk management and regulatory compliance.

All financial institutions recognize that they must have some form of OTC clearing and collateralmanagement solution in place by the end of 2012. Some financial institutions find themselveswithout a clear executable plan to deliver this important service, even though the budget for thismay have already been approved. The immediate challenge is therefore to get a robust solutionInto production.

Our SolutionCMA has highly experienced collateral and clearing resources, who can rapidly create a customizedexecutable plan within 8 –12 weeks. The team is comprised of business experts in OTC derivatives,clearing and collateral management; supported by highly experienced business analysts, changecontrol, testers and integration experts. They are familiar with all the major collateral and clearingsolutions, guiding the selection if decisions have to be made.An executable plan can cover any or all of the following:- Business change- Technology implementation- Systems integration- Data migration- Testing- Implementation into production

Financial institutions who engage us to establish their executable plan, can be sure of having an agreedplan of action for 2012 that will enable the creation of their required client clearing service in time for theregulatory deadline.