Assessing the Impact of EMIR’s Clearing Requirement on End-Users: A study on the cost-efficiency of using central clearing to eliminate counterparty credit risk in OTC interest rate derivatives

Christian Friis Jensen

Student thesis: Master thesis


Seeking to eliminate counterparty credit risk, the recent European Market Infras- tructure Regulation mandates central clearing of all eligible over-the-counter deriva- tives. Focusing on interest rate derivatives, this thesis develops a framework for analy- sis to compare end-user costs of clearing to the costs associated with the counterparty credit risk present in pre-EMIR bilateral contracts. The overall framework structure is based on transaction cost economics theory, and divides the cost factors into di- rect and indirect end-user costs. For each type of costs, key cost factors speci c to either the clearing process or bilateral counterparty credit risk are identi ed based on available literature and market player evidence. The costs associated with bilateral counterparty credit risk are based on (i) the expected counterparty exposure on a given contract, which must be modeled, and (ii) the counterparty propensity for default, which is available through market credit spreads. The thesis develops an econometric tool to model counterparty exposure under standard bilateral collateral agreements. As dealers must remain pro table, the end-user should expect to cover their own as well as dealer expenses. The costs speci c to central clearing are found to be based on clearing house risk management requirements and fees paid to cover expenses incurred by the clearing member who facilitates the clearing process. The risk management requirements and fees are estimated based on available market-player data. The framework was applied to a case study to illustrate potential present day end- user costs. As the framework includes both direct and indirect costs, the case study considered costs in terms of portfolio drag on a modeled end-user. The end-user hedges an interest rate exposure through respectively bilateral and cleared interest rate swaps, removing funds from the portfolio to meet risk management requirements and cover expenses. The results show that in the illustrated situation, the portfolio drag associated with central clearing exceeds the drag associated with bilateral counterparty credit risk by a factor of 63. The framework was also applied to a scenario where the end-user and dealer alike faced historically high credit spreads. In this case, the portfolio drag from central clearing exceeded the drag from bilateral counterparty credit risk by a factor of 24. As the clearing industry structure is still in its infancy, long-term costs are inves- tigated through potential future scenarios for the clearing industry structure. The consequences of identi ed scenarios are suggested through changes to the framework cost factors. The industry structure analysis suggests that the ownership structure of clearing houses is likely to be of importance, and that the potential for reductions in end-user costs of clearing is limited.

EducationsMSc in Applied Economics and Finance, (Graduate Programme) Final Thesis
Publication date2014
Number of pages93