In an environment where bilateral and cleared trades are more appropriately risk mitigated through bilateral margin, CCP margin and guarantee funds and Basel III capital, fragmentation costs and increases in systemic risk due to regulatory clearing mandates may actually outweigh systemic risk and funding and capital benefits. Why?   Because mandatory clearing has fragmentation costs and some systemic risk increases associated with CCP proliferation.  The national nature of derivatives clearing mandates and associated encouragement of onshore "national CCP champions" and some focus on buy side preference for national legal regimes as opposed to the existing accepted international legal regimes of US or UK encourage a national / regional EU environment where previously CCP clearing was largely a global effort governed by ISDA and influenced by the US Fed. Why is fragmentation bad?   Essentially because this drives reduced global competition and/or a lot of increases in participant costs and the economic benefits and even systemic risk reduction benefits of the clearing mandate become questionable in aggregate. What are the clearing mandates direct fragmentation costs? Essentially the clearing mandates imply the following gross up effects on risk and funding costs:

• Banks which are already on an elective basis major clearing participants – because of existing or future balance sheet or funding benefits – have their cleared portfolios fragmented across more CCPs
• Buy side firms cannot in practice choose a single CCP in practice given CCP-specific pricing which means they may have to fragment their cleared portfolios for a given asset class across more than one CCP
• End-user clearing mandate exemptions cause dealers to have in effect an imbalanced cleared portfolio in aggregate – where if everyone cleared there would be the possibility for their CCP portfolios to be largely balanced  at least in aggregate (albeit split across CCPs)
• Mandating clearing leads to inflexibility at the product scope boundary – e.g. counterparty portfolios combining both cleared product (e.g. IRS) and uncleared product (e.g. IR swaptions) incur CCP margin on the IRS side and bilateral IM on the bilateral swaption side where on the other hand if allowed to stay uncleared they would net out – reducing systemic risk and the absorbed funding and capital costs.

What does this say about the clearing mandate?   All in all, having spent a couple of years in the "it's a no brainer" camp, I'm beginning to wonder whether in fact it would have been better for systemic risk and aggregate costs to the participants to have clearing be incentivized or encouraged in a sublter way i.e. via capital rules (e.g. Basel III) and bilateral margin mandates rather than being mandated outright.   The bilateral margin and capital incentive would naturally encourage CCP clearing in many cases but without a clearing mandate those cases where non-clearing reduces systemic counterparty risk and the associated margin cost and capital cost – the parties to a trade could mutually agree not to clear. Food for thought but at this stage too soon to raise a red flag… Jon S.