The drive towards implementation of new regulatory structures in the over-the-counter (OTC) derivatives markets has gathered pace in recent months. Market transformation will lead to a wider choice of clearing broker models, greater transparency and open access to central counterparties. Cliff Lewis, executive vice president of State Street Global Markets, offers his views on the main factors to consider when selecting a clearing provider.
Increased regulation of the world’s derivatives markets is becoming reality. The first wave of clearing in the United States is set to phase in during Q1 2013. Enhanced reporting and registration requirements will soon be implemented. Traders face a major push to electronic execution platforms. With the US election behind us, those on the buy side who had hoped that the global OTC derivatives reform might just go away must now prepare for the changes ahead. The time to get serious about this market transformation is now.
When selecting providers to comply with the new requirements, clients should adhere to a coherent strategy across the front, middle and back office, as this important decision will have implications across all three. Regulations will transform the entire lifecycle of derivatives trades. Execution will move from bi-lateral agreements to electronic platforms. Clearing will be a separate service with its own cost structure, and a client’s clearing broker’s financial strength and business model should be of paramount concern in their selection process. Margin requirements, and their implications for collateral management and transformation, could be the biggest change of all, as those mandates will affect both bi-lateral and cleared transactions. In the future, the central counterparts (CCPs) will provide pricing for valuation. Beyond that there are also registration and reporting requirements to take into account. Our belief is that market participants need to immediately begin conversations with potential providers to take full advantage of this new regime. For today, let’s focus on three aspects around clearing.
Currently, many clearing firms encourage clients to do all of their trading with them as market makers by offering “free” clearing services. In reality, this is a false promise, as all dealer firms that offer bundled clearing build the costs of clearing into the price of the derivative itself. Additionally, the ability to bundle clearing and trading will quickly fade in the new market. First of all, the majority of the cleared market is anticipated to move to electronic trading venues. Execution – once provided by the big dealers – will move to platforms such as State Street’s SwapEx. Secondly, the new capital rules will make these sell side transactions significantly more expensive – an expense that will be passed on to the buy-side. In the new market structure, the buy-side will have the ability to take advantage of increased transparency and competitive pricing. Therefore, it is important that market participants evaluate several providers, including a custody bank that approaches clearing from a buy-side aligned perspective rather than the traditional sell-side, market-maker norm. Diversity is key, but multiple providers all with the same business model will not help accomplish that goal.
Next, for a buy-side participant, depending upon what assets it has in its portfolio, its clearing firms must be willing and have the necessary capital to arrange through affiliates for initial and in limited circumstances also variation margin financing. Firms should make clear the different ways in which they are able to handle collateral transformation and collateral management. These services will be critical for market participants whose portfolios may include several illiquid assets and may not include the collateral required by the clearinghouses.
Finally, buy-sides need to seek out the best mechanisms to ensure asset safety. While LSOC provides some protection of customer assets, it does not provide the same protection as tri-party custody would in cases of fraud. Several of our clients have already expressed interest in constructing tri-party custody arrangements. In Europe such arrangements are available for futures and OTC cleared derivatives. In the US, tri-party is available for OTC cleared and uncleared, but not futures. This approach is an issue that US regulators are working on, and State Street is playing an active role in pushing for the necessary changes.
Change is coming. Market participants, managers and providers alike face an eleventh hour rush as markets near implementation of these new regulations. Those who have a plan and prepare in advance will be in the best position to succeed.
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