CCP clearing will introduce a stack of contracts. Clients of clearing members must review and negotiate both clearing house and clearing member agreements. This web of complexity, spurred Insight Investment to forge ahead with its own overarching client clearing agreement to simplify the documentation required and minimise the documentation impact on the manager’s clients. DerivSource’s Julia Schieffer explores the motivations behind this pioneering move and asks if others will follow suit.
Insight Investment estimated that for its 350 clients, which includes managed accounts, each client would have to sign an average of 30 contracts to centrally clear OTC derivatives. To combat this mountain of paperwork, Insight made a pioneering move to create its own overarching client clearing agreement to define the terms of central clearing with (chosen) clearing members on behalf of its clients.
There were many drivers behind this innovative move, but above all, the investment manager wanted to simplify and streamline the documentation process to reduce the impact on its clients who otherwise face a laborious process of reviewing many complicated contracts and also doing so regularly as the central counterparty (CCP) clearing space for derivatives evolves.
Plus, Insight which started working on its own client clearing agreement in July 2011, wanted to get something in place and not wait for the standardised language via the European ISDA cleared derivatives addendum to be agreed; a process that has been fraught with delays.
“Insight recognised the strategic importance of the new regulatory framework and set out very deliberately to influence it, seeking to achieve the best possible framework for our clients. ” said Jane Ivinson, General Counsel at Insight Investment in London.
Buy-side institutions may rely on ISDA cleared derivatives addendum, which is used in conjunction with an ISDA master agreement (US version of addendum corresponds with a futures clearing agreement).
Even with use of the addendum, a client will need to negotiate a clearing contract with each clearing member appointed, (some firms may use up to five (or even more in due course) clearing members), as well as negotiate contracts with each clearing house the clearing member will use. This means that a buy-side firm with three clearing members but accessing three different CCPs per clearing member will have to sign 9 different clearing agreements. Furthermore, as the CCP space evolves in the next couple of years the client will undoubtedly have to renegotiate and amend these terms as changes take place.
“There are [firms / managers] who have to go to their clients for sign off of any new trading agreement that they do and there is concern about [the volume of documentation involved],” agrees an independent lawyer who works closely with the buy side. Depending on the investment management agreements, some firms have the authority to enter into clearing documents on behalf of their clients but cleared swaps may not be covered in these documents because this is a newer requirement and may not have been contemplated previously, the lawyer explained.
The clearing documents are confusing for a lot of clients as it is a new scenario and some may not be familiar with the terms, added the lawyer. “I think there is concern about getting clients comfortable with the [clearing agreements] and the terms they are negotiating,” the lawyer added.
Recognising the possible confusion its clients may experience, Insight’s clearing agreement is designed to facilitate a better understanding of risk and terms of clearing for its clients, said Ivinson.
Insight’s agreement, which is called the overarching client clearing agreement, is an identical agreement for the first 32 clauses to describe the nature of the relationship and clearing agreement as per the CCPs standard rulebook, which outlines the strategic rules. Then, the schedules that supplement the 32 clauses explains the services offered by the clearing member including their Value at Risk (VaR) calculation models and other details.
Signatories of the overarching client clearing agreement give Insight their power of attorney to negotiate the client clearing documents and get CCP access on their behalf so long as they fall within the description of the authority agreed to under the agreement.
“What I set out to do was to create a document that was at a sufficiently high level of principle that would describe [the terms] to the client in a way so that they could understand the risks they were taking, and what was determined by the CCP or lay with the clearing member,” Ivinson said. “From my point of view, I think we are asking for the client to concede very little because the commercial terms we can negotiate anyway, and most of the strategic structural frameworks is in the CCP rules – and that’s not negotiable.”
This also means a client does not have to be consulted every time there is a change that does not impact the overall agreement. So, for instance, if the clearing house launches new products, clients will not have to worry about signing another agreement because they signed the carefully crafted first document, which clearly states what a client has agreed to, she explains.
The placement of the clearing member services in the schedules provides transparency which means that clients can easily compare the services offered by different clearing members.
For clearing members, the motivation to agree to identical terms was the opportunity to win the book, if they provided the right service offering and price, explained Ivinson. This also means that clearing members only have to negotiate once and then Insight will intermediate for the client with the broker. On the flip side, because of this situation, the clients are not able negotiate but it is homogenous and fair, much like Insight’s ISDA umbrella structure that many of its clients already rely on.
“There was initial scepticism but actually when you go through the reasons why [they] should do it then we feel that it is compelling,” said Ivinson, who noted the five clearing members did agree to similar terms in the end.
The uniform contract allows clients to focus on the really important things: protection of margin, decent pricing and portability, said Ivinson.
Portability is a big concern and is absolutely critical. The use of the client agreement facilitates a fast porting process because the brokers have all agreed to the same terms for clearing.
Ivinson explains: “The idea is that every client would be signed up to all the clearing members but they probably wouldn’t use them all; so a client might use two clearing members and the other three would be a warm back up. But because for the other three [members] we divided the book between them, they know they are getting trades from us and so they are willing to take the rest of the book from the clients that they currently don’t clear for [via porting] because they know it is going to be done using exactly the same pipes, the same structure, and the same risk metrics…. it makes no qualitative difference to them. For me that was critical.”
Commitment to porting is important because this ties in with the protection of assets and addresses the worst-case scenario for many market participants – a clearing member or a CCP default.
“Particularly for our clients who have long dated positions, such as 50-year swaps, the worst thing in the world that can happen to them is for a clearing member or a CCP to default,” Ivinson said. “This is the real risk of moving to the clearing world so we have to mitigate against it.”
But, this also means that Insight can port trades or switch the flow based on price or product availability, not just because of a default. And as the service provider for its managed accounts, Insight will act as the eyes and ears to the market but it is crucial that porting is also easily done.
“If there is one thing that we are well placed to do, it is to judge the market. We will hear things in the market that our clients aren’t going to hear and if we get wind of a collapse we want to be able get the client either out of the clearing member or the CCP,” said Ivinson.
Despite the ease of the document, some clients may think they have more power in having their own clearing agreements, just as they may have their own ISDA contracts for OTCs. However, the financial crisis revealed that some clients may not have the full picture of their exposures and also the firm in question might not have the best negotiating power to terminate a contract if, for instance, a counterparty is downgraded, explains Ivinson.
The semblance of control by hanging on to the ability to exercise rights and negotiate your own terms does not necessarily put a client in a better position especially if a service provider such as Insight is equipped to provide greater access to CCPs and products on the clients’ behalf and thus give the client time to make the bigger decisions, she said. “In hugely complex matters, appoint an expert, trust them, supervise them, monitor them, have them report to you and hold them accountable – thus exercising control not by doing it yourself, but by getting the expert to do it for you.”
Insight did not wish to comment on the prospect of sharing the terms with others at press time.
Not all investment managers will write their own clearing terms. Some may rely on the addendum, with possible modifications, or even look to use exchange-traded terms as a base for agreements, said Jane Lowe, Director, Markets, for the Investment Management Association (IMA).
“She said: “I think some will [write their own terms] but not everybody is well resourced enough to do that. And even if you have the resource to do it, you have to have buy-in from your counterparts. I think quite a few [investment managers] are fearful that their counterparts will just try and impose the addendum and they won’t have enough fire power to push back on them,” she said.
The potential problem of buy-in is a familiar one for the IMA, Lowe explained.
Following MiFID I, there were no model broker terms in place for the cash markets. Initially there was agreement, albeit lukewarm, that multiple industry associations would work jointly on model terms, but this didn’t happen. In the end, the IMA drafted a set of terms, complete with a user guide, to provide its members and anyone else who wished to use them. The terms helped clients to break down and understand the component parts of the new broker/client relationship. These terms were clearly identified as buy-side accepted terms but not negotiated terms, as the IMA had been unable to obtain the necessary input from the broker community. The terms could be used as a complete package or wording could be taken for a single clause, by anyone not just IMA members. However, although quite a lot of firms tried to use the model terms as a base for the broker agreements they met considerable resistance from their counterparts, notwithstanding that the Lehman collapse highlighted the very real need for comprehensive contractual terms to protect both parties, Lowe explained.
“So, although [the terms] did help people and gave them some wording that they could use and we gave lots of training so that people understood the ins and outs of what they needed to deal with in these relationships, the reality is that the balance of power remains with the large global banks and they can be very reluctant to negotiate,” Lowe said. “You have the same issue [with the clearing terms]; even if Insight has really good terms that the rest of the market could use, and Insight was prepared to share them, that would be great but it doesn’t mean that other firms will necessarily get any take up from their counterparts, even if Insight does.”
