As the OTC derivatives market moves to CCP clearing, new best practices are emerging to support an efficient pre and post-trade workflow. In a Q&A, experts from SunGard discuss the emerging best practices to support electronic trading, use of swap futures and credit counterparty risk and identify where the opportunities for growth lie in this evolving space.
Q 1. Electronic Trading: What are the suggested best practices for trading OTC derivatives as the industry moves towards electronic trading via swap execution facilities (SEFs) and to support central counterparty (CCP)?
A. Tim Dodd: With new market practise in the US spreading to the rest of the world, best practise is now to work as agency with client flow and, where still possible supply liquidity to venues to service this flow. SEF flow will be exposed to multiple counterparties on a request for quote or closed limit order book basis. Those servicing the flow need to bring best prices and other client interest at the same venue. Acting as agent, they need to be aware of interest (managing indications of interest is ideal) and have visibility on swaps and swap future activity on multiple venues. Without this insight, edge will be lost. Where bank’s balance sheets can still be deployed, quoting into SEFs is the way to do so. Organised Trading Facilities (OTFs) in Europe and other electronic venues in the rest of the world are already seeing changes in practise towards this model.
Marcus Cree: The key here, for me, is minimisation of margin impact. This means thinking through the front end to ensure that the venues selected for clearing are appropriate with the lowest margin in mind. That said, the fact that the CCPs themselves are not risk free has to borne in mind, and trading/settling at CCPs should bear this in mind in terms of concentration risk. The key is that whilst CCPs remove a fair amount of risk, they do not eliminate it.
Q 2. Swap Futures: When speaking to clients, what are your recommendations for how they should review swap futures and futurisation in general?
A. Tim Dodd: Swap futures currently enjoy a better margining regime than swaps traded over-the-counter (OTC). My view is this won’t continue forever, but it does give a small advantage to those members of exchanges that offer swap futures. Indeed cross margining can extend this advantage even more. We have seen some exchanges offer the ability to do hedge trades packaged with swap futures too. However, for those smaller institutions that fall outside the mandate to collateralise their swaps, futures will always be way more expensive. Moreover, the intrinsic need for customised swap profiles for hedgers will never go away. For these reasons I expect to see the playing field level in the future and margin and collateral needs unify.
Financial institutions should keep their options open, adds Jerome Dumaine.
Jerome Dumaine: For sell-side firms, being able to process both is necessary to capture institutional business. In the old OTC markets, traders were compensated for their ability to price deals (spread + fees). Under new OTC market rules, a trader’s value comes from a combination of 3 things:
1. Customer and product suitability – (based on models defined by the firms compliance)
2. ROI analysis – Now that OTC derivatives are less attractive there are many ways for a firm to maximise investment returns while minimising expenses and keeping risk within agreed limits. Regulatory regime and tax implications should also be taken into consideration
3. Straight-Through Processing (STP) – linkage to existing back-office structures
Being able to process cleared OTC swaps and swap futures will add options for customer and product suitability and ROI analysis as stated above. Clearing of swap futures is highly efficient (in line with STP linkage to existing back office structures as also stated above).
I find it interesting that a number of firms believe that because OTC derivatives cleared markets may now be ‘over regulated’ all the liquidity could move to the futures markets. This is probably an extreme point of view but an indication that firms should keep their options open.
For buy-side firms, there is more competition to clear futures than OTCs. Ensuring that clearing agreements cover both OTCs and swaps may be the best strategy to push OTC clearers on price.
Q. 3 Post-Trade Workflow: What are the suggested best practices for post-trade processes within the CCP clearing lifecycle?
A. John Omahen: The key to post-trade/post-clearing processes is to make them as repeatable as possible, as automatic as possible and as uniform across instruments as possible. Doing so allows firms to process these instruments at the lowest possible cost and allows them to bring on new business and volumes with little or no incremental spend. Most firms trading in multiple, cleared products have come to embrace the fact that traditional listed products and OTC cleared products are more alike than they are different – from both an operational and from a system perspective. This is not to say that they are 100% alike (they remain, very different products with significant differences in life cycle events) but the trend in new regulations and new CCP offerings is to increasingly see all of these products together, as one class of cleared derivatives. Firms that are investing in creating a combined operational and IT staff that handles all cleared instruments are at the ones that are positioned for success in the long run.
Tim Dodd adds: Post trade, the need for reporting is essential and automation of this is a must have. Interaction with the CCP to manage margin and lifecycle events will require automation to keep margins up. Pre-trade, limits should be checked, but certainly must be post trade so a full modelling of margin is worthwhile. Indeed, margin optimisation will suggest reassignment of trades to CCPs as a must consider. So post trade, automated connectivity to CCPs and assisted re-hypothecation will be the new norm. Of course, business will be nothing like that in equity, short term interest rate or bond derivatives and so only a few institutions will aim to be full clearing members and those that do will want to enhance their returns by clearing for others. Best practise will include such extended clearing as a norm.
Marcus Cree adds: For post trade, I would say that making sure of available offsets (futures/swaps optimisation) is key. This may mean optimising outside of the tools provided, for the sake of timeliness, but is worthwhile and will make a difference to the final margins. After that, I would say that checking the CCP margins is key, especially as the process is so young.
Q. 4 Credit Counterparty Risk: What are the suggested best practices for counterparty credit risk management within CCP clearing workflow?
A. Tim Dodd: CCPs aim to reduce credit risk by making them the counterparty to all counterparties, but they will require margin to be posted post deal to ensure market security. So pre-trade exposure checks by client are a must to ensure that banks and brokers are comfortable and that individual orders that execute will be able to be supported by the margin/collateral a given client can post. This requires that, pre-trade, what if analysis can be made to determine the margin/collateral requirements can be met by a client. Limit reservation and, where necessary, workflow to allow smaller deals or requests for further collateral to be posted, pre-trade are all part of the same. This is especially true of those clearing for others.
Marcus Cree adds: This largely relates to the first question. It is likely that low concentrations with higher risk counterparties will be replaced by high concentrations with lower risk CCPs. This will likely result in a lower risk profile but maybe not as low as people may expect. Counterparty credit risk has well established best practices and these should be followed still.
Q. 5 Opportunities: What opportunities do you see firms able to take advantage of in the future?
A. Tim Dodd: Both the burden and opportunity lies within collateral management.
Estimates for collateral in this new world for supporting new and open business are large and will certainly impact the market liquidity. We have seen estimates as high as 5 trillion USD! Even with a much smaller number, there is obvious advantage in ensuring that assets are put to best use and collateral optimised. Not only is collateral for OTC going to be larger going forward, but there is an obvious use of extra collateral in deals between counterparties. All in all, margin management is no longer just a cost to a business but has the potential to be a profit centre.
Marcus Cree agrees and adds: Collateral optimisation is certainly the main opportunity, and to that end, as stated in our whitepaper “The New World of Central Clearing,” margin optimisation (venue and futures offsetting) is really a subset of that wider optimisation.
Jerome Dumaine adds: There are various business opportunities and sources of value for firms to take advantage of. Looking at what happened on the securities markets as an example, one could expect:
1. More standardised workflows – Leading to higher processing STP/efficiencies and lower operational and technology risks
2. More participants to the OTC markets will lead to increased liquidity and more transparency and efficient pricing
3. Greater opportunities for value added services once pricing methods are more-or-less harmonised between dealers (especially analytical capabilities for ROI analysis, What-if scenarios, and optimisation of trading costs, capital impact and collateral usage). Buy-side firms are repeatedly indicating that these value-add services will influence which FCM relationships they decide to establish or privilege over time. For sell-side firms, being able to pool together all their liquidity intra-day to minimise margin calls is seen as a critical capability which could dramatically affect the reserves they need to pass regular industry stress tests and, in turn, how much capital they can distribute to their shareholders.
Q. 6 New Trends: What is one upcoming trend firms should focus on within the evolution of CCP clearing?
A. John Omahen. Regulators around the world, while they may not agree on a lot, are unified in their desire to push every major financial product towards a centrally cleared model. I would expect to see other counterparty-to-counterparty products to be brought under the same model soon. The Asia Pacific region has the most room for growth in terms of clearing offerings, but continued efforts to meet the remaining Dodd-Frank and EMIR regulations are likely to steal much of the attention in the near future.
Marcus Cree states the focus should be on products rather than just regional expansion.
Marcus Cree said: I would concentrate on a widening of the clearable products, rather than a geographic region. This is a curve to stay ahead of, especially for CCPs as a service to their clients.
Tim Dodd adds: Bank boards across the world need to decide whether they are going stay in the OTC derivatives business, white label or step out. The costs of new practise are non-trivial and with margin of flow business likely to contract, there will only be room for a certain number of players.
* For more in-depth analysis of CCP clearing best practices and more please see SunGard’s whitepaper entitled “The New World of Central Clearing.”
About the Contributors:
Tim Dodd, Head of Product Management for SunGard’s Front Arena.
Jérôme Dumaine, Senior Vice-President with SunGard Capital Markets.
John Omahen, Vice President of Post Trade Solutions at SunGard.
Marcus Cree, Vice President, Risk Management, SunGard Capital Markets
