The ongoing departure of FCMs has left an opening in the OTC clearing world but views differ as to who will fill these openings. Lynn Strongin Dodds looks at the different participants hoping to gain a foothold.
Nomura’s recent retreat from OTC clearing was just one of the many high profile exits seen over the past two years. Jefferies, State Street, BNY Mellon and Royal Bank of Scotland have all already exited the client clearing space and more may follow. One of the big questions is who will fill the gap? While some believe non-bank futures commission merchants (FCMs) will step into the breach, others are worried that the larger players will only tighten their grip.
This trend is already in evidence according to the latest statistics from the Commodity Futures Trading Commission (CFTC). It shows that there is a total of $53 bn of client collateral sitting with the 12 FCMs that offer OTC derivatives clearing. However, the top three account for a 50% chunk of the tally while the leading six hold 75%. A main concern is that there may not be enough clearing brokers to go around if volumes, which have been sluggish in the US, start to rise, and when the clearing mandate in Europe takes off next year.
“From time to time consolidation can be a good thing but I am not sure the concentration that we are seeing in fewer hands is desirable from a systematic risk point of view,” says Dr. Anshuman Jaswal, senior analyst in Celent’s securities & investments group. “However, the restructuring in the industry is expected to continue due to the economic and regulatory constraints.”
The main culprits have been the continuing delays to the European Market Infrastructure Regulation (EMIR) which was cited by BNY Mellon as one reason for its withdrawal as well as the more onerous Basel III requirements. The leverage capital ratio (LCR) obliges banks to set aside more capital for counterparty risk in cleared derivatives, including both futures and swaps. Last year, the definition of exposure was extended to include off-balance sheet transactions such as OTC derivatives, and required those trades to be counted in gross notional value. The capital rules also require banks to fund both initial and variation margin at long-term funding rates, increasing costs significantly.
Moreover, the largest eight bank holding companies in the US have been hit by the enhanced supplementary leverage ratio (eSLR) which came into effect last year. According to Radi Khasawneh, research analyst at Tabb Group, the new calculation imposes a stricter, additional 2% capital buffer on these organisations and requires them to calculate notional, rather than netted, derivatives exposures in some cases. The leverage ratio denominator also takes into account off-balance sheet exposures that were previously not included. Tabb research shows that nearly 90% of FCMs canvassed cited regulations – and specifically the SLR – as the key issue over the past 12 months.
Legislation, though, has not been the only factor behind the OTC clearing pull-out. “The sustained low interest rate environment has meant that there has been no collateral reinvestment opportunity,” says Khasawneh. “The combined impact has been that the clearing business has become expensive and challenging. I think what we are seeing is a rebalancing with some firms leaving and some other increasing market share and product scope. The other trend is that banks who are staying in clearing are likely to focus on the most profitable clients and find ways to pass down the extra costs to the end user. This could be by introducing a basis point fee on margin or minimum floor on activity.”
Christian Lee head of consultancy Catalyst’s clearing, risk & regulatory specialist team, echoes these sentiments. “All clearing brokers are examining their price and fee models and most if not already impose a monthly fee which could significantly increase in the near future especially with the advent of MIFID II,” he says. “I also expect FCMs to segment clients and focus only on the most profitable. I am sceptical of non-bank FCMs offering OTC clearing but can see the business trickling down on a regional basis to smaller to medium sized banks.”
Gerry Turner, executive director, Object Trading, though envisions a playing field which has non-FCMs sitting alongside their opposite numbers. “I think talk of the demise of the FCM is very much overdone at the moment. However, the global banks and FCMs are actively looking at their account lists and beginning to service a very distinct customer base out there: the larger funds. There are concerns about the buy-side being disenfranchised and actually being driven out of the market because either they can’t find anybody to service their requirements, or just the cost of doing business means that the risk weight equation is no longer there.”
He said: “Non-bank FCMs are good at servicing requirements, be it down to one asset class or a group of asset classes, or geography. We’re seeing that with RJ O’Brien’s recent push into Europe and the UK with its purchase of Kyte. This reflects the ambition of these firms.”
In March, US futures brokerage and clearing firm RJ O’Brien acquired European derivatives clearing company, Kyte Group, from broker GFI Group for an undisclosed fee. Some would argue though that the move was in the tried and testing futures market and that regional players such as Wells Fargo might have greater success in the OTC space. Valued at $278bn, the San Francisco bank moved into the prime services market two years and recently was given the green light by US banking regulator, the Financial Industry Regulatory Authority (FINRA) to provide self-clearing facilities for its prime clients.
“In general, I think it will be those higher credit rated firms with limited legacy positions that are in a good position to pick up market share and benefit when volumes increase,” says Khasawneh. “Scale is also necessary in order to make the investments into the necessary technology and systems. They also need to have a certain number of clients to make it worthwhile. We haven’t seen any non-FCMs entering into the OTC market because the barriers to entry are so high, although a successful precedent exists in the futures market.”
Jaswal agrees, adding, “The set-up cost is also a big factor. It takes time to develop the systems and this can be discouraging for other players to come into the market. I think what we will see is universal banks continuing to offer clearing but like Morgan Stanley they will keep the service separate. I also expect that in the future buy-side firms may look to connect to clearinghouses directly as well as the creation of utilities. This is the direction that the industry will take eventually because it overall it is the cheaper and more efficient option. However, it will not happen immediately.”
Peter Meechan, director of business consulting for global markets at Sapient, adds, “People are definitely looking at the utility model where they can keep their front end processes and then outsource everything else to the utility. I think this would be particularly attractive to smaller buy-side firms or banks who want to share the cost of the back office and have access to more clearinghouses without having to make the initial investment in infrastructure. I also see niche firms emerging to clear for a particular product/region or sector. The question mark is over those who occupy the middle ground.”
John Omahen, vice president of post trade solutions at SunGard also sees a future where utilities play a larger role. SunGard has been one of the first out of the starting gate with its newly minted model that provides derivatives clearing operations as well as technology services for trade clearing, trade lifecycle management, margin processing, brokerage, reconciliation, data management and regulatory reporting. Barclays was the first bank to migrate parts of its clearing and reporting functions to SunGard.
“There is no reason why we cannot provide clearing operations services for non-investment banking groups whether it is insurance companies or pension funds,” he says. “There are still some other challenges that would have to be overcome for these types of buy-side firms to self-clear but if they are I can see them handing over the back and middle office functions such as reconciliations and reporting to a utility. This would be much more cost efficient than hiring the expertise and building the operational processes themselves.”
Calypso Technology has also joined the fray with its recent Bank-in-a-Box product that simplifies and streamlines capital markets business processes. It not only reduces operational risk by integrating standardised processes and addressing regulatory compliance but also paves the way for shared services on a utility.
Related Content:
“FCMs – How the Business Model is Changing”
In this DerivSource podcast we speak to Gerry Turner, executive director of Object Trading who discusses the changing FCM model, the new players and evolving OTC derivatives market. Listen or read the transcript: http://development.derivsource.com/content/fcms-how-business-model-changing
