In preparing for mandatory central clearing for OTC derivatives under EMIR, asset managers must give themselves time to complete complex legal negotiations with clearing brokers, as well as review and potentially overhaul their operational infrastructure. David Brown, Technical Manager, derivatives at Royal London Asset Management explains.When central clearing regulations were first proposed two years ago, Royal London Asset Management (RLAM) made a strategic decision to be an early adopter. Convinced central clearing would eventually become mandatory, the firm wanted to be at the heart of the initiative, helping build an efficient and cost effective process within the industry, and gaining benefits for its clients. RLAM actively engaged with the central counterparties (CCPs), helping them develop their product offerings.
At RLAM, we also engaged with clearing members, looking at what systems we could provide, how that would fit in with its own legacy systems, and what additional new systems would be required to meet the new clearing requirements. We recognised it would take some time to get the operating model up and running in an efficient manner, to incorporate not just the central clearing obligations, but also all of the additional EMIR obligations around reporting, reconciliations, and confirmations.
Selecting CCPs and Clearing Brokers
RLAM first looked at its client base, examining which products needed to be cleared centrally from a mandatory perspective, as well as which products it made sense to clear on top of that. We then assessed the main CCP offerings and services in the UK and Europe—to see what products we could clear both now and in the future, how easy it would be to access these products, and to make sure we had the liquidity needed to trade them.
At the same time, we looked at which clearing members RLAM wished to engage with to actively clear trades on behalf of our clients, performing a request-for-proposal (RFP) process with brokers. RLAM assessed brokers’ credit ratings, their operational offerings as well as the costs involved—focusing on the most sensible fees rather than just looking for the cheapest. We looked at each client accordingly to make sure they had enough cover, depending on the size of their book.
Broker credit worthiness was a key criteria to ensure the counterparties would be able to continue offering their services for years to come. RLAM also sought a diverse set of clearing members, so that in the event of any broker going into default, we would be able to port trades away from them into another clearing member. RLAM has completed the onboarding process with three clearing members to date, and will add a further two.
“While standardised broker contracts are available, buy-side firms may not be comfortable with some of the terms, and the negotiation process can be tough. Asset managers should not underestimate the amount of time needed to go through these legal documents and agree terms with their brokers.”
Legal Negotiations Can Take 6-12 Months
Once we had chosen our counterparties, we went through the process of legal documentation. This is far less trivial than some may realise and can take anywhere from six to 12 months. While standardised broker contracts are available, buy-side firms may not be comfortable with some of the terms, and the negotiation process can be tough. Asset managers should not underestimate the amount of time needed to go through these legal documents and agree terms with their brokers.
With some clearing brokers exiting the market, some asset managers may feel they have little choice but to accept the terms they are offered. However, buy-side firms need to do their due diligence and fight their corner. Most legal firms would be very reluctant to sign off on a standardised contract that a clearing member says is mandatory and must be signed in its original form. In order to negotiate these terms properly—and in fact guarantee that a firm will have access to clearing services at all given the shrinking pool of providers—asset managers need to start negotiations as soon as possible to ensure they have enough time to get the terms they want.
Assess Your Operating Model
Central clearing for the buy side is a very new concept. Asset managers cannot expect simply to adapt their existing exchange-traded operating models to include OTC derivatives. Here are some key questions asset managers need to ask themselves:
- Can existing systems capture the OTC trades being executed?
- Can the system confirm these trades in such a way that they are also passed down to the clearing member via the CCP and back up for confirmation? (Firms need to make sure they are confirming their trades for the correct mechanism so that they can get into central clearing in the first place.)
- Once trades have been captured, can the system actually process the arrangements every day?
- Can it process initial margin, variation margin—all slightly different from the current OTC bilateral process.
- Can it capture all of the additional data required from an OTC trade now, such as the unique trade identifier (UTI)? (UTI is necessary in order to be able to forward those trades on to EMIR reporting.)
- Can the system get that back from the clearer and capture that in an adequate manner?
- Can those trades then filter through to the accounting systems and be accounted for in the correct and robust manner that they should be?
Collateral Issues Will Become More Prominent
In an ideal world, everything would be automated, but in reality, there will always be some level of manual intervention. This is especially true given that most accounting systems were not built specifically for derivatives. For example, buy-side firms need to work out where they are going to put initial and variation margin in their accounting systems, and how they are going to reconcile the margin requirements that come in from the CCP via the central clearing member. They also need to decide which collateral they are going to post, and how the operational teams are going to get that collateral to the clearing member within the necessary timeframes.
Collateral issues will become more prominent as the industry moves from bilateral to cleared trades. Firms can currently post stock collateral to satisfy margin requirements or collateral promises, but once they move to centrally-cleared OTC trades, the variation margin must be paid in cash in the denomination of those trades. Some portfolios might not have these cash reserves sitting around. For buy-side firms that are only processing for funds that hold large cash reserves, this is not currently an issue, but it will be in the future. In addition, collateral calls are generally going to be very early in the morning—8 or 9am—firms need to make sure they are set up operationally to be able to make those calls.
Automate, Where Possible
If asset managers are using three or four different clearing members, they need to be able to capture the margin requirements from each of those brokers, each day. Ideally, there would be a uniform set of statements coming in from each broker to be passed into the system so it can generate the amount of margin firms need to pay out. The reality is there is no standardised reporting across the clearing members. Each one is either trying to use their legacy systems or building new systems. Therefore actually entering those reports into asset management systems and generating payments on the back-end are manual processes.
If an asset manager is using a third-party operating model then much of the heavy lifting is taken off their hands. If not, firms can resource it manually but this is not a cost-effective long-term solution. Or—as we did at RLAM, firms can invest in a new infrastructure that can address the obligations under EMIR in an operationally efficient manner, capturing derivatives trades and disseminating the relevant data to providers so they can reconcile and calculate their positions.
Time is running out for buy-side firms. EMIR reporting will be a reality for the largest asset managers in six months’ time. Smaller firms that think they have plenty of time must start to prepare now if they have not already. They need to establish satisfactory legal agreements with the appropriate number of clearing members for their business, review their operational infrastructure and decide what investments need to be made from a technology standpoint in order to automate as much of the derivatives processing as they can.
* Comments from video interview with David Brown. See video interview on DerivSource YouTube Channel here.
