Lynn Strongin Dodds looks at the different direct clearing approaches for CCP clearing of OTC derivatives and why buy-side firms may increasingly take this route.
As the derivative regulation takes hold in Europe, it was inevitable that different clearing models would emerge. It has been well documented that many sell-side firms are buckling under the stringent capital restrictions while buy-side firms are looking for more cost effective ways to grapple with the new derivatives regulation. Direct clearing is one answer but Futures Commission Merchants (FCMs) are expected to continue playing a significant, albeit altered role.
Like other post global financial crisis trends, the evolution will be slow and steady, according to Tom Lehrkinder, Senior Analyst at TABB Group and author of the recent report – “Clearing House Calculus II: Exchanges Expand the Boundaries of Self Clearing.” “These are new models and the differences are subtle. It is like buying vanilla ice cream. It always tastes slightly different from place to place, he says.”
One of the challenges will be getting the buy side to sign up for it. “I think we will see a cross section of the top European buy-side firms use direct clearing because they have the trading volumes in derivatives,” says Haider Mannan, Head of Buy Side EMEA at GoldenSource. “However, many firms use derivatives for hedging strategies and for matching assets to liabilities – not for alpha generation. Second and third tier asset managers may not be able to justify the move to direct clearing and will stick with the status quo.”
It may also take time for institutions to understand the models and appreciate the advantages. Lehrkinder highlights “the ability to decouple from other firms because assets are not co-mingled and to be more efficient because they have cut a few steps in the settlement process and are only dealing with the exchange. Costs may be lowered since they will not have to pay the FCM’s a per contract clearing fee.”
Reducing concentration risk is also expected to win hearts and minds. The TABB report shows that the numbers of FCMs in the US has almost halved from 154 in 2008 to 70 in May 2016 which has resulted in the top 15 accounting for a hefty 85% of client assets. Although tighter regulation has made life difficult, “the impact of low interest rates has decreased bottom-line revenue by more than 25% for the average FCM, and depressed commissions for execution and clearing has certainly not helped,” says Lehrkinder. “In addition, costs of running the business continue to increase as firms try to keep up with the demand for more transparency, compliance reporting and the need for automation.”
Matthias Graulich, member of the Deutsche Börse-owned Eurex Clearing executive board, also voices concern over concentration risk. “We are definitely seeing an increase in client asset pools into fewer hands,” he adds, “If a default happened, finding new clearing brokers who would be able to pick up the position and collateral accounts of potentially hundreds of clients in a short time frame is a big challenge. The top five clearing brokers account for 70% of client risk of US OTC clearing. Imagine if one or two of the top five would default and porting of client accounts cannot be achieved – this would add significant stress to a crisis situation and cause deep trouble for the overall market.”
This does not mean though that the FCM is being pushed out of the clearing picture. “If you look at the models from CME and Eurex, they have both taken steps to ensure that they are still available to cover any contingent liability that these new membership categories may introduce,” says Lehrkinder. “They are all keenly aware that there needs to be a partnership between clearinghouses, exchanges and FCMs and that the FCMs provide the processing engine well as stability and financial backing. They act like an insurance policy for the marketplace.”
For example, the CME’s Direct Funding Participant (DFP) model, which was recently launched, enables a firm to clear trades solely for its own account. It would not have to contribute to the group’s guarantee fund or be responsible in case of default by one of the CME’s other clearing members. These obligations would have to be certified by at least one other clearing member or FCM of the firm registered with the US Commodity Futures Trading Commission (CFTC).
Under Eurex’ ISA Direct model, the FCMs act as clearing agent, covering the default fund contribution, default management obligations and optionally operations and financing functions such as transaction, collateral and cash management. The clearing agents are only left with a capital charge from the default fund contribution and not a client’s margin call. As for the buyside, the new model not only reduces transit risk but also puts a structure in place that allows clients to port its assets from one clearing broker to another should its clearing broker defaults.
“The liabilities of the clearing member facilitating access for our ISA Direct service are limited to default management obligations and default fund contribution on behalf of the client,” says Graulich. “This will help to improve their leverage ratios and reduce risk-weighted assets while generating a more attractive return on capital. That has become very important today as capital is scarce and the return on capital differentiates those who are running successful businesses from those who aren’t.”
He adds, “our calculations show that the reduction could be up to 95%. If parts of these capital savings would be reflected in the charges for the buy-side clients, the fees for ISA Direct should be significantly lower compared to the traditional client clearing service.”
One of the biggest differences with the CME is that the service will be applicable across all products including interest rate swaps, OTC and listed derivatives as well as repo and securities lending. “This provides clients with the opportunity to be also very efficient on the collateral side,” says Graulich. “For instance, say there is a cash rich investor in the repo market who receives securities from a cash taker. If this client, for example, a pension fund, is in the ISA Direct model in both repo and derivatives, not only should he get better terms on the reverse repo transaction, but he can additionally re-use the received securities to fund the margin requirements on the derivative side.”
Another variation on a theme is ICE’s Sponsored Principals account. “ICE’s existing Sponsored Principal model is a fully-intermediated client clearing model – rather than a form of membership – which provides the client enhanced asset and position segregation and additional protections post-default, but is underpinned by a Clearing Member (the “Sponsor”) which has unlimited liability in the event that the Sponsored Principal defaults – i.e. there is no limitation of liability on the Clearing Member and therefore no mutualisation of any client losses.”
The clearing member though is fully liable for the client’s losses in the event of default but a separate guaranty fund amount is calculated per Sponsored Principal, which is provides transparency to the Clearing Member acting as its Sponsor. According to Mark Woodward, head of the corporate development team at ICE Clear Europe.
“The fundamental question when looking at the different structures is what is the risk and reward profile of each model,” says Woodward. “The structures may vary but they are all trying to solve the same problem of delivering a capital efficient mechanism for clearing members to provide access to market participants while at the same time ensuring that the risk profile of the CCP is not put under stress.”
Although these three CCPs have been the most prominent, there is also activity in the niche markets with ECC debuting its own version to allow power trading participants to have direct access to clearing and trading of spot markets, independent of a clearing member. The service is especially beneficial for smaller members who, together, are significant contributors to market liquidity,” according to the ECC spokesperson.
Initially, the direct clearing model will be available to the Dutch and Belgian EPEX power spot markets, to be followed by the French, German, Swiss and Austrian markets by the end of 2016.
Looking ahead, CCPs will continue to forge their own innovative paths. As Lehrkinder puts it, “The convergence of technology, regulation, and capital constraints is providing the framework to allow exchanges and associated clearing houses to explore new boundaries in clearing futures. What remains unknown is what will happen to the existing FCM clearing and trading framework as exchanges move beyond traditional business models.”
