Pioneering technology and post-trade derivatives OTC clearing utility, Sernova Financials Limited (Sernova) recently went live with its first client clearing through LCH SwapClear. DerivSource spoke with Richard Thompson, Sernova’s co-founder and chief operating officer, about sell-side clearing services realignment, the benefits of being a direct clearing house member, and Sernova’s role providing innovative infrastructure as part of the new world of CCP clearing.
Q: What are the market factors that drove you to start up Sernova?
A: In short, three changes to the market space relevant to clearing: most importantly, the move away from the traditional clearing model and secondly, the evolving market space and new challenges and opportunities as a result.
Both I and my co-founder, Venkatesh Ramasamy, Sernova’s executive chairman, saw first-hand in our previous roles working in prime services and OTC clearing that new capital and liquidity requirements were making it difficult for firms to run a profitable OTC derivatives client clearing business under the traditional client clearing model. At the time, many firms were realising the same thing, and soon many of the global banks were facing difficult decisions about the scale and scope of their client clearing activities. Those that remain have greatly reduced the number of clients they service or re-engineered their pricing model in light of the new regulations.
One result of this sell-side re-alignment is a growth in the demand for direct membership at clearing houses. Once off-boarded by their clearing broker, many clients were looking for ways to maintain access to central counterparty (CCP) clearing. Sernova was created to reduce the barriers to entry and enable the transition from being a client of a clearing broker to becoming a direct member.
Non-cleared margin rules under BCBS/IOSCO are pushing more and more products into clearing. At the moment interest rate swaps (IRS) make up a large part of the OTC cleared market, but foreign exchange (FX) and repo will soon move towards central clearing and a number of CCPs are now looking to introduce new cleared FX products. CCP clearing will continue to grow to encompass all sorts of OTC and financing products.
Finally, as a result from these changes, the consequent market change is that financial institutions are much keener for domestic or specialist regional banks to clear for them than they once were.
In response to this market trend, Sernova’s solutions helps regional banks to successfully achieve the specialist capacity and capability towards running clearing operations as principal with a nominal initial investment and flexible ongoings cost, which means they don’t need hundreds of clients or excess staff capacity in order to have a sustainable clearing business. Direct membership provides regional banks with potential revenue opportunities as regional clients look to them to provide more and more clearing services. Overall, this is a positive development for client market access, market liquidity and the successful evolution of market participants to successful compliance with the obligations of the emerging world of derivatives trading.
Q: Let’s focus on direct membership. How would direct member clearing address the market trends you just mentioned?
A: We believe that direct membership with a clearing house will help Tier 2 and Tier 3 banks as well as buy-side firms that were previously using global banks to access clearing in the OTC, exchange-traded derivatives (ETD),FX and financing markets save money, reduce risk, efficiently manage financial resources and provide the potential opportunity to generate revenue. However, becoming a direct member is not a simple task. It requires a large amount of market knowledge and experience, operations expertise and technology that they don’t necessarily, at the onset, have and need to build in-house. Firms can either build the required expertise and capabilities in-house, which is a significant investment, or they can use a service provider like Sernova, which aims to support those operational and technology aspects for them.
Q: As Sernova is a start-up and offers a new solutions to CCP clearing, can you explain how your model works and enables direct clearing for tier 2,3 firms and buy-side institutions?
A: One key stumbling block for direct membership is the default management process because the auction process in the OTC product is quite complex and thus can be challenging for some new members. We help to clarify and simplify the default management process for them, by providing the information in a post-calculated way that aligns to the clearing member’s internal risk models and taxonomies. This reduces data manipulation and expedites the auction response by the clearing member. The clearing member is better able to validate the report data and make risk decisions based in part on the output we give them once internalised by the clearing member and incorporated into their in-house default management risk processes, operational controls and reporting processes.
Overall, we provide a service that facilitates direct membership but we are not principal to the membership itself or to the associated obligations required of clearing members. Our clients have direct membership at a CCP. We operate the infrastructure and the service 24/6 in order to enable clearing. In some cases, clients want to offer clearing to a few group entities or franchise clients and Sernova can support this. Multiple clients can share a single infrastructure, enabling them to mutualise infrastructure and operational costs, and giving them greater flexibility to move from one clearing house to another, introducing new products, or scale their business up or down with relative ease and flexibility.
For example, if a client had connected to a particular CCP expecting it to gain liquidity, but it had failed to do so. In a traditional build, that connection would have been costly to build and run, and switching providers would add significant additional cost. Using Sernova, the firm can mutualise the upfront build costs as well as the risk of having to decommission existing infrastructure, while ensuring the running costs are commensurate to the size of the business in that particular clearing house. To dial up or down the products cleared with a particular clearing house, Sernova would simply adjust their specifications and change the pricing accordingly.
Q: As you mentioned firms have the option to build in-house to support direct membership if the traditional FCM support model does not suit. With those utilising the Sernova solution what cost savings can they expect compared to building in-house?
A: We target a material cost saving versus an in-house build. That percentage differs, depending on the number of CCPs—the more CCPs, products or clients a firm utilises, the larger the savings and therefore the more cost-effective Sernova is as an enabler. We can also enable clients to be up and running with clearing much faster than they could with standalone internal builds. Aligning the internal build required and the skills and capacity needed to be a clearing with Sernova’s support capabilities enables the faster speed to market.
Q: What about the other hybrid clearing house solutions in the market? Where do you see Sernova fitting in with these offerings, which also cater to tier 2 and 3 banks and buy-side firms?
A: These CCP hybrid offerings show the direction the market is heading. Services like ISA Direct from Eurex Clearing have enabled firms to think differently about direct membership. That is an exciting proposition for the market, as it reduces systemic risk at the clearing house as well as the concentration risk we see at the moment, where some clearing houses have only a small number of clearing members. Overall, the market benefits from a greater diversity of participants able to provide liquidity in an appropriately risk managed way.
These services also enable the buy side to have more of a voice in the cleared space. Currently, tier 2 and 3 firms and buy-side institutions take on a considerable amount of risk but are not able to mitigate it in the same way a direct member can. So, there will still be a need for agent or sponsoring members to connect clients to the clearing house. That sponsoring member may or may not choose to provide all the infrastructure, expertise and operational processing required. We believe they should not, in order to limit their exposure to information security and Chinese wall issues. This creates a natural fit for Sernova to provide the clearing infrastructure services alongside a sponsoring member.
Another services model possible would be where firms outsource operational components of the membership criteria to a major bank and using the Sernova connectivity to become a direct member. Sernova has spoken to many buy side clients looking for banks to provide innovative auction and default fund enablement services. As this space evolves, we expect to see more tier 2 and 3 banks buy-side firms becoming direct members in the next 12-24 months.