For derivatives market participants, the focus for 2019 is very much a mix of regulatory compliance and mitigating geopolitical change. In a DerivSource Q&A, Phil Simons, Global Head Fixed Income Sales – Derivatives, Funding & Financing and Ricky Maloney, Head of Buy-Side Sales at Eurex look at how to balance the need for liquidity and margin efficiency with regulatory compliance in this ever-changing industry.
The derivatives market has evolved significantly since the first European Market Infrastructure Regulation (EMIR) swap central counterparty (CCP) clearing obligation took effect in 2016, however; change continues as market participants must contend with geopolitical uncertainty and upcoming regulatory deadlines that impact both cleared and uncleared derivatives.
Not long after category 1 and 2 firms started clearing via CCPs, the first phases of the Uncleared Margin Rules (UMR) came into force, which drove greater volumes of derivatives trades to be centrally cleared, as firms looked to aggregate portfolios to a cleared environment to get a single margin number.
This year, EMIR continues as category 3 firms must meet their swaps clearing obligations by 17 October (as per EMIR Refit). In addition, financial organisations in the final two phases of UMR (Phase 4 and 5) must be ready to meet these margin requirements by 1 September 2019 and 2020 respectively.
|EMIR Refit effective 17 June 2019|
Clearing obligation for Category 3 starts 4 months following their notification to ESMA and the relevant NCAs (at the latest possible until 17 June 2019)
– Clearing Obligation starts on 17 October 2019
Otherwise clearing obligation started on 21 June 2019
Firms must consider both the geopolitical risks and their best execution obligations when working out the best way to comply with the June deadline. They have considerable work to do in implementing a solution and must select and sign up to execution platforms, arrange connectivity agreements, appoint clearing brokers with supporting legal documentation and choose which CCP to clear at. Firms impacted by the upcoming UMR deadlines have even more preparatory work to do and may find that voluntary clearing offers an optimal derivatives execution and post-trade management strategy whilst better satisfying best execution obligations.
The main challenges that firms choosing to retain bilateral swap portfolios with multiple counterparties will need to solve is how to handle multiple margin calculations and collateral pools whilst managing the costs, risks and the operational burden such a strategy entails.
Geopolitics and accessing liquidity
Category 3 firms that fall under the clearing mandate will have to choose whether to use a UK-based CCP or an EU27 CCP – as well as whether to access those CCPs via an EU27 or UK clearing broker. Despite the ongoing uncertainty around Brexit, it is highly likely that the UK will become a “third country”. Regardless of the hard or soft nature of any deal, there will be a loss of passporting rights for UK firms looking to offer services to EU27-based clients.
The implications on Euro clearing location have been well documented and while everyone obviously hopes for the best, long-term financial planning requires prudence. Getting access to euros via an EU clearing broker at an EU27 CCP is therefore the safest route to go and covers all eventualities.
We are already witnessing a significant shift in OTC Interest Rate Derivatives (IRD) euro liquidity to the continent. Eurex’s market share in IRS has grown from 3.7% to 7.4%, with Forward Rate Agreement (FRA)market share growing from 3.2% to 41.3% in the last year. LCH itself has moved almost all euro denominated repo and government bond trades to Paris from London (See press reports).
With these moves, market participants can protect themselves from the geopolitical uncertainty surrounding Brexit and the potential regulatory implications on the euro clearing location, by ensuring they have access to Euro liquidity within Europe as well as the UK. We have seen bid-offer spreads converge to those offered at LCH in Euro swaps since the start of Eurex’s successful partnership programme, and we have seen a stable and range-bound CCP basis develop, both of which are healthy signs of deep liquidity.
A major challenge for funds in the new world where all derivatives need to be cleared or collateralised is that funds need to stay as fully invested as possible to optimise returns. For a euro-denominated UCIT fund, the bulk of its assets, or securities, are euro-based bonds, euro-based equities etc. As an EU-based CCP with access to European Central Banks we accept these as collateral for initial margin (IM), which allows underlying fund to stay invested. If the fund is unable to use those securities, they need to be able to place cash – which is a drain on investment returns.
The other issue is access to cash euros for variation margin (VM). To access cash euros, funds either have to be uninvested to pay their VM, or they need to be able to repo out their securities and generate cash that way. We have a solution for the buy side to directly access our Repo market to either raise cash if that is their requirement, or to deposit VM cash that they don’t want to leave unsecured with their broker/bank. We accept reverse repos, which means their cash is fully secured against securities held in the CCP.
Optimisation and best execution
The preparation for, and implementation of UMR, is a significant task from – among others – a legal, compliance, operational and technological perspective; requiring project resources as well as the engagement of all bilateral counterparties and a plethora of custodial considerations.
Preparation for UMR begins with the aggregate average notional amount (AANA) calculation, required 12-18 months ahead of implementation. If the calculation indicates a firm is in scope, it is required to disclose this to its counterparties. Thereafter Minimum Transfer Amounts (MTAs) and IM thresholds will need to be determined and eligible collateral schedules and haircuts agreed with each counterparty. Additional custodial relationships may also be required. The International Swaps and Derivatives Association (ISDA) estimates approximately 1,100 firms with over 9,500 in-scope relationships will be drawn in to the final phases (see ISDA Margin Survey).
Clearing with a CCP enables firms to optimise their collateral processes. Compare the 10-day margin period of risk (MPOR) applied to a bilateral derivative with a 5-day MPOR at Eurex Clearing. As bilateral portfolios are rarely executed with just one counterparty, firms need to think about collateralising that 10-day margin requirement, above certain thresholds, with multiple counterparties – whereas those same derivatives when cleared via Eurex will require just one collateral pool per client account. If a buy-side firm has two clearing brokers with Eurex, for example, it will be required to deliver just two lots of collateral, versus multiple bilateral deliveries per day. From an operational workflow perspective, this is extremely efficient and aligns with today’s futures workflow.
Beyond the immediate benefits of the above example, firms can also offset margins at Eurex, be it cross margining of Over-the-Counter (OTC) and Exchange-traded Derivative (ETD) portfolios, or simply the correlation of risk from a portfolio perspective. By grouping swaps together into the most efficient packages, margin requirements can be greatly reduced, and there are some excellent tools available to validate these themes.
Finally, financing these derivatives at the lowest possible cost is extremely valuable from a performance-drag perspective. Eurex offers a wide range of acceptable collateral, as well as repo/reverse repo and collateral reuse functionality.
How can firms get started now?
Firms looking to achieve the benefits and efficiencies of clearing their clearable derivatives over retaining bilateral portfolios should decide which CCP might best suit their requirements. They should reach out to the clearing broker community, perhaps leveraging their existing ETD or OTC execution relationships. The method of segregation is an important consideration. Eurex obtains a legal opinion in each country in which it offers clearing services, and these have been tested against local bankruptcy laws. From an execution perspective, clients should also choose their preferred trading platform(s) and ensure they have the necessary documentation to receive competitive bid/offer prices either by RFQ or disclosed streaming from their choice of banks and brokers.
Firms can also leverage pre-trade margin calculation technology when evaluating their derivatives strategy. Some of the margin calculation results clients have shared show quite remarkable differences between bilateral and cleared margin. Firms are also able to analyse bilateral portfolios alongside cleared portfolios. We have been working closely with CCP switch service providers to help where any transition of inventory between CCPs, or from bilateral portfolios to cleared might be required.
The end goal for clients is to ensure an efficient derivative portfolio management strategy, not only taking into account operational workflows, but also to ensure an optimal margin requirement with the best possible financing rate being achieved to fund those margins, reducing funding drag. We strongly believe that Eurex, with its portfolio and cross margining capability, allied with its funding and financing toolkit is the CCP at which those aims can best be achieved.
Phil Simons, Global Head Fixed Income Sales – Derivatives, Funding & Financing at Eurex. Philip has 30 years experience in the financial industry where he started life as a swaps trader before moving in to the clearing world, initially heading up the clearing business at UBS followed by Cargill. Philip later moved into the custody and collateral management space at J.P. Morgan before joining Deutsche Börse Group. Philip initially joined as head of the Clearing Sales and Relationship Management Section and is now Global Head of Fixed Income Sales for the Trading & Clearing of Derivatives, Repo and securities Lending products at Eurex, Eurex Repo and Eurex Clearing. Philip is responsible for building strong relationships with clients, attracting new trading and clearing members as well as the development and promotion of new products and services.
Ricky Maloney, Global Head of Buy Side Fixed Income and Trading & Clearing Sales at Eurex. Ricky leads the buy side fixed income derivatives trading & clearing sales business at Eurex Clearing leveraging the 25 years’ experience he has in Financial Services. In that time he has held a variety of positions having worked in front, middle and back office functions on the buy side. Ricky has excellent knowledge of exchange traded and over the counter derivatives products and the associated regulatory requirements, he hopes to combine this knowledge with the Eurex product suite in order to offer clients solutions that are both effective and beneficial to their businesses.