Banks are launching client clearing services for OTC derivatives to support the move towards central counterparty clearing (CCP). In a Q&A, Calypso Technology’s Sanela Hodzic explains how technology helps clearing members build a clearing service capable of meeting both the processing demands of a complex international central clearing landscape and requirements from customers.
Q. Many derivatives clearing members are launching client clearing services for OTC derivatives. What does the role of technology play in the development of a client clearing service?
For derivatives clearing members (DCMs), connectivity is the very first thing they grapple with. Many DCMs already have connectivity to clearinghouses for futures and exchange-trade derivatives, but the OTC derivative clearing space is brand new for them. Connectivity is first and foremost in building a client clearing services.
In addition to connectivity, a DCM must also be able to process OTC derivatives throughout the entire trade lifecycle process. A DCM has to keep track of those transactions, independently value them, and then reconcile trades with the books and records of the clearinghouse it is dealing with.
Compared to how the clearing process works with futures and listed derivatives, the process for OTC derivative products is different in that they are far more complex. It can be very challenging for a bank to replicate the post-trade processing of a swap with a future, especially for swaptions and FX options, which are the next generation of cleared OTC products on CCP New technology is required to complete processing of OTC derivatives contracts including valuation, reconciliation, and record keeping.
Technology also has a role to play with differentiating client-clearing services offered by different clearing members. DCMs need to evaluate how to differentiate itself when other banks are offering the exact same service to the end customer. And I think if a DCM can offer some innovative technology to support the main service functions such as trade processing capability and optimal margin management, technology can play a really important role in distinguishing client clearing services from the bank next door.
And finally, technology enables DCMs to start clearing its trades and those of client’s quickly and in a cost efficient manner. In today’s fast paced industry, time to market is important.
Q. Many banks have launched client-clearing services already but more are expected to join the race. Can you explain what functionality is required to build a DCM client clearing service capable of handling OTC derivatives?
There are several elements that make up a complete client clearing service that require robust and flexible technology to support the functionality to create a high quality service.
Connectivity
There are two main elements of connectivity: intraday and end-of-day.
Firstly, DCMs have to be able to connect to the clearinghouse on an intraday basis to retrieve a record of every transaction cleared in that particular clearinghouse, and to value each OTC product.
Secondly, end-of-day connectivity is required to get all the transactional data for the day and reconcile back to a DCM’s own records to make sure nothing has been missed. And this end-of-day connectivity and reconciliation can be difficult to do with multiple clearinghouses in multiple jurisdictions.
Processing
A DCM will have to keep an independent record of those transactions and will need to be able to value complex derivatives products. Many DCMs will try to replicate exactly what the clearinghouse does so that at the end of the day, it can see if the transactions and valuations are in sync. Additionally, technology can provide tools to create specific margining rules for client collateral requirements.
Margining
Margin is important for two reasons. Firstly, a DCM will have to pay immediately when a call for margin is made, so understanding upfront what the margin call is likely to be becomes very important and enables a DCM to anticipate the amount of funds it will have to request from a client to meet the initial margin requirements.
To support this need, DCMs need a margin calculator to be able to replicate the margin calculations used by the various clearinghouses. Calypso has connected to the margin calculators of multiple clearinghouses through its multi CCP connectivity portal to give its DCM users the ability to load up a portfolio and get a margin estimate directly from a clearinghouse.
Furthermore, this pre-trade initial margin calculation estimate is a service that a DCM can then offer to its clients as a value-added service. (See next question).
Collateral Management
A DCM has to be able to view what margin a customer has pledged and manage any further changes required such as a requirement of additional margin.
Collateral management can also be a valued-added service offered by DCMs who have the ability to take bond collateral for instance, and convert this into cash collateral for a client. Many DCMs are evaluating how collateral management services could deliver additional value to clients and could then generate additional revenue for the DCM. As consequence, I think it is very important that a DCM has an adequate collateral management system in place.
Many banks will already have such systems in place however; new entrants to the client clearing space will be able to get the collateral management functionality as part of a wider trade processing and clearing solution.
Client Account Risk Management
Client account risk management is the final part of a complete client clearing processing lifecycle. The risk between the clearinghouse and the DCM is mitigated by the clearinghouse’s ability to apply very stringent collateral calls on the clearing member as soon as there is deterioration in a portfolio.
With central clearing, this credit counterparty risk hasn’t gone away; the credit risk between the DCM and the client still has to be managed. And the onus of this credit counterparty risk management falls upon the DCM to mitigate. Therefore, DCMs have to have very stringent counterparty risk management processes and supporting technology in place.
Enterprise-Wide Risk Management
The challenge is managing this risk on an enterprise-wide basis. A DCM may be offering prime services, bilateral trades processing, futures clearing and now OTC clearing to a client, which means the DCM then has to figure out how to combine all of those activities to find the single risk exposure it has to the client. Only with this enterprise-wide risk view will a DCM really understand what risk exposure it holds to a single client. Technology can enable a bank to integrate feeds from multiple places internally and from various clearinghouses so it can obtain this enterprise-wide picture of risk.
There are lots of enterprise-wide risk systems out there and they been around for quite a long time, but I think the real need for DCMs is the integration between clearing and risk systems.
There is also the issue of collateral. If a bank is processing collateral it can consider the net position to client and then incorporate this net position with the data from other feeds to identify its comprehensive, enterprise-wide risk exposure to a single client. Thus, the combination and seamless integration of clearing, risk management and collateral functionality creates what I call the golden triangle, is crucial for a DCM to create a complete and efficient client clearing service.
Q. Can technology be a differentiator for a DCM? If so, how?
Margining is a real issue and providing margining services to clients is important on a pre-on boarding basis. For instance, two banks may be bidding for the exact same client business, and imagine if one of them could offer technology that has the ability to optimize the use of client’s capital when it comes to clearing?
Specifically, a multi-CCP margining portal gives a DCM the ability to simulate loading up a portfolio to several clearinghouses to compare the cost of margining for that portfolio. Replicating a clearinghouse’s margin enables the firm to perform ‘what if’ testing to identify margin on a trade prior to dealing and clearing. For a DCM, this means when pitching to clients, it can bring that comparison of cost to the table on a pre on-boarding basis to show the client what is the most optimal clearing scenario. Such a service is valuable especially given the first question customers typically ask is how much will the clearing cost be. For many of the banks we have talked to so far, this ability to provide the most optimal clearing choice in terms of margining cost is the golden bullet when securing new customers for their client clearing services.
Q. How is technology mostly used when it comes to compliance with new regulation for central clearing?
A challenging time lies ahead for both DCMs and all derivatives market participants, as the industry adjusts to a new CCP clearing infrastructure introduced as part of ongoing regulatory reform of the financial industry. DCMs and the end client must adhere to new requirements to centrally clear standardized OTC derivatives contracts once rules are formally introduced in the US in July 2011 and a year later in Europe.
So by virtue of that, clearinghouses have invested in core technology to be able to offer OTC derivatives to the marketplace, and now the DCMs must invest in technology to connect to these clearinghouses and test operations to ensure that when regulation truly kicks in, DCMs can start clearing volumes for their own trades and those of their clients.
Calypso Technology offers core technology and solutions for both the clearinghouses and DCMs to help the market participants get a leg up in compliance with new regulation. The ability to use technology to connect with the market quickly is crucial in a time when the derivatives market is changing fast.
* Sanela Hodzic is Manager Director, Strategy & Business Development, Calypso Technology.
