Mandatory clearing came into effect for Category 1 firms on June 21st 2016. Category 2 firms are preparing for their December 2016 deadline, and Category 3 firms are currently scheduled to go live in June 2019. In a recent DerivSource webinar, panelists from Bank of America Merrill Lynch, Swiss Life, Eurex Clearing and Clearstream discussed lessons these firms can learn from Category 1 firms and from the US move to clearing in 2014, as well as specific challenges lower-tier firms face.
Compared with the US rollout, where a quick succession of deadlines meant all categories of firms went into clearing within the space of a year, leading to large numbers of technological and setup errors, the timeline for EMIR compliance is less rushed, giving the marketplace more time to prepare. EMIR also allows for different segregation models—individually segregated vs omnibus structures—while the Dodd-Frank Act set up the standardized legally separate but operationally comingled (LSOC) model. More choice enables firms to tailor practices more to their individual requirements, but also adds to complexity.
One key lesson learned from the US experience is that firms have ended up using fewer clearing brokers than they originally expected. Global choice is limited, with a shrinking pool of only a dozen or so key providers of OTC clearing. ““Many clients in the US selected 3, 4, or 5 OTC clearers but over time, due to confusion around margining and to be more efficient, they’ve moved to using one primary and a backup,” says Bob Burke, CFA, managing director and head of global OTC trading, foreign exchange, and fixed income prime brokerage at Bank of America Merrill Lynch.
“Many clients in the US selected 3, 4, or 5 OTC clearers but over time, due to confusion around margining and to be more efficient, they’ve moved to using one primary and a backup,” says Bob Burke, CFA, managing director and head of global OTC trading, foreign exchange, and fixed income prime brokerage at Bank of America Merrill Lynch.
“When clearing became mandatory in the US, some clearing firms initially required breakage agreements, sometimes known as cleared derivatives execution agreements (CDEAs), which set potential remedies for failed trades. However, in the US, the CFTC feared that these breakage arrangements could have a negative effect on the competitive landscape and access to clearing, and, as a result, these agreements fell by the wayside. Ultimately, if the credit checking system works properly between the clearinghouses, the electronic trading venues, and the clearing members, there should not be a lot of broken trades. There is still work for the industry to do here. There have been discussions over introducing these now in Europe too, but it is unclear which way the industry will go,” says Burke. There have been discussions over introducing these now in Europe too, but it is unclear which way the industry will go.
Frontloading for Category 2 began May 21st
Frontloading has been a significant challenge for Category 1 firms under EMIR, as they in effect had to start clearing from February 21st—four months before the official clearing start date. Membership of central counterparty (CCP) Eurex Clearing jumped up by more than 20% for firms following that frontloading start date. Frontloading for Category 2 firms came into effect on May 21st, and so these firms have to ensure they are onboarded with clearing providers and are able to start clearing now, even though the official start date is not until December.
Clearing brokers have had to work to educate Category 2 and 3 firms and assist them with the onboarding process. Clearstream had a segregated model in place prior to the clearing mandate, but most firms dealing with derivatives were not yet in the triparty agent space. There has been a long education process, as firms figure out how to efficiently provide collateral to the CCP. Now, the focus has shifted to initial margin segregation, according to Otto Vaisanen, head of global securities financing sales – Europe, Africa, Middle East, Clearstream Banking.
Variations between Category 2 and 3 deadlines present challenges for buy-side firms. Some buy-side firms have both category 2 and Category 3 commitments from different funds, and often bundle orders together from an operational point of view.
“Beyond understanding frontloading window requirements and when their obligation starts, many Category 2 firms still have questions regarding the implications of this, especially in regard to the economics of pricing a derivative trade. Clients want to know if there is a price differential being made at the point of execution of a swap for cleared versus non-cleared trades, and they may receive a different answer from one liquidity provider vs. another,” says Burke.
Improving capital efficiency
Capital requirements introduced under Basel III protect customers by ensuring the client’s money is segregated, and can be returned in full should a clearing member fail. However, this increases the cost of capital for the clearer, which they are starting to pass on to their customers. “Central clearing has increased the cost of OTC IRS trading, as clearing brokers have started to charge for the cost of capital,” says Damian Imboden, head of treasury, FX and investment risk at Swiss Life, a Category 2 firm using the omnibus account clearing model.
“Central clearing has increased the cost of OTC IRS trading, as clearing brokers have started to charge for the cost of capital,” says Damian Imboden, head of treasury, FX and investment risk at Swiss Life.
To keep clearing costs as low as possible, clearing firms need to manage their capital footprint efficiently, but questions remain on how best to do this, and practices—and therefore clearing costs—may vary between firms. There is still uncertainty over how to capture clearing under leverage ratio rules. Currently, clearing brokers are able to count client’s assets on their own balance sheets. “In the denominator of the leverage ratio, is the gap balance sheet plus a capital add-on, and so brokers are able to count all clearing balances in the denominator of the leverage ratio,” says Burke. However, some in the industry are advocating against that, arguing the assets are remote.
ISA direct access model
Category 2 and 3 clients can avoid paying for substantial capital costs by using a direct access model with a CCP, such as Eurex Clearing. Under Eurex Clearing’s ISA direct model, a buy-side firm has a contract relationship with Eurex Clearing, with whom they are responsible for meeting the margin requirements. The clearing member continues to provide the default fund contribution on behalf of the buy-side firm, participating in any default auctions, and providing optional cash and collateral services as a clearing agent. However, trade exposure and initial margin are not on the sell-side clearing member’s books, which reduces their exposure and therefore their capital costs. “’The ISA Direct Model because of the direct legal relationship between the buy side clearing member and Eurex Clearing gives significant Leverage Ratio and RWA benefits in terms of Trade Exposure and Initial Margin for the Sell Side Clearing Member acting as a Clearing Agent’ says Byron Baldwin, deputy global head, fixed income and FX trading derivatives and clearing sales, Eurex and Eurex Clearing.
‘The ISA Direct Model because of the direct legal relationship between the buy side clearing member and Eurex Clearing gives significant Leverage Ratio and RWA benefits in terms of Trade Exposure and Initial Margin for the Sell Side Clearing Member acting as a Clearing Agent,” says Byron Baldwin, deputy global head, fixed income and FX trading derivatives and clearing sales, Eurex and Eurex Clearing.
“For category 2 companies that have the infrastructure to handle cash and securities collateral directly, it makes sense to use the direct access approach. Given its advantages, like bankruptcy remoteness and lower capital cost for clearing brokers, I think it will be a model offered more and more by CCPs,” says Imboden. However, while an innovative solution, the direct access model does not completely mitigate the capital footprint for a clearer. There is no silver bullet, so FCMs and clearinghouses must continue to devise solutions for improving capital efficiency and reducing their capital footprint, especially as the uncleared margin rules come into force in September 2016, says Burke.
“For category 2 companies that have the infrastructure to handle cash and securities collateral directly, it makes sense to use the direct access approach. Given its advantages, like bankruptcy remoteness and lower capital cost for clearing brokers, I think it will be a model offered more and more by CCPs,” says Imboden.
Collateral management
Managing collateral is a big challenge, especially for Category 2 and 3 firms that do not hold large portfolios of securities, and do not have previous triparty agent experience. Triparty collateral management providers like Clearstream provide tools to help them manage and optimize their collateral portfolios, automatically allocating securities to the CCPs or to any type of trade. They also offer tools that help them go to the repo market, lend cash, receive securities and reuse them to cover their CCP margining, as well as source collateral from various global custodians.
“Buy side firms need to talk to service providers to make sure that they have the full picture, including understanding the linkage between the different products—some triparty agents offer repo and securities lending products which can be used for generating collateral, and then that collateral will keep the full economic advantage when used to cover the margin cost,” says Otto Vaisanen, head of global securities financing sales – Europe, Africa, Middle East, Clearstream Banking.
“Buy side firms need to talk to service providers to make sure that they have the full picture, including understanding the linkage between the different products—some triparty agents offer repo and securities lending products which can be used for generating collateral, and then that collateral will keep the full economic advantage when they were used to cover the margin cost,” says Otto Vaisanen, head of global securities financing sales – Europe, Africa, Middle East, Clearstream Banking.
Evolution of the clearing space
Looking forward, the clearing space will continue to evolve. The swaps market is likely to become increasingly futurized. Compression tools will become more important to increase margin efficiency and reduce notional footprints of OTC derivatives. There will be more of a move towards using securities instead of cash as collateral—driven primarily by the cost of cash. Uncleared derivatives rules will come into soon, pushing the clearing and uncleared world to start working together in terms of collateralization.
As the clearing landscape shifts, Category 2 and 3 firms must continue to educate themselves around emerging best practices, and the tools available to help them handle these changes effectively.
Comments made during a recent DerivSource webinar. To watch the on demand webinar please click here: EMIR OTC Clearing-What’s Next?
