The first deadline for central clearing of certain swaps has passed but category II and III market participants must now gear up for their deadlines. Amy Young of State Street Global Services offers four areas of market change that industry participants should focus on as they assess their own infrastructure and readiness for CCP clearing.
Mandatory clearing of certain swaps went live March 11th in the United States for transactions between Category I participants (as defined by Commodity Futures Trading Commission regulations). Category I entities include major swap participants, swap dealers, who have been clearing sell-side to sell-side for years, as well as large buy-side firms, many of which were early adopters and were preparing for this market transformation since the crisis. These groups embraced central clearing with the goal of mitigating counterparty risk. While the March 11 go-live for Category I entities went relatively smoothly, what will mandatory clearing for Category II and III entities bring, when the rest of the buy-side enters into the world of mandatory swaps clearing? Are those parties ready?
Across the industry, concerns have been voiced about the market participants who have yet to prepare for regulatory reform. What will happen when a buy-side portfolio manager requests a trade for a security that has moved to central clearing but their traders lack the legal documentation and infrastructure to comply with the new requirements? Will there be a legal bottleneck as players rush to comply with regulation at the last minute? How will the clearing broker time and resources for on-boarding be allocated? Will some market participants be temporarily locked out of the market? Will they have to find alternative ways to meet their investment objectives?
With all of the changes ahead, the sell-side is generally more prepared, since they have traditionally been members of the clearing houses and have historically cleared their own transactions against each other to mitigate counterparty risk. Although some of the regulatory changes will be new for all market participants, the extent of regulatory change is particularly important for the buy-side. While all parties engaging in cleared swap transactions will have to assess their own infrastructure and readiness, we believe the best areas to focus initial attention are on the four pieces of the market that are experiencing transformational changes: clearing, execution, collateral and reporting. The timing and clarity of regulations vary for each of these topics and are also determined by the region where they are being implemented.
• Clearing – Early adopters are ready and clearing. However, Category II and III participants who hold instruments mandated in the first wave of central clearing, but who have not completed test trades, are now behind. Firms should already have a Futures Commission Merchant (FCM, or clearing broker) in place and the process of on-boarding should be scheduled or have begun. It is also imperative to understand which OTC derivatives are transferring to central clearing. While US clearing generally had an uneventful take off, market regulation that will alter the market structure is far from complete. Until the swap execution facility (SEF) rules are determined, cleared transactions are still being executed bilaterally. The coming bifurcation of trading and clearing will result in additional transparency in the market but will also require changes to current connectivity, processes and procedures.
• Execution – Swap Execution Facility (SEF) rules have been anticipated since last fall, but we now expect an announcement from the CFTC in Q2 2013. Assuming this timeline holds, it is possible that electronic trading will be mandated for those instruments that have moved to the cleared environment by the end of 2013 / beginning 2014. While some market incumbents have announced their intent to provide liquidity in the new marketplace, new market entrants are customizing execution solutions to meet the buy-side’s needs and provide them with additional flexibility. The industry’s review of technology and platforms should begin in earnest once the SEF rules are announced.
• Collateral – While clearing was the hot topic of 2012, collateral management is becoming the dominant theme of 2013. This is perhaps the area with the least clarity, driven in part by BCBS-IOSCO delays in finalizing margin requirements for uncleared trades as well as by the rising concerns regarding the potential for shortages of acceptable collateral. No matter how the final rules play out, collateral requirements will have wide-ranging impact. With collateral mandated for both bi-lateral and cleared transactions, the cost of swaps trading will increase. Balance sheet impact to providers and the opportunity cost to investors of the requirement to post collateral could result in impact to both sides of the market. Fear that lack of the required collateral could reduce the overall market size and liquidity is being weighed against the need to have high-quality securities as the safeguard to mitigate risk. The proposed approach to encourage transactions to move to clearing (10 day VaR for bi-lateral vs. 5 day VaR for cleared vs. 2 day VaR for a “futurized swap”) is being challenged. How collateral requirements play out could impact investment decisions as well as overall market liquidity and health.
• Reporting – Reporting is another area where regulatory requirements are increasing, with these changes coming sooner rather than later as the dates for some are already upon us and others loom close at hand. What happens across jurisdictions, instrument types, currencies, and industry participants will have a huge impact on whether or not the desired market transparency is achieved, or if the sheer levels of data spread across the multiple swap data repositories and regions will overwhelm the industry’s ability to manage, standardize and analyze it.
Mandatory clearing for Category I entities in the US is just the first step of this market evolution. Regulation around risk mitigation and transparency in the swaps market is occurring globally and is expected to take years to play out. Mandatory clearing for Category II and III in the US involves buy-side entities for whom clearing swaps is a new undertaking. With the pace of most global regulation trailing the US, the trials and tribulations of these transitions will have a considerable impact to how the final integrated landscape evolves.
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