September 2012

INSIDE VIEW: Anxiety builds over central clearing

Buiness-FunnelMandatory central clearing of over-the-counter derivatives is fast approaching, but are fund management firms prepared for the changes ahead? Omgeo’s Tony Freeman explores some of the challenge. The impact of regulatory reform of the over-the-counter (OTC) derivatives market will hit fund managers investing in this asset class in a few months’ time. The decision to bring the majority of OTC derivatives trades into a centrally cleared environment, where they will be cleared through central counterparties (CCP), has been one of the most hotly contested proposals contained in the Dodd-Frank Act in the United States and the European Markets Infrastructure Regulation. Indeed, the rules around which products will be eligible for central clearing and which will remain bilaterally cleared are still being written – which in itself highlights the size of this undertaking. Given the implementation time frame, it is little wonder that some fund managers are beginning to feel anxious about the continued lack of detail relating to which products will be eligible for central clearing. There are two reasons for this. First, clearing requirements are likely to influence investment decisions. Second, there are mounting concerns from fund managers about the risk and operational implications of these changes. The experience of many fund managers in the aftermath of the Lehman Brothers’ default demonstrated an acute need for a reduction of systemic risk as well as a change in the existing mechanisms for the clearing and settlement of OTC derivatives contracts. This view was, and is, shared by funds, banks, service providers and regulators. ‘Living wills’
The concept of central clearing – whereby both sides of the transaction are protected in the event that one defaults – makes sense as a means of mitigating risk, but it is not the solution for curing the issue of risk. This has become apparent to regulators who have been moved to publish a consultation on “living wills” for CCPs, in the event that the CCP itself goes bust. There are concerns within the wider market about the level of concentrated risk that will be held by these entities. A question mark remains over how market stability would be preserved if a CCP failed. Indeed, before central clearing becomes ubiquitous in the derivatives markets, it is imperative that CCP resolution is addressed. Despite the fact that these particulars are still being ironed out – even if further delays to implementation occur over the next few months – central clearing for the majority of OTC derivatives is on its way and asset managers need to prepare for this.   It is anticipated that a significant percentage of OTC derivatives products will become centrally cleared, but the final numbers are still unknown. The remaining products – for example, those which are not deemed eligible for clearing – will continue to be bilaterally cleared and will be subject to timely confirmation, robust and resilient auditable processes with frequent reconciliation and effective dispute management, in addition to being subject to appropriate capital requirement levels. As CCPs enhance their capabilities, we are likely to see further growth in the products eligible for clearing. In turn, this is likely to result in two related yet opposing impacts to trading. Some fund managers will substitute OTC derivatives transactions with exchange-traded derivatives in order to avoid the increased cost of clearing while others will increase their use of OTC derivatives because of the increased transparency and standardisation. Amid the hype of regulatory reform, participants have proved resilient to changes in the financial market infrastructure in the past. Furthermore, concurrent with the regulatory decision-making process, investor demand for exotic and standardised derivatives has shown encouraging signs of recovery since the decline experienced in the immediate aftermath of the global credit crisis. As long as there is a demand for derivatives from an investment perspective, fund managers will learn to adapt to the operational and processing requirements of central clearing. The need to clear some products bilaterally and others centrally has raised questions among fund managers about how to manage collateral and counterparty risk in this new environment. Concerns are centered, in part, on the high margin requirements of central clearing, the large capital costs of clearing centrally and bilaterally, and the complexities around providing a consolidated view of counterparty risk across OTC derivatives, exchange traded derivatives and securities lending markets. In this complex clearing structure, the need to manage counterparty risk and simplify processes has gained heightened attention. Ensuring that counterparties have a consistent view of risk exposures through an established collateral management process will become critical to the effective management of counterparty risk. To this end, investment in sophisticated collateral management systems will allow fund managers to calculate their counterparty exposures and to know whether they are under or over collateralised on an ongoing basis. There is a growing need for firms to automate their collateral management processes. A recent study by Finadium demonstrates the extent to which this sentiment is increasingly shared by the buy-side community who felt that the complexities of collateral management are becoming too diverse to be managed by Excel spread sheets or antiquated technologies. Integral role
Innovative, advanced technology is increasingly considered the only viable solution for effective collateral management in the new “mixed” bilateral and centrally cleared environment. It was seen as playing an integral role for firms looking for a balance between revenue optimisation, relationship management and human capital. Overall, there is a common understanding of what constitutes a successful collateral management strategy in today’s environment and that relates to scale, timely reporting and liquidity. While there is less consensus over what the future derivatives landscape will look like in practice, it will become essential for fund managers to have a near real-time consolidated view of their counterparty exposures across both their bilateral and centrally cleared portfolios. And this is only possible with full post-trade automation.
Tony Freeman is executive director of industry relations at Omgeo ©2012 funds europe

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