As regulators move to standardise the complex world of derivatives, Nicholas Pratt outlines what the changes mean for fund managersThe rehabilitation of the over-the-counter (OTC) derivatives market continues apace. The Federal Reserve in the US and the European Central Bank have made announcements regarding the central clearing of standardised OTC instruments.
Meanwhile, the industry has moved from an initial position of guarded scepticism to a growing realisation that the imminent introduction of central clearing is a reality, and the focus is now on the likely implications of the regulatory changes.
A significant question, if a central-clearing model is introduced, is: What companies or trade bodies are best equipped to fulfill the role as the central counterparty of choice?
In the post-mortem of the financial crisis, the OTC derivatives market was cited as a major contributor to the turmoil. Its involvement in the collapse of Lehman Brothers and the near bankruptcy of AIG meant that regulatory intervention was inevitable, if not entirely welcome.
For example, some believe that risk management can only really be enforced from within. “All in all it is good that the regulators are getting involved to ensure that there are no blow-ups,” says Igor Golutvin, of Russian-based asset manager VTB Capital. “But once the bank has all the risk management procedures in place and can manage its market and credit risk, I don’t think more improvement can come from the regulators. It is more a matter of internal approach to risk management. A bank should understand what it is doing and have adequate people and processes.”
Meanwhile others point out that, while government and regulator concerns are important, it is investor concerns that will really drive the market. “Investors have been somewhat spooked by the post-trade process in the wake of Madoff and Lehmans so they are taking much more care in terms of due diligence,” says Sarah Jane Dennis, a consultant with the operations and technology division at UK-based Investit. “What these proposals have done is given a high profile control to these OTC instruments that have endured a negative press of late.”
How far is far enough?
Supervisors on both sides of the Atlantic have so far focused their standardisation efforts on the credit default swaps (CDS) market which is both the largest OTC market with the most outstanding contracts and also the most standard in terms of contract terms. But, says Dennis, fund managers should be asking how far the regulators intend to extend their standardisation efforts.
“Are the regulators going to standardise every OTC instrument or stop at CDSs? If they go further they will hit upon the problem that the industry has struggled with for so many years: How do you standardise non-standardised instruments? What does this mean in terms of messaging formats and protocols? We will have to wait and see how aggressive they are.”
There are also a number of operational specifics that are yet to be clarified, says Dennis. “Fund managers need to understand the operating model and where they fit into it. They also need to understand the likely cost of participation and what benefits it will give them.”
The benefits of a centralised clearing and settlement facility were outlined recently by Michaela Ludbrook, vice president of Goldman Sachs Asset Management, who was speaking at a webinar hosted by US-based broker Brown Brothers Harriman.
Centralised clearing and settlement would bring guaranteed payment and a reduction in funding costs and cash breaks. It would lead to automation of trade flows and an increase in straight-through processing. There could also be a reduction in the number of settlement transactions and of settlement risk, and it may lead to the enforcement of best practice among fund managers.
Although they are two separate initiatives, Ludbrook sees centralised settlement as an important stepping stone in enabling central clearing. A dealer-to-dealer central clearing service has just begun and there is also a working group led by the largest dealers and MSA, SIFMA and ISDA members to go through the various global challenges involved.
“They are discussing the various legal jurisdictions and different scenarios and exactly how the clearing house would work,” says Ludbrook. “From an asset management perspective, there are also discussions over initial margin segregation and the portability of assets [ensuring that, in the case of a brokers’ default, a fund manager’s initial margin or payment is protected and that any assets involved can be transferred to another broker thus avoiding a lengthy unwinding of positions]. So we are eagerly awaiting the findings of the working group.”
Earlier this year, the European Fund and Asset Managers Association (Efama) laid out its various concerns regarding the establishment of central clearing for CDSs. According to Peter De Proft, Efama’s director general, the investment management industry “needs to be included in the discussion on the ‘rules of the game’”.
In addition to the measures taken to ensure mitigation of counterparty risk (including the segregation of initial margin), De Proft also said central counterparties should provide evidence of robust risk management, sound valuation for collateral, and good governance. “The interests of buy-side users must be considered within the CCP’s governance objectives. At least one buy-side representative should be on the board and the rules should be transparent to non-CCP members.” Furthermore, says De Proft, “CCP rules and contractual arrangements should be designed for maximum legal certainty, particularly with regard to credit events, and interoperability between EU CCPs is essential so that the transfer of positions between clearing members and between CCPs should be possible.”
De Proft also outlined some of buy-side’s concerns regarding the infrastructure requirements to connect to CDS CCPs. According to Courtney Gavin, vice president of investor services at Brown Brothers Harriman, these requirements will be minimal.
“Enhancements were made to the FpML message structure to accommodate the new European and North American Standard CDS contracts. As a result, fund managers transmitting their CDS trade instructions as FpML messages will need to make minimal enhancements to account for these changes.”
Gavin also believes that the benefits of a streamlined process outweigh any potential loss of flexibility or privacy from moving CDSs from an OTC state to a centrally cleared environment. “From an asset servicing perspective it makes processing much easier because there should not be any confusion or question marks over contract terms, payment frequencies, maturity dates and so on. It should be a more streamlined process in terms of accounting and valuations than is the case with bespoke instruments.”
The Operational Management Group (OMG) is the industry collective that has taken on the responsibility of discussing the aforementioned ‘rules of the game’. Notably the group includes a number of buy-side firms among its members and has recently committed to granting buy-side firms access to CDS clearing platforms – either through direct membership or through their dealers – no later than mid-December this year.
The OMG’s recent letter to the Federal Reserve Bank of New York did, however, contain a disclaimer of sorts regarding its analysis of the legal and regulatory issues that may arise from ensuring buy-side access. “If through this analysis we determine that regulatory and/or legislative changes are required to accomplish buy-side access to CDS clearing, we will seek assistance from the supervisors.”
In order to work out these legal and regulatory issues, the Federal Reserve and European Central Bank must first decide which parties will provide the central counterparties. In Europe there are currently four candidates – a consortium involving Markit Partners and the Intercontinental Exchange (ICE); the Chicago Mercantile Exchange; NYSE Euronext’s London-based derivatives arm Liffe and Germany’s Eurex.
Two of the candidates are Europe based, which is the preference of the EU, but the two US-based offerings are felt to have the most credibility. The ICE platform is currently in action in the US and already has most of the dealers on board. The CME is the only platform to have actively sought to include the buy-side as a key target market but although it is available to use, it has attracted very few dealers so far.
What seems likely is that the EU will try to avoid endorsing a single CCP and, for the moment, be open to the idea of multiple CCPs. Speaking at a recent conference in London, Sebastijan Hrovatin, a policy officer in the EC’s market infrastructure unit, confirmed these suspicions stating that although a single CCP makes sense from an economic perspective and in terms of collateral management, it would also create more problems than it solved. Hrovatin cited the lack of competition and the prospect of an inefficient monopoly as the principle concerns, particularly should it be a US-based monopoly.
There are also obvious commercial implications from changing the current landscape. There are a number of services that currently exist for both sell- and buy-side firms engaged in the non-standardised OTC market, such as TriOptima’s Tri-Resolve service which provides bilateral margining for non-standardised derivatives. “The philosophy is about creating a central facility to resolve disputes,” says Brian Meese, chief executive of TriOptima. Of course such a service becomes redundant when central clearing is introduced, so what does this mean for TriOptima and any other similar vendor?
“There has been a lot of progress on central counterparties but bilateral margining can work just as well for those derivatives that are not viable candidates for clearing,” says Meese. “I believe the industry and regulators have all understood that there will always be significant positions outside the clearing infrastructure. Right now there is a need for centrally cleared and non-centrally cleared environments.”
©2009 funds europe