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Magazine Issues » October 2010

CENTRAL COUNTERPARTIES: a good time to talk

dangling_phoneCentral clearing is set to become an important feature of the financial markets, but greater protection will come at a cost.

Nicholas Pratt looks at how buy-side firms may best be able to engage with the all-important central counterparties.

The introduction of central counterparties in the clearing of both over-the-counter (OTC) and exchange-traded instruments has moved closer in the last three months thanks to the passing of regulation on both sides of the Atlantic. In July,  the US passed the Dodd-Frank Wall Street Reform and Consumer Protection Act and in September the European Commission passed its draft regulation based on the G20’s Toronto Communiqué to introduce central clearing for OTC derivatives.

The intentions behind the regulations are clear: greater use of central counterparties (CCPs) will introduce greater transparency and reduce counterparty risk from derivatives trading, thus giving investors greater protection. But this protection will come at a price. If buy-side firms are to be more involved with central clearing they will have to meet more onerous collateral and margin requirements, leading to some debate among asset managers about who will ultimately foot the bill for these regulatory changes.

Jane Lowe, director of markets at the UK’s Investment Management Association, believes that further work is urgently required to make the proposals economically viable for the client side of the market and to prevent risk transferring from the banks to end investors. “Investment managers are not asking for exemption from legislation or for a special framework: they want to see issues relevant to their clients addressed. As things stand, the costs of central clearing are likely to be borne disproportionately by end investors, despite the fact that they present an extremely low risk to the system.

“We therefore call upon the European institutions working on this legislation to engage with investors and re-evaluate the key provisions set out in draft regulation, in particular those relating to margin and collateral. The regulation will mandate central clearing for many OTC instruments, thus introducing a high degree of concentration at the clearing house level and limiting choice for end investors. In the interests of market stability and to retain good competition discipline, we urge the commission and others to look again at the impact on end investors and work to redress imbalance between risk and cost.”

Despite the protestation of the IMA, many investment managers are pressing on with their preparations for central clearing. In July 2010, Dutch asset manager Robeco became the first European asset manager to successfully execute a centrally cleared, over-the-counter credit derivative trade. The preparations began in September 2009 and involved an examination of the concept, the selection of clearing brokers and a study of all of the legal documentation. “Right now we are assessing the impact of centrally cleared trades on our back-office systems so that we can make the necessary changes to handle a large volume of derivatives transactions,” says Erik Leeuwen, head of Robeco’s portfolio engineering team.

The operational work over the last twelve months has been made more significant due to the lack of clarity regarding certain legal aspects, says Leeuwen. “It was not clear in the beginning what payments would be netted, whether cash flow from OTCs would be mingled with margin requirements or stay separate and there were still some outstanding issues around transparency of margins. These issues could impact your back office significantly so while we feel operationally comfortable, getting the legal framework finalised has been the biggest delay in the whole process.”

Risk reduction
But despite the operational and legal challenges, Leeuwen is convinced of the benefits of central clearing and confident that they will outweigh any costs involved. “It reduces counterparty risk to an extent that could never occur in an over-the-counter environment and the standardisation involved would lower our transaction costs and allow for more trading possibilities with these kinds of instruments, all of which will benefit our clients. In terms of clearing costs, there is still a big difference between the cheapest and the most expensive which suggests that the firms have not yet decided on their pricing. But all of these costs will be comfortably offset by the reduction in transaction fees that we will see.”

At the moment, Robeco and other asset managers are in frequent discussion with the various CCPs about how their interest can best be met but in the longer-term future Leeuwen is content to let clearing brokers handle most of the interaction with the CCPs, as is the case with the futures market. Indeed, Leeuwen believes that a lot of the concern being raised over central clearing for OTC derivatives is unfounded given that the futures market has functioned smoothly enough despite having a model where there is a lot more margin at risk than would be the case with OTC derivatives.

“No-one asks any difficult questions of the futures market because it works, but all of these difficult questions are currently being asked of the OTC market and are being resolved. So it would be good if the same detailed questions were asked in the futures market and maybe we might see more segregation of margin and a market that will be as well organised as the OTC market promises to be.”

While Robeco is happy to let clearing brokers handle the communication with the CCPs, there are some buy-side firms, particularly the larger asset managers with comprehensive back offices and a strong balance sheet, that would prefer to deal directly with the clearing houses and thus save themselves the expense of working with a broker. However, direct membership is expensive in its own way and the CCPs are not overly keen to widen their membership base.

The desire for buy-side firms to become more directly involved with CCPs is not reciprocated by all CCPs. “We have no appetite to directly take on buy-side clients,” says Anthony McGuigan, head of the UK office for Six X-Clear. “That is the role of the general clearing member (GCM) banks and our mandate from the Swiss regulator has not changed.” And in terms of the complaints over the high cost of central clearing, McGuigan believes it is a debate for asset managers and their GCMs, not the CCPs. “The algorithms we use to calculate margin requirements have not changed since 2003 and all the CCPs publish their fees. The GCMs will provide the default fees themselves but will pass on the margin requirement to the buy side. Whether they choose to add a fee on top of this is up to them.”

According to Tony Freeman, director of industry relations Emea at post-trade services provider Omgeo, one idea that has been floated by some buy-side firms is that some kind of ‘lite’ membership is extended to them so that they are able to use the CCPs without having to meet the large margin requirements. “That is quite a difficult concept to understand because the whole point of using a CCP is that you are posting collateral as margin against your potential losses in order to protect your counterparty,” says Freeman. “The chances of these wishes being met are very remote because CCPs are very risk averse. What is more likely is what happens today in the futures market, where a clearing broker is hired to manage the CCP process and post the necessary margin.”

A similar model is used in the equities market where Omgeo has recently teamed up with EuroCCP to offer the buy side the opportunity to settle their equity trades through a CCP rather than relying on the broker and the custodian it appoints. “The danger for the buy-side is that the broker may default and the asset manager then has to replace that trade, possibly at a loss,” says Diana Chan, chief executive of EuroCCP.

Custodian responsibility
The interaction with the CCPs would still involve the buy-side’s custodians, but rather than them acting as an agent on a per-transaction basis, they would be contractually serving the buy side as a general clearing member of the CCP. “There would be an assumption of greater responsibility from the custodian but that is no bad thing,” says Chan. “And since most buy-side firms are buy-and-hold investors, the collateral required should not be a problem. The amount of collateral needed for the equities market is a very small fraction of that involved in the derivatives market; in any case, the additional cost can be offset by the operational efficiencies gained by netting and the reduction in exceptions and failed trades.”  

LCHClearnet has been running SwapClear, a central clearing service for interest rate swaps, for over ten years, but in light of the regulatory developments of the last year, it has extended the service to cover not only the interbank market but also the buy side through its SwapClear for Clients service. Under the conditions of the SwapClear For Clients service, the buy side will still access the SwapClear platform via a clearing member, but the essential difference is that there will be the option of segregation of margin and portability of assets – two options that many buy-side firms have asked for from CCPs in order to protect themselves against default. “Our service gives buy-side firms the option. If they want segregation and portability, there will be a higher margin requirement because increased protection will involve a cost,” says Alberto Pravettoni, managing director of LCH Clearnet.

Although SwapClear for Clients does allow for more buy-side involvement, it is unlikely that the buy-side will seek direct membership of the CCP, says Pravettoni. “Because we are dealing with an OTC market, full clearing members have to be able to help in the case of a default and contribute to an ongoing default fund. So while the service has been adapted to cater for the buy side, the criteria for membership have not changed and, theoretically, as long as a firm can meet that criteria there would be no problem, regardless of whether it is a clearing broker or an asset manager.” Consequently, Pravettoni rejects the argument that by catering for buy-side firms, CCPs will become structurally weaker and less robust than when they focused purely on the interbank market. “On the contrary, I think that by actively including all kinds of buy-side firms in our discussions we now have a more rounded view on managing risk and a stronger platform as a result.”

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