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Magazine Issues » October 2014

CLEARING & SETTLEMENT: The fog In clearing

FogAviva Investors has halted trading with US counterparties because of differences in regional clearing rules, finds Nicholas Pratt. For funds in general, the costs of central clearing may be disproportionate to reducing risks.

Regulatory bodies were always in danger of creating unforeseen consequences as they tried to de-risk markets with a flood of regulation following the financial crisis. The overhaul of derivatives clearing is one such area, where an already complex framework risks becoming more complex in its simplification.

Amid the international march towards central clearing of derivatives, Barry Hadingham reveals that Aviva Investors, where he is currently head of derivatives and counterparty risk, has chosen not to trade with any American counterparties because of a lack of harmony between US and European rules centring on central clearing. 

“We would have hoped that harmonisation of cross-border rules would have been sorted out by now. Instead we now have regionalised markets and that’s not a good thing,” he says.

In addition to more regionalised markets, it may actually exacerbate risk rather than reduce it, says Hadingham. “The complexity of our operations will go up considerably as a result of central clearing and, more importantly, the new rules for bilateral derivatives. My concern is that we are in danger of creating a system that is so highly technical it will create operational risk which can then turn into counterparty risk, which is the very thing central clearing was supposed to alleviate.”

It is five years since the G20 announced that the murk of over-the-counter (OTC) derivatives should be replaced by the glare of transparency through trade reporting and central clearing. It is two years since the EU’s rules – the European Market Infrastructure Regulation (Emir) – came into effect. But it is only in 2014 that the first central counterparties (CCPs) have been granted approval and the process of central clearing has begun.  

As this new environment rumbles into life, fund managers face a number of challenges. The first of these relates to exactly which derivatives are eligible for central clearing and which are not. For those eligible, managers then have to choose a CCP. 

For those not eligible, managers have to work out what extra margin is required and whether the hedging benefit of a bespoke instrument outweighs additional administrative costs imposed. 

This is likely to lead fund managers to a greater reliance on clearing brokers as intermediaries with the clearing houses, which means not only will they have to manage additional fees, but also more oversight surrounding the appointment of clearing brokers, instructions for them and service levels.

One of the first problems for fund managers to solve is the possible bifurcation of their portfolios. Central clearing is currently focused on plain vanilla instruments within the biggest asset classes, such as interest rate swaps and credit default swaps. However there are many related instruments, such as swaptions and inflation swaps, which are not clearable by clearing houses but are held by fund managers within the same portfolio. 

“A lot of our strategies will end up with a mixture of cleared and non-cleared derivatives, some sitting within a clearing house and the rest sitting outside,” says Hadingham. “We will end up with two different collateral pools, both subject to different collateral requirements which could create a serious liquidity issue.” At least Hadingham is hopeful that a solution for inflation swaps will be available from clearing houses sometime next year, should there be sufficient volume. “A CCP cannot clear an instrument if it is not confident that it can manage a default in that market. So you need a degree of liquidity in the underlying product and a decent number of participants. But there are fewer clearing member banks that are engaged in the inflation swaps market when compared to interest rate swaps.”

When it comes to the choice of a CCP, the ability to offset margin requirements across the portfolio and create cross-margining will be key, says Hadingham. So rather than having to pay a flat margin rate for each derivative contract, the margin can be reduced by looking at the portfolio as a whole and taking into account any offsets there may be. 

“The more offsets you can have the better whether that is with exchange-traded derivatives or OTC derivatives.”

The fact that European CCPs have been subject to rigorous testing and reapproval under Emir could be cited as a reason for the limited progress in terms of their product development, says Hadingham. That said, the majority (with the exception of the Intercontinental Exchange) have now obtained reauthorisation under Emir and will be able to push on with developing solutions, including the crucially important task of cross-margining.  

Nor has it been helpful, says Hadingham, that European regulators have pushed back the date for mandatory central clearing for Category 2 participants to the second quarter 2016, thereby reducing the revenue that clearing members and CCPs will gain and, consequently, the amount of resources they can devote to developing their services, including cross-margining.

The appetite for central clearing among buy-side firms is hard to judge given its heterogeneous make-up. For hedge funds that are often less directional in their investments, it represents a way to minimise their exposure to counterparty risk for little extra cost. But for many long-only managers holding assets that are long in duration and highly directional in nature, the opposite is true and central clearing will generate a lot of extra cost which is disproportionate to the reduction in counterparty risk. 

Some buy-side firms will use their derivatives to create highly bespoke instruments that create a perfect hedge. The big question for Aviva Investors, says Hadingham, is whether it looks instead to the exchange-traded derivatives market for similar products, such as swap futures or ultra-long gilt futures. While not offering a perfect hedge, these instruments will have lower margin duration – two days as opposed to five days – than in the centrally cleared OTC world.

Consequently, Hadingham expects the exchange-traded world to benefit from the early stages of central clearing.

Another group that will do well from central clearing are clearing brokers. Fund managers will look to them to manage their central clearing obligations and this will mean more use of existing services, like clearing and custody reporting.

There are also two areas where clearing brokers will look to offer new services, says John Nicholas, global head of new regulation monitoring and implementation at clearing broker Newedge. The first of these is collateral transformation. 

“Clearing houses may demand collateral above and beyond what fund managers would put up for an uncleared OTC transaction. The most successful clearing brokers will be the ones that are able to transform that collateral so that it is acceptable for clearing houses,” says Nicholas.

The second area is indirect clearing whereby the clearing broker acts as the intermediary between a fund manager and a counterparty (such as a regional bank) that does not wish to take up exchange membership. 

“Indirect clearing from a clearing broker enables fund managers to still maintain the same relationships with these counterparties while also benefitting from central clearing,” says Nicholas. 

Clearing brokers may also be able to help provide cross-margining in the absence of such a service from clearing houses. 

“If a fund manager client has a number of different positions for which it cannot get regulatory approval for offsets, clearing brokers can offer these internally by reducing the amount of collateral needed from the fund manager and then providing the extra funds to the clearing house to the meet the margin requirements,” he adds.

Such an approach may also help to solve the bifurcation issue that Hadingham refers to by reducing the amount of collateral needed and financing the shortfall to the clearing house. “It may not be ideal in that fund managers would have to pay a fee for that risk financing but it would solve any liquidity issue,” says Nicholas.

Cost is an essential issue and even with a greater reliance on clearing brokers, fund managers will still need to invest in the services that can help them price the impact of new rule changes on their trading and investment strategies – from managing their collateral, to calculating their margin requirements. 

“The conversations we’re having with clients revolve around cost – the cost of exposure and how the exposure can be limited at the cheapest cost,” says Matt Gibbs, product manager at software provider Linedata. 

For example, would this exposure be most efficiently managed by a derivatives-based fund, or by investing in the individual stocks, or by constructing, for example, a total return swap. 

“They will have to factor in the initial purchase cost and the cost of initial margin. What fund managers need is an initial margin calculator,” says Gibbs.

For portfolio managers, their interest in central clearing is not solely cost-related, says Aviva Investors’ Hadingham, but more about the strategic implications. 

“What they want to know is how much of what we do today will have to change because of central clearing,” he says.

The unintended consequences of regulatory reforms have become a common feature in recent years and it seems that the central clearing initiative agreed by the G20 as a supposedly global response to a global financial crisis may well be no different.

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