Lehman Brothers in 2008

The introduction of mandatory clearing for over-the-counter derivatives will bring with it a widescale, and costly, post-trade infrastructural reorganisation and a host of new considerations for the industry.

Following the collapse of Lehman Brothers, the G-20 decided it was not enough to regulate the banks; better oversight of the markets they dealt in was also needed. In order to detect a build-up of large customer positions and enable multilateral netting, regulation will extend to clearing over-the-counter (OTC) products, and the trade repositories that are being set up to report trades both cleared and bilaterally settled.

In the words of Paul Tucker, deputy governor, financial stability, at the Bank of England, central counterparties (CCPs) will become “de facto regulators and supervisors” that also “act as a central market authority for valuing positions and setting minimum margin levels”.

Speaking at the DTCC-CSFI Fellowship Launch in June, Mr Tucker said: “CCPs are, in truth, system risk managers. They absolutely must think of themselves as that, and organise themselves accordingly.” While there is some debate at the moment as to whether CCPs are becoming systemically important, Mr Tucker said he believed that CCPs were already systemic for the markets they cleared, and had been for some time.

No easy answers

Werner Steinmueller, head of global transaction banking and member of the group executive committee at Deutsche Bank, who is taking part in the Big Issue debate on post-crisis financial transaction infrastructure at Sibos, says there is no one-size-fits-all approach to current CCP concerns, given the global approach to regulate OTC derivatives.

“In terms of OTC derivatives, adding a CCP for each asset class reduces netting efficiencies, thereby increasing costs and operational and settlement risks for each different type of asset class traded by the same counterparty. Regulators and markets are both sceptical about using interoperability as a means for introducing competition in the derivatives space. Hence, the market has been much more receptive to the idea of having more than one CCP to maintain an element of competition, but which can cover multiple markets by being connected through interoperability if there is a business case driven by user demand,” he says.

But Mr Steinmueller believes that the real challenge for the industry is that the regulatory response does not sufficiently distinguish between the needs of the different asset classes, and how the infrastructure supports these operations.

The European Commission (EC) consulted the market earlier this year about its intention to replace the previous soft law approach of the Code of Conduct with a binding regulatory framework for central securities depositories (CSDs) at the European level. While the code has spurred discussions around a greater level of competition, it has also been apparent that differences related to risk and regulation cannot be solved by market forces, an issue acknowledged by the EC. At the time the code was launched, there were more than 50 access or interoperability requests, but only a handful have been implemented.

Mr Steinmueller says: “Both the upcoming regulation on CCPs and CSDs will now address how and under what conditions interoperability can be built. This will likely improve things and provide clarity on what can and cannot be done going forward. However, interoperability was and is a means to an end; it’s the price the market has to pay to move to a more consolidated infrastructure landscape in the long run.”

Crowded market

Alan Cameron, head of client segment, broker/dealers and investment banks at BNP Paribas Securities Services, believes there are too many CCPs in Europe. At present, there are more than 20 members of the European Association of CCP Clearing Houses (Each), with more joining annually.

He says: “The industry has been talking about CCP consolidation for some time, but in actual fact the opposite has been happening. Just collecting information on them all and connecting to them all makes for quite an expensive exercise for banks. They have to be a member of so many CCPs and each one is very different. We can see no evidence of consolidation taking place and if anything there is likely to be still more across Europe.”

However, CCPs are there to manage risk and at the top of the list should be making sure that they remain risk-mitigators for the market, so while Mr Cameron believes that interoperability would be a positive move in principle, it has to be introduced in such a way that it will not increase risk.

Currently interoperability only applies to CCPs for cash equities, and there is no indication that CCPs will be able to request interoperability for OTC derivatives. Interoperability is dependent upon the CCPs getting trading feeds from the exchanges and platforms, and the fact that some of the market infrastructures operate within silos would limit the number of connections.

Besides, Florence Fontan, head of public affairs at BNP Paribas, says that managing interoperability between large numbers of CCPs would be very difficult. She says: “Interoperability would mean the CCPs are exposed to each other. It can be managed between limited numbers of CCPs. But even between two, it changes the dynamic, let alone between 20. With so many CCPs it is not a viable solution, both in terms of risk and the cost of building links."

Still evolving

Unlike the US, Europe is not imposing mandatory execution of OTC derivatives on electronic platforms, but it may come in the Markets in Financial Instruments Directive II (MiFID II). European Market Infrastructure Regulation is only dealing with post-trade. The draft form of MiFID II is slated to be published in October this year.

Ms Fontan says that the world of OTC derivatives is going to change significantly in terms of market organisation requiring mandatory clearing on CCPs for "eligible transactions", and even bilateral trades will require trade reporting and collateralisation. This is a major change for the sell-side, and the buy-side. The buy-side will have to build a new back office to connect to those new infrastructures and to be able to interact more and on a regular basis, with its counterparts, whether its transactions are CCP cleared or remain bilateral.

Also, there will be an additional cost due to the need for increased collateral. Ms Fontan says: “Traditional buy-side firms will need to put up collateral, either to support mandatory clearing, or for bilateral trades, counterparts will be required to add collateral. Optimising collateral adds a new layer to buy-side operations as well as the increased requirements to have independent mark-to-market of OTC products.”

Questions remain

No one really understands what happens if a CCP goes bust. The problem is, from a risk point of view, with so many CCPs under different regulatory environments, no one really knows what the regulator would do, and which regulator would act on some of them. A lot of questions remain.

Other question marks exist around the issue of specialisation. Mr Cameron says: “If someone is an expert in equities and they have to become a member of a CCP that is actually focused on pork belly futures, then it is very hard for them to access the risk profile of that CCP and we think it makes sense for the risk categories within each CCP to remain separate.”

Furthermore, Mr Cameron says CCPs are being asked to take on additional functions, and it is important to ensure that they are comfortable with the risk they are taking on when being asked to clear OTC products, and that their members understand and want them to take on this risk as well. He says: “It is all very well for the regulators to say that everything should go into a CCP, however, who decides what is eligible for clearing is not so well-defined.”

Unlike equities clearing, that roll in and roll out of a CCP in three days, clearing OTC derivatives can mean the CCPs are taking on some very long-dated risks, and the risk is higher where the instruments are less liquid. “So it is important that they don’t get bullied into taking risk on that they don’t feel comfortable with,” adds Mr Cameron.

Risky business

Creating new risks with so many infrastructural changes is a concern in the industry and Mr Cameron says regulatory demand that this is margined for is prudent and has rightly been reviewed. “Taking long-dated illiquid instruments into CCPs is certainly a new risk that must be managed.” But in the long run, Mr Cameron believes the new infrastructure will foster and improve business rather than hamper it. “All the players have a huge focus on decreasing costs, particularly fixed costs, so we are looking forward to seeing the costs go down,” says Mr Cameron.

It has yet to be decided whether CCPs will adopt gross or net margining and whether clearing members will be allowed to net off the positions of their customers and their own house position. Rory Cunningham, director of public affairs at LCH.Clearnet and chairman of Each, says that the decision about margining is more about future account maintenance at the CCPs. He says: “The current debate is really around whether there should be individual client segregation or omnibus accounts in clients of clearing members, and whether there will be a separate account maintained at the CCP for their positions, or if they will be all maintained in an omnibus account.”

LCH.Clearnet launched client-clearing for interest rate swaps in 2009 through SwapClear. Individual client accounts are, on request, maintained separately but as a general rule in most markets, it is an omnibus account, margined on a net basis across all the clients, which is what happens in the futures and securities markets. LCH.Clearnet is currently building a clearing solution for FX products, which is due to be launched by the end of the year. 

Mr Cunningham says: “LCH.Clearnet’s position is that CCPs which are clearing OTC derivatives should be required to offer these legal protections at the individual client level. This is partly because this is where problems arose during the Lehman Brothers default. Also, given that customers will be mandated to clear these products, it is important that the structures are as robust and protective as those covering collateral posted bilaterally.”

Changing landscape

One of the biggest impacts the newly emerging market infrastructure will have on the industry will be the increased focus on collateral. Mark Gem, head of business management at Clearstream and a member of its executive management team, will be speaking at Sibos on the topic of 'Securities regulation: How to turn threats into opportunities'. The key message for the Sibos community is that the current wave of regulation combined with Target2 for Securities (T2S) in Europe will significantly impact the post-trade landscape. “This creates challenges and opportunities for all market players. Some will be directly confronted with increased pressure as settlement is being commoditised, regulated activities are made more restrictive and collateral and capital requirements are increased,” he says.

As both a CSD and an International Central Securities Depository (ICSD) providing custody in 52 markets, Clearstream will offer customer solutions to ease compliance with the new regulatory environment that will cause the cost of exposures to go up and lead many market players to re-evaluate their collateral management practices. Mr Gem says: “The strong growth in our collateral management services is expected to continue and intensify. When signing up, customers often report on the heightened importance and internal visibility of collateral management discussions. Collateral management is also seen as an increasingly decisive factor when considering where to deposit assets. Market players seek to ensure that their custody arrangements enable optimal use of collateral.”

Mr Gem believes that margining collateral offsets, whether in OTC or exchange-traded derivatives, actually provides an incentive to move to central counterparty clearing, regardless of the regulatory requirements. Clearstream can act as a collateral venue for derivatives clearing organisations and to support reporting systems. He says: “The market needs to recognise the need for collateral management to become a strategic liquidity management function and not an appendage to each trading desk.”

Mr Gem argues that the market’s focus in the past was on reducing transaction and securities holding costs for clients, but now there is greater emphasis on the cost of collateral and how to manage it. “Not being able to deploy collateral is a much bigger cost than adding a few pips to the cost of a trade,” he adds.

Better balance

For many years, regulators and clients looked at market infrastructures predominantly from a cost and competition angle. Deutsche Bank’s Mr Steinmueller believes this is now much more balanced, with considerations around risk management. Regulation has increased the importance of market infrastructures with the most obvious example – mandatory CCP clearing as a pre-condition for trading – but the new world also offers opportunities.

Mr Steinmueller says: “Today, infrastructures compete by entering new markets or asset classes. Yet, they don’t necessarily compete by considering their different user base. Self-clearing in-house business or providing clearing on behalf of clients requires a different level of risk controls and we could see much more differentiation in how infrastructures approach clients acting for themselves or as intermediaries.”

Whether this process will lead to consolidation is an open question. New regulations are being considered that may impose additional capital requirements for infrastructures to cover their business risk. Therefore, competition driven by such measures as introducing interoperability is limited by the need to ensure that infrastructures operate in a safe and stable environment. The future environment, according to Mr Steinmueller, will depend on how that dilemma is resolved.


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