At the Futures Industry Association’s annual London event in June 2015, Mark Woodward, vice president for corporate development at clearing house ICE Clear Europe said, “We are seeing increased interest in direct clearing [from buy-side firms] as a consequence of [brokers’] increased costs and capital charges.”
With mandatory clearing of over-the-counter (OTC) derivatives trades expected to begin under the European Market Infrastructure Regulation (EMIR) in April 2016, getting clearing arrangements addressed should be a top priority for asset managers.
Several European central counterparties (CCPs) are said to be weighing up a form of sponsored direct access to buy-side members, in order to work around capital and default fund rules. This type of model, already offered by ICE Clear Europe as a ‘Sponsored Principal’ account, allows the client to become a direct counterparty to the clearing house with separate position, margin and asset accounts. The direct posting of collateral with the CCP would prevent it being counted on the clearing broker’s book, and therefore being subject to a capital charge under the Basel III rules.
However, the need for a clearing broker to cover their client’s contribution to the buffer of collateral required by CCPs from direct members creates obligations that not all brokers will be happy to take on. With the full direct membership of a clearing house challenging for many asset managers, this new model may provide a solution to the perceived risks faced by existing clearing arrangements.
“There are clearing houses looking at these alternative mechanisms for people to have direct access, Eurex are discussing their model called ISA Direct with the market, whilst ICE offers the ‘sponsored principal’ membership and other CCPs will look to provide similar options,” says Eugene Stanfield, head of derivatives execution and clearing services at Commerzbank. “But what all of these types of memberships have in common is that they need some form of a sponsor, and one of the key requirements of the sponsor is their obligation to the default fund contribution on behalf of the client.”
The challenge
Buy-side faith in clearing brokers was shaken by the collapse of Lehman Brothers and MF Global in 2008 and 2011. These cases led to the requirement for segregated accounts to be offered to investment managers, so that the cash or bonds that they used to underwrite their derivatives trades could be secured against the failure of their broker.
Now the brokers are publicly questioning the economics of the clearing business as the Basel III capital rules increased their costs. The number of futures commission merchants (FCMs) in operation has been falling annually in the US, dropping from 83 registered firms to 73 in the 12 months to September 2015. JP Morgan halted the provision of clearing services to the hedge fund clients of its introducing brokers earlier this year, with estimates of up to 1000 firms being affected according to industry sources.
For the sell-side, a clearing broker’s contribution to the CCP’s default fund triggers the requirement for the clearing broker to capitalise that exposure under Basel III. That adds cost and can be seen as doubling up the protection for the risk.
“In the derivatives world we set out that a firm will hold a certain amount of cash or liquid government bonds in sufficient value to cover the mark-to-market volatility of open positions, cleared or otherwise,” says Richard Walker, head of sales and marketing for Swapclear at clearing house LCH Clearnet. “The challenge comes when you do both, if you put the collateral aside to cover that loss what is the requirement to hold lots of capital?”
The interest in direct membership therefore hinges upon several points. As a driver for direct membership there is the risk that clearing members might be unwilling to provide intermediary services on a cost-effective basis. Secondly the ‘surplus’ cost added to clearing brokers’ under Basel III makes a revision to the existing model preferable, if it can rework the economics of membership with harming the protection a CCP offers.
Despite these motivations for direct buy-side membership, a check against that is the capacity of an asset management firm to join a clearing house as a member under the current set of rules. The requirements for any firm to engage as a direct participant include a contribution to the default waterfall (see box above) according to each CCP’s own rules, and to report on prices at the end of each day. Even if these can be managed, the operational cost of becoming a direct clearer would have to be considered, in the connectivity the resources allocated to default contribution.
The broader umbrella of ‘buy-side’ certainly includes firms who are becoming direct clearing members – for example smaller banks that use derivatives to support their operations are reported to have taken direct membership of the CCP at German derivatives market operator Eurex, which declined to be interviewed for the article. However, direct membership of clearing houses by traditional asset management firms is a harder sell.
“There is no reason in principal why that shouldn’t happen and we have heard expressions of interest in exploring that option from very large institutional investors,” says Angus Canvin, senior adviser, regulatory affairs at buy-side industry body the Investment Association. “There doesn’t seem to have been much action there with a number of factors at play; foremost is that everyone in the market has an interest in in ensuring the current high standards required of clearing members are maintained. That is a significant commitment, not least the acceptance of loss mutualisation.”
For most funds it would be a step too far, says Walker, as they are not authorised to use their assets for purposes other than investment.
“I think it would be challenging for buy-side firms to become direct members; some of the larger funds may, but in general I think not,” he says.
That leaves the question of a sponsored membership open. ICE Clear Europe, which already operates a sponsored model, does not disclose the number of sponsored members. Although it is authorised as a clearing house, it is not as a CCP under the EMIR rules. Buy-side firms are waiting to see concrete proposals.
Next hurdle
There are operational issues that will need to be resolved if the model is to work. For example, if an asset manager has 100 pension funds as clients, each of those would have to become a member of the CCP. That would normally require the posting of default fund, but the pension funds could be exposed to the loss if another clearing member defaults and their initial margin and default fund contribution is exhausted. Most charters do not allow that level of mutualisation on and so it would be down to the broker to sponsor clients and make the default fund payment in behalf of those clients.
“If a clearing broker is prepared to underwrite that business all can proceed. Whether they are prepared to underwrite that business is a question for them,” says Walker.
Even then, he notes there could be a challenge for the CCP; if there are 100 pension funds behind an investment manager becoming members, each of those clients would be subject to due diligence, with the CCP look at all of the investment management agreements and their performance each quarter. CCPs tend to have high double-figure or low triple-figure numbers of members and are responsible for monitoring their credit.
“If you allow every single fund to join, now you would be talking about thousands, even the low tens of thousands of firms each making variation margin payments,” says Walker. “That is quite a scale challenge. I’m not saying it is not possible, but it would be a change in credit diligence and collateral topology that people need to be thoughtful and surefooted about.”
That operational pressure may have to be evaluated by the firms who are contracting with a CCP as managing that scale challenge may be a risk in itself. It is clearly a break from the traditional CCP model of dealing with a small number of high credit quality members.