May 28, 2012
Buy-side braced for collateral challenge – The TRADE Poll
Readers of
theTRADEnews.com have overwhelmingly identified the cost of clearing and
collateral as the primary concern for institutional investors in light of the impending shake-up
of the OTC derivatives market.
Just over 54% of
respondents selected clearing and collateral costs as the issue money managers
should be most worried about, followed by 16% each for reduced hedging
opportunities and liquidity fragmentation and 13% for counterparty
management.
All four aspects
will be key considerations for buy-side firms as the new swaps rules draw
closer, but issues related to collateral have been thrust firmly into the
spotlight.
“Nobody is any doubt that the cost of doing
swaps business is going up,” said Jane Lowe, director of markets at UK buy-side
trade body the Investment Management Association. “The cost of clearing is a
large part of this as buy-side firms can no longer be as dependent on their
counterparties as service providers in this area. The question is whether is
this added cost is worthwhile, in terms of the additional security the industry
will get.”
Under the new
rules – enacted in Europe under the European market infrastructure regulation
and MiFID II – the demand for high-quality assets to mitigate the risk of
counterparty failure will increase exponentially. Many trades in OTC
derivatives, which have hitherto been largely traded on a bilateral basis with
no need for margin payments, will be transacted on exchange-like platforms and
centrally cleared. While some aspects of the regulation, i.e. the instruments
it will cover and the types of collateral that will be accepted by clearers,
remain unresolved, the International Monetary Fund estimated in a recent report
that up to US$3 trillion worth of extra collateral could be sought after the
new rules have been implemented.
Entering the new world
Ted Leveroni, executive
director of derivatives strategy and external relations at post-trade processing firm Omgeo, said
the results of the poll tally with client feedback.
“The cost of
clearing and collateral is a real and very new issue for the industry,”
Leveroni told theTRADEnews.com. “The other options in the poll are relatively
similar to others the industry has faced before, such as fragmentation of
liquidity and the ability to find appropriate hedges for tailored exposures,
which is essentially one of the buy-side trader’s core competencies.”
Leveroni added
the uncertainty in how market participants will change their derivatives
trading policies in light on the new rules further complicates the size of the
collateral challenge the industry will face.
“Following
implementation of the new rules, swaps trading could increase or contract,” he
said. “Some firms may opt for listed futures or options that require lower
collateralisation, while others may feel more comfortable using OTC derivatives
when there is a central clearing obligation. This makes estimating future
collateral needs very difficult.”
The danger of burdensome
collateral and clearing requirements could hit smaller firms or those that
typically trade a low number of OTC derivatives, claims Anthony Belchambers,
CEO of trade body the Futures and Options Association.
“If you assume margin
costs will rise to meet regulators’ countercyclical buffer requirements, margins
could be called more frequently as risk management moves into real time, collateral
transformation services could become extremely expensive if there is a
collateral crunch and that clearing members may have to increase fees to make
their business viable, it is clear we are reaching a tipping point,” said
Belchambers. “Buy-side firms will be faced with the decision of taking risks
that are unmanaged, or pricing this risk into their fees and passing this on to
end-clients.”
While admitting
that issues around counterparty risk aren’t being as closely scrutinised as
collateral, Belchambers added the buy-side is thinking about how to manage
their counterparty obligations.
“Buy-side firms
and end-users will need to decide whether they prefer to take counterparty risk
with a recapitalised bank via title transfer or link to clearing houses
directly,” he said. “This is hard to judge at the moment and will depend on the
level of segregation firms opt for.”
He added that
when it comes to liquidity fragmentation, although competition between trading
platforms will be healthy for the swaps markets, the concept of best execution
could change to one that now includes certainty and likelihood of execution in
addition to finding the best price.
Anish Puaar
+44 (0)20 7397 3817
anish.puaar@thetrade.ltd.uk