The trials of separation

Despite a likely delay to the enforcement of new OTC derivatives rules in Europe, Renaud Huck and Stuart Heath at Eurex believe buy-side firms must soon make decisions on how best to protect their clients’ assets.

Segregation gives the buy-side the ability to legally and operationally split their collateral and exposures from other clients of the same general clearing member within a clearing house. Eurex, which is the derivatives exchange owned by Deutsche Börse, has offered segregation for the listed derivatives it clears since last August.

“Our intention is to extend the fully segregated service we offer for listed derivatives for the OTC derivatives we plan to clear, which will offer the buy-side the highest level of protection for their swaps exposures,” said Heath, who heads Eurex’s representative office in the UK.

Under the European market infrastructure regulation (EMIR), many bilaterally traded swaps will be standardised so they can be centrally cleared and traded on exchange-like platforms. Article 37 of EMIR requires central counterparties (CCPs) and their clearing members to offer the buy-side ways for them to segregate their collateral and positions.

While Eurex has begun engaging with institutional investors, other CCPs stand accused of providing insufficient detail on segregation arrangements, thus hampering preparations for the new rules.

Eurex’s full segregation model splits the collateral and positions of each fund that uses the clearing house from other participants. This means that the exposures of each fund are kept separate from their clearing members and CCPs, allowing them to easily port positions to other entities in the event of a default.

Clearing member risk 

Heath asserts that the need for segregation lies more with the risk associated with the clearing members themselves, rather than CCPs.

“Each buy-side fund could have more than one clearing member associated with it, so although only part of that portfolio is at risk, you don't know who the other clients of that clearing member are,” he says. “You could be the most conservative fund in the world but there is no transparency as to what other entity is in the same pool and the risks they may pose.”

Eurex also plans to offer an omnibus segregation option that will bear similarity to the “legally separated, operationally comingled” approach detailed by US regulator the Commodity Futures Trading Commission.

Under this approach, all of a buy-side’s fund exposures, as well as those of other buy-side firms in some instances, are separated from clearing member contributions. If a clearing member defaults, positions and collateral can only be transferred to another firm if all clients in the pool agree, which is considered unlikely.

“Ideally, all firms would opt for full segregation but it can prove quite expensiveand operationally cumbersome, particularly for those buy-side firms that run a large number of funds,” says Huck, head of UK institutional investor relations.

Cleared for clearing 

Eurex has also begun work on deciding which products it will consider eligible for clearing. This is a process each CCP will be required to carry out in conjunction with regional watchdog the European Securities and Markets Authority (ESMA).

CCPs will first need to decide what they are able to clear and then seek final approval from ESMA.

Eurex announced on 31 May that it plans to rollout EurexOTC Clear for interest rate swaps, the largest and generally most liquid type of swap, in the second half of this year. The launch will be supported by Barclays, BNP Paribas, Citibank, Credit Suisse, Deutsche Bank, J.P. Morgan and Morgan Stanley.

Huck says the main driver for clearing other instruments is risk.

“Our primary consideration when deciding what should be made clearing eligible, is whether we are on a position to accurately value and assign a daily mark-to-market price for OTC derivative instruments,” says Huck.“There are a number of instruments that do not trade frequently and are relatively illiquid, and would therefore hamper our ability to effectively manage risk.”

Although some buy-side firms continue to express concern at the increased cost of doing business in the new, cleared world, Heath believes most are now preparing for the regulation in earnest.

“The buy-side now seem more concerned with the operational aspects of the rules, rather than the overall impact of the clearing obligation,” he said. “While it’s hard for the buy-side to have a full understanding of this given the regulatory uncertainty, they are taking steps to choose their partners in the new world.”

While the G-20 wanted new derivatives rules to be in place for the start of 2013, Patrick Pearson, head of financial market infrastructure at the European Commission, stated last week that Europe was unlikely to begin clearing by this time.