The seismic shift in the derivatives market post-financial crisis has seen not only a change in the way the products are traded and cleared, but also in the nature of relationships throughout the process.
The clearing of interest rate swaps was not completely alien to the buy-side prior to the financial crisis, however asset managers and pension funds were never directly attached to the clearing process of derivatives. With less clearing activity pre-2008, a middle-man between the clearing house and the executor made sense.
So imagine their surprise when asset managers were told that not only would they be clearing inflation swaps, single-name credit default swaps and repo, but they could actually become direct clearing members of central counterparties (CCPs) such as LCH, Eurex and DTCC.
Throughout 2016 and 2017, a number of clearing houses have established direct clearing routes to enable more buy-side volumes to flow through. Last year LCH onboarded the UK’s Insight Investment as the first sponsored clearing member of RepoClear, Eurex signed up signed Dutch pension fund PGGM as its first buy-side member for its securities lending clearing house, and in April Northern Trust helped facilitate the first directly cleared cash and repo trade on behalf of the Healthcare of Ontario Pension Plan (HOOPP) with Canada’s main derivatives clearing house.
Hedge funds were also one of the early movers into voluntary clearing, largely due to the margin efficiencies offered to them as opposed to trading in the bilateral market. Regulation has become one the main incentives for the buy-side to take up voluntary clearing of their derivatives. Dodd Frank and EMIR have made clearing for the most widely traded swaps mandatory, while the uncleared margin rules have made it too costly for the buy-side to stay in the bilaterally traded world.
“Currently there exists a price spread between cleared and uncleared derivatives,” says Rob Scott, head of custody and clearing, Commerzbank. “The commercial cost of operating in a non-cleared, bilateral environment is becoming increasingly apparent in terms of price and margin requirement. This is leading to increases and an incentive to voluntary clearing activities.
“The US NDF market has set a precedent by voluntary clearing through LCH ForexClear, and we will see the move in Europe to perform more voluntary clearing.”
LCH has posted a number of record-breaking achievements in cleared volumes, largely due to massive uptick in voluntary clearing of certain products from the buy-side. SwapClear, LCH’s interest rate derivatives clearing service processed over $873 trillion in notional volumes during 2017, with member and client flow increasing 31% year-on-year. It also saw over $3.1 trillion of inflation swaps cleared, meanwhile compression volumes rose 58% from 2016 to over $608 trillion.
“We’ve seen significant growth in volumes across multiple asset classes driven by new customers as well as additional flow from existing customers,” said Daniel Maguire, chief executive of LCH Group in January. LCH’s RepoClear service cleared $175 trillion over the course of the year, a 25% increase on 2016, while EquityClear processed over one billion trades and ForexClear processed more than $11 trillion in notional. The CDSClear service recorded $1.1 trillion in notional processed across its CDS index and single-names offering.
“The size of credit lines given for cleared trades rather than for bilateral is more favourable due to the credit profile of facing a clearing house, and they [hedge funds] are seeing better pricing in some cases,” says Jamie Gavin, head of OTC clearing EMEA and APAC, Societe Generale Prime Services.
“We also see new entrants, with broker-dealer clients who are facilitating trades between a pool of banks and hedge funds. That model previously didn’t work in the bilateral world due to capital reasons, but with clearing and the added benefits you get that is increasing.”
Now that mandatory clearing is entrenched in the OTC markets, more and more market participants are moving to a cleared market not because they are required to, but because that is where the liquidity is. Regulations such as EMIR and the uncleared margin rules have made it pricier to do business bilaterally, and instead have shifted focus to the benefits clearing offers.
“There has been a mentality shift in clearing derivatives,” says Kieron Smith, deputy head of prime services and financing at BNP Paribas. “Previously it was about clearing when it is mandated to do so, now it is to do with liquidity and feasibility to do so. The uncleared margin rules have caused a focus on the operational and simplicity benefits of clearing products.”
“The general view is that clients do not necessarily want to allocate the required bandwidth to handle the requirements of the uncleared margin rules. Clearing may be more expensive on face value, but in the long term it is cheaper.”
This is most evident in the FX market, in which 40-50% of the FX non-deliverable forward (NDF) interdealer market has moved to clearing over the past year. Societe Generale’s Gavin believes the next big asset class to move to clearing is FX options and repo. “We expect FX options will follow the same trend. The big one coming next is around repo, and the we are seeing demand from clients wanting to become sponsored clearing members,” adds Gavin.
For pension funds that are currently exempt from EMIR, repo clearing is becoming increasingly attractive to them, as with the case with PGGM joining Eurex as a clearing member and Insight Investment with LCH’s RepoClear. According to Nick Gant, head of sales trading and EMEA head of fixed income prime brokerage at Societe Generale, pension funds and money market funds, as opposed to hedge funds, have been the early adopters of this model.
“Some buy-side like the cleared model due to concerns around current market capacity. The counterparties most active in pushing have noticed an improvement in pricing for longer-dated repo trades,” he says. “This set-up is good for the larger players that have the infrastructure in place. They are having the balance sheet and liquidity benefits, and for the smaller players that can’t manage multiple repo accounts, it gives them a better liquidity profile.”
However, the extent to which all of the buy-side are taking part in voluntary clearing has been limited, says Nick Rustad, global head of clearing at JP Morgan, in which the majority of activity in NDF and inflation clearing has been the inter- dealer community.
“The banking and inter-dealer community has been active in non-mandated voluntary cleared trades, however you have yet to see demand from the client clearing side reach that level. For OTC derivatives, demand is still in those mandated categories i.e. G4 interest rate swaps, some emerging markets currency swaps and index CDS. The most client interest for non-mandated products are in instruments where there is a cost and liquidity difference at the point of execution. If that changes or you get to a point where banks only want to quote on a cleared basis, you may see a shift to voluntary clearing,” says Rustad.
Certainly, a lot of buy-siders have taken a wait-and-see approach, each one interested in moving to clearing but wary of being the first mover. Furthermore, smaller-sized asset managers and hedge funds may not have the infrastructure in place to clear their trades or even the tools to quantify the impacts of the collateral requirements on their portfolio and the cost differences in moving to clearing.
Commerzbank’s Scott believes it is up to their sell-side partners to provide these tools and help facilitate this move. “It is therefore incumbent upon the service community, i.e. custodians that offer clearing services, to be able to help clients in both understanding and impact assessment,” says Scott. “Once the commercial and counterparty risk benefits are better understood, there should be no reason why you wouldn’t move most of your activities and operate in a cleared world.
“Early on Commerzbank developed a ‘what-if’ scenario capability where clients can backload or frontload their portfolios and see the specific impacts in terms of balance sheet and pricing. However, across the buy-side community this capability is generally lacking, as they do not have sufficient tools and expertise to properly assess and for many it’s not mandatory for them to do so.”
It is also on banks and other clearing infrastructures to provide both the access and the capabilities for the buy-side to move into clearing. Direct clearing models are large step to help this, but take-up has been very slow. Furthermore, liquidity will continue to be one of the main determinations for where the buy-side clear and what banks they use.
“Given these new products are being established all the time, there are more clearinghouses expanding in to OTC. However, some clearers are struggling with scale, and this is where more client clearing volumes will concentrate with the top FCMs,” adds JP Morgan’s Rustad.
BNP Paribas’ Smith says it has become easier for banks to clear bilateral derivatives, given most banks went through a learning phase with the first set of products. However, there remains challenges on the risk management side for client clearing, such as whether the default management processes are appropriate for certain products.
“FCMs and CCP’s will have to adapt their products, but clients will want their banks to be able to clear a wide range of models and be involved in various access models to CCPs,” Smith says.
To a large extent, the ability to venture into voluntary clearing is there amongst the buy-side. The tools are there for the larger players that have the scale to clear their bilateral trades, but for many that are in wait-and-see mode, they will have to rely on their banks and brokers to migrate from bilateral to a cleared world. Furthermore, even for those larger asset managers, voluntary clearing will mean a rejig of broker relationships.
“For large and active OTC players this means that clearing is sometimes spread across multiple clearing relationships. The move towards voluntary clearing will lead to organisations being more strategic towards their clearing brokers and who they partner with,” says Scott.