European Commission (EC) plans to migrate OTC derivatives to clearing via central counterparties (CCPs) will make the market more secure, but could hike trading costs for buy-side firms.
Unlike the present bilateral model for clearing OTC derivatives trades, central clearing will require the provision of fees to CCPs and clearing members which process OTC transactions. CCPs will also require an initial margin to be put forward by fund managers. And because the assets used for the margin must be either very high grade government debt or cash, funds will have to convert assets they hold as part of their mandate to meet margin requirements.
The CCP proposal is one of a number of measures designed to increase market transparency contained in the new European directive on OTC derivatives trading unveiled by single market commissioner Michel Barnier on 15 September. During the financial crisis, many market participants were found to have excessive exposures to certain derivatives which also proved difficult to unwind due to unsatisfactory record-keeping.
In derivatives trading, CCPs operate by becoming one side of every trade, eliminating the buy-side firm's counterparty risk to its broker and providing an audit trail for market activity. However to operate this model, CCPs require trading firms to put assets forward as a margin in case of default.
When a default occurs a CCP uses the margins posted by a defaulting clearing member before using other financial resources to cover losses. If the margins posted by the defaulting clearing member can not cover the losses incurred by the CCP, the CCP uses the default fund contribution of the defaulting member to cover these losses, then those of non-defaulting clearing members and its own financial resources held for the purpose.
The EC does not appear to have understood that this will be a new burden for the buy-side, says Jane Lowe, head of markets at UK fund industry body the Investment Management Association (IMA). In the EC's impact assessment, it states: “A fund that enters in an OTC derivative contract already has to put up both initial and variation margin for the OTC derivatives contracts it enters into. This would not change in a CCP environment.” Lowe notes that in general, initial margin currently only applies to hedge funds rather than to all fund managers.
The CCP clearing model will have a worse effect on fund managers than other market participants says Jacqueline Walsh, head of the derivative development group at fund manager F&C because of the nature of their trading requirements. “The buy-side mainly uses one-directional trading so we will not get the benefits of netting trades, and consequently cannot offset the initial margin requirements as the banks can by having multi-directional trades,” she said.
Not only do these margins add new cost to the derivatives trading process, but fund managers will have to substitute assets from client mandates to secure assets which are eligible as collateral for the initial margin and variation margin. “Approximately 10% of your portfolio is an immediate cost in government bonds for initial margin. If you have a corporate bond fund, it now has to source government bonds for its initial margin and additionally need to source cash for its variation margin on a daily basis.” says Walsh.
Combining this 10% margin with, for example, Anglo-French CCP LCH.Clearnet's 10 basis point fee to cover initial margin, and five basis points in fees charged by the clearing member and CCP, would mean that a £100 million trade could quite easily end up costing a fund £15,000 before any other costs are accounted for, explains Walsh.
Comparatively in a bilateral agreement the fund can deliver assets of its choosing as collateral, which are returned once the fund no longer has that exposure. If cash is used as collateral the fund will receive interest, usually on an overnight rate. The only cost would be paying the spread.
The IMA's members accept they should pay margin, says Lowe, but she emphasises that the allowable margin, how it is held and by whom are extremely important factors relating to the security of assets and overall performance of the funds. “This has not been dealt with adequately for investors in the proposed legislation,” she says.
Steve Wood, founder of Global Buy-Side Trading Consultants, says the fund management industry should push for other assets to be considered. “You will need some aggressive lobbying of regulators by buy-side to consider other instruments but they will have to box cleverly, it has to be very focussed on line of collateral which can’t be expanded on or manipulated,” he says.
Over time, Wood believes that competition will drive down costs, however for the moment he says, “If you want fungibility between CCPs the costs are a cross that has to be borne.”
The proposed legislation is currently being considered by the European Parliament and member states, with an expectation that it once adopted it would apply from the end of 2012.