As regulatory change continues to take hold of banks’ profits, clearing fee structures for buy-side firms are estimated to increase this year to deliver 14-15% return on capital, up from the current 1-2%, argues consultancy firm Catalyst.
Incoming rules such as central clearing for OTC derivatives in Europe and leverage ratios set out in Basel III has placed higher emphasis on profitability and relationships with clients.
Last year saw major banks such as RBS, BNY Mellon and State Street withdraw from the clearing space in Europe.
However, for those sell-side institutions that remain in the space, it has placed them in a powerful negotiating position with hedge fund managers to charge higher fees to stay profitable.
“Today, FCM/Clearing broker cost of capital is over 12%, with brokers targeting a return on capital of 14-15%,” Catalyst states in a recently published white paper. “Average to large hedge fund fees will need to increase eight to tenfold for clearing brokers to make a profit on capital.”
According to the consultancy firm, any hedge fund that uses less of their bank’s capital will bear less cost, enabling more efficient access to trading and liquidity.
To avoid the prospect of higher costs from clearing brokers, Catalyst argues hedge funds should buy into ‘trade compression’ services, which it claims could save tens of millions of dollars a year.
Compression services effectively ‘tears up’ contracts with notional values amounting to trillions of dollars by combining other trades with compatible characteristics, thus using less of the bank’s balance sheet.
Catalyst also argues the same compression tools can be used to lower execution costs.
“The same tools can be used to rationalise the number of trades a fund needs to enter into, as well as to roll the book forward more efficiently where necessary… This typically offers further savings of $3 million a year in execution fees.”
Last year as of October, London-based LCH Clearnet’s interest rate swaps clearing business, had processed swaps valued at a notional of $406.9 trillion, compared to $426 trillion at the start of the year.