Managing the cost of clearing

As new rules governing swaps clearing draw closer, the buy-side will have to ramp up its engagement with clearing houses to find the right balance between the management of costs and risks.

Why does the buy-side need to engage with clearing houses? Isn’t this normally done on its behalf by brokers?

As per new OTC derivatives rules, central counterparties (CCPs) will occupy a larger portion of the trading landscape and have a significant bearing on the cost of trading swaps.

The influence CCPs have on the new swaps trading world requires the buy-side to have a detailed understanding of their processes, to ensure their collateral is properly managed.

The rules require central clearing of OTC derivatives, requiring a more formal approach to collateral management than was previously required under bilateral relationships. This includes posting initial margin for the first time and variation margin – giving CCPs the ability to call for margin multiple times a day.

Dealings between CCPs and the buy-side will still largely pass through a broker, but CCPs will be able to ask for increased collateral multiple times per day.

Clearing brokers will initially manage the collateral burden on their clients’ behalf, but key functions of a clearing house need to be assessed so the buy-side can select partners that best meet their needs in the new environment.

Without detailed information, institutional investors cannot prepare fully for the new legislation and face greater operational risk.

The rules enshrined in the European markets infrastructure regulation (EMIR) and the US’ Dodd-Frank Act, also require OTC derivatives to be traded on exchange-like platforms.

What are the specific CCP capabilities the buy-side needs to assess?

The big issue is segregation of collateral. Article 37 of EMIR requires CCPs to offer the buy-side the ability to separate their margin from other clearing members within a CCP in order to protect their positions.

In the US, buy-side firms are opting for a model known as ‘legally segregated, operationally comingled’ (LSOC), which divides margin held by buy-side firms from clearing member contributions. If a clearing member or CCP were to go bankrupt, positions and collateral can only be transferred to another broker with the agreement of all participants in that pool.

Although segregation offers added protection, it diminishes the possibility of achieving collateral savings through netting, i.e. the ability to offset the amount of collateral paid on correlated assets.

Conversely, if a buy-side firm does not opt for full segregation, institutional investors may find it difficult to port positions to another CCP, in the event of default.

Clearing house valuations for the purposes of variation margin calculations also need to be assessed.

Under the new swaps rules, buy-side firms will not be able to dispute valuations with their CCP as they could under bilateral deals, requiring them to be confident in a clearing house’s valuation processes.

As these new rules approach, how have CCPs performed so far in terms of preparing for buy-side needs?

CCPs have been criticised for not making adequate headway on forming the details these segregated accounts will take. UK buy-side trading body the Investment Management Association has called for clearing houses to speed up the process, as implementation of the rules draws ever closer.

The technical details that underpin EMIR will be finalised on 19 February by European policymakers, while in the US, interest rate swaps and credit default swaps will start being cleared from March.