US asset managers are offering clearing houses a simple deal to attract more centrally cleared swaps trades prior to Dodd Frank’s pending deadline: give us better margin and collateral management opportunities and we will clear more trade through you.
If that demand is not met, asset managers expect to stick with existing bilateral trade relationships until forced otherwise, say industry observers.
Even though the LCH.Clearnet’s SwapClear recently cleared US$712 billion in end-user notional trades over the past two months (a 175% growth year-on-year over April 2012) and rival CME Group’s CME Clearing cleared $53 billion in IRS and credit default swap (CDS) trades in March (a four-fold increase over the previous month), these numbers are a drop in a much larger bucket.
According to 13 April’s Interest Rate Trade Repository monthly report, the last compiled by TriOptima before the Depository Trust & Clearing Corporation assumed responsibility for the repository, there were approximately 3.2 million IRS trades with a gross notional value of $298 trillion that involved dealer-to-dealer and dealer-to-client transactions. Of these, only 1.7 million trades with a gross notional of $199 trillion involved a central counterparty (CCP).
Paul Rowady, a senior analyst at industry research firm TABB Group, attributes dramatic growth rates in cleared IRS trades to a small base of trades that are being cleared rather than being executed on a bilateral basis.
Finding demographic information on which buy-side firms clear their IRS trades today is difficult, but Rowady estimates that the more active buy-side firms, including more sophisticated hedge funds, are experimenting with the process. “Hedge funds are used to posting more margins than pension funds, insurance companies or other asset managers. They have incorporated that increase in margin into their trading paradigm,” he explains.
Unlike posting a variation margin for bilateral trades, which changes as mark-to-market value changes and solicits margin calls when an investment is, say, US$250,000 or US$500,000 underwater, the centrally cleared model requires posting of initial margin as well as regular margin calls from the clearinghouse there after.
“You cannot get something for nothing,” says Ted Leveroni, executive director of derivatives strategy at Omgeo, a post-trade solutions joint venture between Thomson Reuters and the DTCC. “There are added costs that come with the mitigated risks of a centrally cleared model.”
Posting initial margin should not be a new experience for some buy-side firms, he adds. “The independently negotiated nature of bilateral agreements may result in one investment manager having a different collateral relationship with its broker than another investment manager. Some managers already post initial margins while others never have do.”
Besides the posting of initial collateral, the centrally cleared model currently lacks the ability for firms to net their positions, which is typical in bilateral relationships.
“[Pension funds, insurance companies and other buy-side institutions] cannot combine exposures to take advantage of margin relief like the hedge funds might do between futures and swaps, which would net out to a lower risk level,” says Rowady.
The major CCPs recognise that the central clearing model will strain the collateral supply, according to Leveroni. “All have plans in the works, some further along than others, to alleviate this.”
Three potential solutions to mitigate the coming strain on buy-side collateral include clearing houses accepting of instruments other than cash and certain sovereign debt as acceptable collateral, new clearing models that allow position netting and possible cross-netting of positions between clearing houses.
CME Clearing and SwapClear’s parent, LCH.Clearnet, already announced that they will accept gold as well as certain mortgage-backed securities as collateral. CME Clearing also accepts certain corporate bonds as collateral, but takes them with a 20% haircut.
Upstart clearing firm New York Portfolio Clearing (NYPC), a joint-venture between NYSE Euronext and the DTCC launched in March 2011, offers cross-margining of interest rate futures contracts traded on NYSE Liffe US with US Treasuries, agencies securities and repurchase agreements, cleared through DTCC’s Fixed Income Clearing Corporation (FICC).
In mid-March, LCH.Clearnet inked a memorandum of understanding (MoU) with NYPC to examine the possibility of combining NYPC’s ‘one-pot’ cross-margining model to include IRS trades cleared by SwapClear within the US market. Under the terms of the MoU, LCH.Clearnet, NYSE Euronext and the DTCC will examine potential operational and collateral efficiencies among the parties while agreeing to develop a an aligned default management processes. Any resulting agreements between the parties would need approval by the US Commodity Futures Trading Commission (CFTC), US Securities and Exchange Commission (SEC) and other regulators.
“Cross-CCP netting could offset some of the risk mitigation that clearing allows,” warns Leveroni. “If you can get through the hurdles of netting, that definitely has some potential to lessen the collateral shortage.”
No matter how the clearing houses plan to address the pending collateral strain, it will not be a quick process, say Rowady. “You cannot create novel clearing models overnight. They are complex relationships that require a lot of analysis, approval and licensing.”
US regulators are currently working to implement all of the new rules for the OTC derivatives market by the end of this year, as per commitments made by the Group of 20.