How might buy-side clearing costs increase following OTC derivatives reform?
With many OTC derivatives migrating to exchange-like platforms, buy-side firms will need to centrally clear trades they didn't have to previously. The primary outlay relates to the need to post initial margin to cover OTC derivatives positions and manage variation margin, i.e. the amount of collateral required by a central counterparty to cover changes in an instrument’s value.
The centralised clearing of standardisable OTC derivatives is meant to help achieve the Group of 20 goal of reducing systemic risk in the financial market, through use of more formalised structures that encourage transparency and require firms to take more responsibility for their swaps exposures. The three core pillars of the G-20’s plan called for exchange-trading and central clearing of swaps that can be standardised and better quality trade reporting. Separately, higher capital charges will also be levied for exotic swaps that cannot be standardised and remain bilateral, while Basel III could limit banks’ ability to facilitate such deals.
How much more collateral will be needed?
It’s hard to be precise. New clearing obligations could both encourage and discourage trading in the new OTC landscape, as firms see the instruments as safer, or conversely, too expensive for their hedging or exposure requirements.
But one thing is for sure. Compared to the sometimes minimal costs the buy-side pays now under bilateral agreements, the increase for some firms could be astronomical.
The International Monetary Fund estimated in a recent study that US$300 billion worth of new collateral would be needed to support existing swaps positions. This figure was calculated on a netted basis, which means that if clearing houses do not interoperate effectively, the amount could rise to an breath-taking US$3 trillion.
Right now, initial margin is rarely requested under bilateral deals and custodians handle the variation margin requirements on a OTC swap trade directly with the end-client.
From having almost nothing to do from a clearing and collateral perspective, the buy-side now has to take on this collateral burden and figure out the best way to manage access to clearers, which could require a total revamp of internal processes.
Where will the industry find this extra collateral?
Good question. It is important to remember that the jury is still out on the type of collateral regulators will demand, but many expect the list to include cash and highly-rated bonds. Certain clearing houses have broadened the assets they accept as collateral, such as gold bullion and some forms of corporate debt. However, central counterparties are building this list slowly, so that risk does not creep back into the system.
But many industry observers are worried that there is simply not enough good quality collateral to go around. The issues faced by various European economies means that sovereign bonds that were once considered safe are now seen as risky, further reducing the options available for meeting collateral requirements. As economic woes continue, the amount of acceptable collateral will fluctuate.
How prepared are the buy-side to meeting clearing and collateral demands?
The ability to meet collateral demands will largely depend on the type of buy-side firm you are. A boutique asset manager or hedge fund wont have as many assets on their books as an insurance money manager that typically has a larger inventory to put to work, for example.
Solutions to help firms optimise their use of collateral have recently emerged from the likes of Euroclear, Omgeo and SunGard, while brokers are offering collateral transformation services, leveraging the assets they hold on repo and securities financing desks.
But it’s likely that most buy-side firms will take their time. Since Lehman’s collapse, end-clients have demanded that the buy-side shore up their processes, which they have done through restructuring of credit support annexes, beefing up internal and counterparty risk controls and tighter management of collateral. This means the systemic risk issues perhaps aren’t as evident as they were pre-Lehman.
The buy-side could also find it tough to share the cost burden of the new clearing obligations with its end-clients.
The sentiment among long-only firms seems to be, why rush for no obvious commercial benefit? According to one head of trading at a large asset manager, his firm had set a timeline of 18 months for revamping internal process.
Change and higher costs are coming, but maybe not as soon as you think.