Virtually none of the established practices for trading and clearing derivatives will remain unaffected as a result of the implementation of European Market Infrastructure Regulation (EMIR) over the next two years. For some firms these changes are so daunting they will exit the business. For others the cost may inhibit their involvement. But every sell-side firm planning to engage in OTC central clearing is having to re-evaluate and often redesign aspects of their traditional business.
The disruption is partly mitigated by the long transition process, from early preparations in 2009 to pension fund compliance in 2017 and possibly longer. This is giving firms time to adjust many facets of their clearing business, including client pricing models.
“It is very clear that EMIR is directly increasing costs, in terms of new trade reporting, margining and collateral processing requirements,” says Barry Polak, global head of products, ABN Amro Clearing. “But clients are broadly sympathetic to the new fee levels which are required as a result of EMIR.”
Barry Polak, ABN Amro Clearing
Whereas trade reporting deadlines have now passed, the next major phase following the completion of the ESMA central counterparty (CCP) authorisation programme will be the implementation of mandatory central clearing of OTC instruments. The impact of this will affect every stage of the trading and clearing process, from client agreement documentation, through trading, systems, margining and collateral management.
This fundamental reorganisation of the OTC business will also create opportunities for established clearing firms, argues Polak, but it may not lead to an enlarged community servicing that business. “Alongside EMIR we are also facing much higher capital costs from Capital Requirements Directive IV and Basel III, specifically, higher Tier 1 capital requirements, which will have a direct impact on return-on-equity numbers.” he suggests.
Some banks may consider the return does not justify the investment. Bank of New York’s decision to exit exchange-trade derivatives (ETD) clearing in the US in 2013 was followed in 2014 by a similar move in Europe where the decision to exit OTC clearing was attributed to delays in implementation to 2015-16 leading to a lack of prompt return on the investment. Other banks have rushed to cherry pick big OTC clients, leading to concern that smaller clients might not be serviced as that business would be unprofitable against the cost.
That concern may be misplaced. “Many smaller clients will have simpler needs in terms of overall volume, product mix, CCP venues etc.,” says Jamie Gavin, Newedge’s head of institutional OTC clearing sales for the UK. This allows brokers to accommodate their business flow relatively straightforwardly. But they will still “have to conform to the compliance requirements for their legal systems, collateral and funding. There may therefore be some rush to compliance as EMIR deadlines approach, but we are already seeing good enquiry traffic from a broad range of international clients, including from outside Europe.”
Some of the burden of compliance has also been reduced by industry-wide initiatives. The established OTC business was already used to some level of standardised client agreement via the ISDA master agreements. Efforts to tweak these for OTC central clearing have not attracted much support. Instead efforts by the European arm of the Futures Industry Association (FIA Europe) to extend futures clearing documentation into OTC are finding traction.
“FIA Europe has produced numerous industry templates for the execution and clearing of swaps under EMIR, segregation models for exchange traded derivatives and cleared swaps, and risk disclosure statements,” says Simon Puleston Jones, CEO of FIA Europe. Work is already underway to bring all these together both for EMIR and MIFID II purposes in 2015.
Such initiatives do not tick all the boxes though, says Gavin. “Newedge’s offering of OTC-ETD cross product margining requires some adjustment of this standardised paperwork.”
But the largest changes required by the industry are undoubtedly in client margining and collateral management for OTC central clearing. Highly geared OTC products tended not to operate on collateralised margin, and never with daily variation margin. Both of those are core features of ETD clearing. The implementation of mandatory OTC central clearing will sharpen the focus on these activities.
The credit crisis has been moving this trend towards a more collateralised trading regime anyway but now specific aspects of CCP practices need addressing, says Eugene Stanfield, head of derivatives execution and clearing services at Commerzbank Corporates & Markets. OTC clients, he notes, “will need to set up accounts for same-day margining, systems of handling margining in different currencies, and even adjust to quite basic issues as bank holidays.” CCPs in international markets ignore some national holidays which domestic clients observe. Clients will need to be able to accommodate margin transfers on such dates.
Some of these adjustments will be easier for some clients than others. Initial margin is usually in the form of assets but variation margin is almost invariably cash. However, “Some clients, such as a fully invested or geared corporate bond fund, may have neither the underlying asset [acceptable to a CCP] nor the cash for both the initial and variation margin. In that instance we work with them to resolve that, for example, by developing their repo and financing capability.” says Gavin.
The main operational choice facing clients adopting a clearing regime for the first time concerns account segregation. The somewhat opaque ESMA CCP authorisation programme required CCPs to detail their client account segregation models and asset protection schemes before authorisation was granted. Most CCPs only received their authorisation green light in the second half of 2014, which hasn’t given clearing brokers much time to get to grips with the different models. At one time it was estimated that upwards of 15 different segregation models would be available from Europe’s CCPs.
Broadly, however, it comes down to clearing brokers offering individual segregated accounts (ISAs) where individual client assets are isolated, or omnibus segregated accounts (OSAs), where client assets can be commingled with other clients but not the broker’s. Initial responses from clients seemed to indicate a preference for the security of ISAs. But as mandatory clearing approaches OSAs are gathering support.
“New services will incur new costs,” Commerzbank’s Stanfield adds. “Certain choices, for example between ISAs and OSAs, are not simple binary either/or decisions but part of a broad-based adoption of the new regulatory requirements. Early expectations that clients would routinely adopt ISAs are now evolving into a broader recognition of the virtues of OSAs.”
The cost of clearing
Gavin agrees. “There is a growing comfort level with the gross omnibus margin model, partly because clients are becoming better understood and partly because the initial client fear of fellow customer risk is being ameliorated by the segregation of their assets at the CCP, though not all CCPs offer that,” he said.
The growing preference for OSAs also clearly reflects their lower fee levels. “Clients looking to engage new clearing brokers, and most will generally appoint two or three, will assess different offerings according to a range of factors, such as support models, the ability to provide what if assessments, margin simulations, collateral optimisation schemes, fees, IT etc. Fees are a major factor, although clearly different clients will have different needs depending on the complexity of their requirements,” says Tony Sodhi, managing principal at GFT, which advises both sell-side and buy-side firms on clearing and brokerage and clearing services.
“Clients are becoming more relaxed about OSAs. The cost variances are significant, with one CCP pricing ISAs at three times the costs of OSA gross. Given the proliferation of accounts in different currencies that may be required by a typical asset manager or hedge fund this is a significant differential.” he notes.
It may not always be a question of election though, says Polak. “Some institutions have articles of association which prohibit them from using pooled risk products, or who genuinely prefer full segregation. But increasingly the transparency and new asset security of lower cost OSAs is attracting institutions.”
Tooling up for these new procedures is also occupying sell-side time and investment. “Around 10% of ABN Amro’s IT change budgets recently have been dedicated to EMIR compliant processes such as trade reporting systems and new connectivity to trade repositories,” indicates Polak.
How the IT sector adapts to EMIR-affected markets is by no means clear however, in particular whether OTC or ETD practices are the more transferable. Established IT regimes for ETD would seem to provide a good base for OTC markets. Matt Streeter capital markets strategist at FINCAD, a markets infrastructure consultancy, notes that “Given their ETD experience vendors are leveraging their existing range of products for the new cleared OTC market. Reconciliation, margin and collateral management systems for ETD markets, for example, can be leveraged into cleared OTC.”
GFT’s Sodhi sees things differently. “The traditional complexity of OTC instruments makes it challenging to adapt ETD vendor products for the OTC market. However existing derivatives system vendors are offering configurable solutions for the changing OTC landscape. They are developing mechanisms to standardise matching/affirmation, messaging, margin calculations and so on, towards higher levels of STP. This has been evolving in vanilla products for some time but it’s gradually progressing deeper into the product mix as OTC clearing develops.”
Some lack of agreement on such points at this stage in the transition towards OTC clearing is probably inevitable. Over-arching regulation by political dictate was always going to throw up inconsistencies and exceptions. But on one point the industry is completely agreed – it’s going to cost more.