The European Commission has effectively set the date of October 2016 for buy-side firms to become subject to mandatory central clearing, but should they begin earlier than that? Jonathan Watkins presents the arguments for both cases.
European regulators made another leap in terms of implementing central clearing rules for OTC derivatives last week, in a long and drawn out process.
The European Commission approved the rules set forward by Europe’s derivatives regulator, meaning mandatory central clearing will now take effect in Europe from April 2016. Buy-side firms will have six months from that date to comply with the new rules.
There are still a few formalities to go through, but this is the most clarity the market has had in terms of a fixed date in some time.
“Happy to say that following the adoption of the rules by the Commission we hope that there are no further delays on route through the Parliament and Council so that the market has certainty on the timetable for implementation,” said Sebastian Reger, partner at law firm Sackers.
So while most asset managers won’t have a choice but to clear from the end of Q3 next year, should they begin clearing early?
YES
It may not be compulsory to clear OTC derivatives right now – or even in the next 12 months for that matter – but there are some significant benefits to starting clearing early, which the buy-side need to consider.
As shown in the financial crisis, bilateral trading carries a greater risk than other more regulated markets and this can be avoided through the use of central counterparties (CCPs) and stricter new rules around collateral. The reforms may be increasing the cost of trading, but they are providing protection and safeguards against a repeat of what happened during the financial crisis.
SimCorp, provider of investment and portfolio management software and services to the buy-side, believes that a move to central clearing early is ‘compliance friendly’ with compliance teams looking more favourably on cleared contracts given the lower risk, giving investment managers more flexibility to hedge and trade with these tools.
While margins are now a concern for both cleared and non-cleared trades, the use of CCPs allows for netting and offset opportunities. This will reduce the amount of collateral firms need to put up.
The first products in line for mandatory central clearing are interest rate and credit default swaps, and while firms may not be obliged to clear products like inflation swaps, it makes sense to clear these products alongside rates trades in order to benefit from efficiencies and avoid bifurcation.
The buy-side has had plenty of time to get to grips with the changes which have been in the pipeline for five years, allowing them to understand the requirements, get internal procedures in place and secure arrangements with clearing brokers if they want to clear early.
Some major firms also operating in the US will have the central clearing pipelines in place in order to comply with Dodd-Frank.
While the price and effort of preparing early may seem a deterrent, there are cost benefits to begin clearing now. Even for some pension funds who have been given at least a two-year exemption, if the liquidity is with the cleared markets this could be the more desirable place to trade.
NO
The end of 2016. That is the date that the buy-side should have in their diaries for clearing interest rate and credit default swaps, and until then there is plenty of other business to attend to.
After years and years of regulators crying wolf and promising that central clearing regulations would come into force, the buy-side is deciding to address this issue when the implementation dates are set in stone.
Anyone who signed up with RBS, BNY Mellon or Nomura as a clearing broker will vouch for the fact that rushing to sign up a clearing broker didn’t benefit them. If there is still over a year to prepare legally, operationally and ensuring the appropriate connectivity in place, then this is plenty of time, right?
At a recent Euroclear Collateral Conference, buy-side firms said they did not see the use of clearing derivatives at the present time.
One buy-sider said earlier today that the buy-side “don’t have the luxury to build models around a hypothetical landscape that could be around in five years time”.
An audience response showed that while 42% believed the benefits of cleared derivatives are clear and have a very positive impact, 29% said they had no plans yet and only 14% see the shift from uncleared to cleared derivatives to represent a 50% change for their business.
In the US, many firms began clearing on the first day of the mandates coming into force, Europe may well be the same.
While there is liquidity in the bilateral space, and higher margin requirements haven’t come into force, it seems unnecessary to clear right now. Undoubtedly the rules will reduce systemic risk in the market and there will be benefits in the long-run, but if the efficiencies and cost savings of clearing aren’t obvious right now, then waiting for the rules to become mandatory may be the answer.