What is the landscape like in the Nordics markets and what has the impact of ESMA’s July 2023 proposal on the clearing obligation been?
Kristine: As the regulatory landscape around clearing has intensified over the years, introducing amongst others the Uncleared Margin Rules (UMR), and the Clearing Obligation, we have seen an increasing demand for over-the-counter (OTC) clearing in the Nordic markets. This has predominantly been spearheaded by the larger financial counterparts (FCs), specifically in the pension scheme arrangement (PSA) segment. Whilst some clients have been clearing for a long period of time, others have used the time given from the temporary exemption from the clearing obligation to prepare their operational models for clearing and in some instances also to exchange bilaterally non-cleared initial margin (IM).
In the aftermath of UMR Phase 6 coming to an end, we see the large majority of Nordic PSA’s being connected to at least one interest rate derivative (IRD) clearing broker at this point, which holds true to our client base. Although some PSAs in the Nordic market currently only clear portions of their portfolios, we see an increased operational readiness of clients to take on more cleared trades, which is further incentivised by the upcoming Clearing Obligation. As our clients overcome the initial challenges of managing risk, collateral and liquidity related to central clearing, we see and expect an increased demand to diversify risk by connecting to more than one clearing broker and multiple central clearing counterparties (CCPs), as well as an increased focus on collateral optimisation.
What are some of the challenges that clients are facing around Phase 6 and what considerations are they making in light of these as they enter the cleared space?
Kristine: Transfer timing and access to cash remain some of the absolute largest hurdles to overcome for clients intending to clear, as the move from the bilateral to the cleared space significantly increases the need for sourcing cash in a timely manner with harsher obligations to meet margin calls. Even though some participants are initially working with posting additional initial margin at the CCP level to ensure that they are not as impacted by short noticed intraday margin calls, we also see a larger demand for quick access to liquidity in order to minimise these add-on amounts and optimise the use of collateral.
Another challenge is striking the balance between, on the one hand, the efficiencies gained in the clearing space through existing relationships, for example, by using current post-trade service providers to ensure synergies and cost optimisation in the operational flow whilst venturing into clearing. On the other hand, clients aim at reaching operational excellence reducing and diversifying counterparty risk, by considering the use of a constellation of local and global clearing brokers simultaneously.
Lastly, clients should consider the operational benefits of clearing as opposed to managing bilateral agreements against other counterparties. Shifting to clearing may introduce new costs both for clearing itself and for managing liquidity more actively than in the bilateral space. However, clearing also introduces other efficiencies that reduce risks through multilateral netting and lessens the administrative cost of managing multiple bilateral counterparty thresholds. Therefore, new participants should not look at the added fees so much as a trade-off for regulatory compliance, but rather consider it as an investment in their operational models through stronger operational resilience, lowered risk exposure, and collateral management efficiencies. In this light, Danske Bank sees OTC clearing as an integral part of our strategic offering as one of the few Nordic Clearing Brokers servicing our clients end-to-end and assisting them in future-proofing their operational models.
What do you observe are the main aspects specifically pension funds are considering regarding their overall clearing strategy?
Jens: In addition to the expiration of the derivatives clearing exemption next summer, EU-domiciled PSAs also need to be aware of the expiry of the temporary equivalence arrangement granted to UK CCPs. This equivalence permits derivatives exposure clearing at a UK domiciled CCP until mid 2025. Any clearing strategy past 2025 needs to incorporate the risk that the temporary equivalence expiries and, as such, consider a long-term strategy for derivatives clearing that addresses those concerns. On top of the 2025 deadline, the European Commission legislative proposal from December 2022 with the aim to strengthen the Capital Markets Union and to promoting clearing activities within the EU and thereby reducing reliance on third country market infrastructures gives an indication that active clearing accounts with EU based CCPs in several products are already required before the 2025 deadline. Based on the current understanding these products include for example Euro denominated OTC interest rate swaps as well as Euribor futures.
Preparing for these new requirements, Eurex offers a solutions-based service to PSAs. In partnership, we help clients navigate unfamiliar pathways and plan for an optimal approach to their cleared derivatives strategy. This includes optimising new and legacy exposures to reduce margin requirements and informing clients of the benefits of leveraging the Eurex’s repo product suite when looking to optimise funding costs and ensure access to liquidity particularly in stressed market conditions.
To support buy-side clients to start clearing OTC interest rate derivatives positions in the EU, Eurex complemented the CCP Switch Incentive Program with a buy-side focused program. The aim is to flank regulatory measures by stimulating client activation. The program rewards parties that clear their OTC IRDs at Eurex with an incentive award of up to EUR 50,000. All they need to do is fulfill certain milestones by clearing their OTC IRDs transactions with Eurex Clearing in 2023. Registration for this program is free and possible until 31 March 2023.
What would you say the advantages are of centrally cleared repo markets?
Jens: The centrally cleared repo market is the perfect tool to manage liquidity demand. It lets firms that are ‘asset rich’ meet their daily variation margin obligations in a cost-efficient way. Since 2008, cleared repo markets consistently demonstrated that they are a reliable liquidity source and a more robust alternative than the bilateral repo market in times of stress.
While more than 1,900 buy-side firms in the US already use central clearing for their US$ repo transactions, the European cleared banks-to-client segment with focus on Euro based transactions is just starting its growth phase. In the meantime, multiple buy-side firms already have access to Eurex’s centrally cleared repo market via its ISA Direct access model as it addresses concerns from pension funds to a large degree.
Accessing Eurex’s liquid and centrally cleared repo markets enables them to invest their cash safely or raise short-term funding. There is a wide range of more than 10,000 fixed income securities available, and they can trade with the entire universe of Eurex’s repo trading participants. That means access to more than 150 repo counterparts, ranging from commercial banks and central banks to sovereign debt management agencies. It’s a single facility, under a standardised legal agreement, with STP and without need for bilateral credit lines. We believe that funding needs and requirements are likely to increase. With our tried and tested toolset, we’re ready to meet the expected challenges on the horizon.
Do you observe an uptake in demand for EU based central clearing in the Nordics markets?
Sebastian: For institutions looking to on-board their first clearing broker relationship there has definitely been an increased focus on understanding the clearing operating model and the offerings being provided by both CCPs and clearing brokers, and indirectly also which clearing brokers are providing access to the clients preferred CCPs.
When it comes to EU based clearing, what we initially saw being a primarily regulatory driven demand, is now also becoming a more product and liquidity driven demand from some of the institutional clients here in the Nordic region. For PSAs that have taken advantage of the PSA exemption or an institution that will become mandated for clearing at a certain point, they will of course take into consideration any uncertainties to ensure they have a future-proof setup in place.
We do expect clients in general to demand a greater flexibility in the future in regards to which CCPs are available to them through their clearing brokers. Access to EU based central clearing is definitely something that has become more sought after and will likely become a licence to operate in the future for the OTC Clearing Broker community.
For Danske Bank as a provider of clearing services within the Nordic region, it´s important that we can continue providing our clients with regulatory reassurance by offering access to EU based clearing.