CCPS TO THE RESCUE.
Mary Bogan assesses the new role of CCPs as banks withdraw under stricter banking regulation.
As Europe’s over the counter (OTC) derivatives business finally emerges out of the shadows and into the bright rays of lit exchanges, the demand for clearing services has taken a mighty shot in the arm. However, just as demand is ready to soar, the supply pipeline is spluttering. As the banks retreat from the market to nurse bruised balance sheets, how to fulfil mandatory clearing obligations has become a headache for clients. Enter to the rescue the once sleepy central counterparties (CCPs
Removed from the comfort of their protected markets and newly plunged into a fiercely competitive world, the drive to keep the clearing pipeline flowing and revenues rolling is stimulating new thinking at CCPs and producing fresh ideas which, they claim, will ease banks’ balance sheets, curb rising costs and open up new access routes into clearing for buyside clients.
The decision by regulators after the financial crisis to introduce mandatory central clearing for the $553tn OTC derivatives market looked like bonanza time for banks. As the main gateway into CCPs, they expected big volumes and juicy cross-selling opportunities from new OTC clearing services to clients. But not anymore.
“The financial landscape has been decimated over the past few years,” says Joshua Satten, director of business consulting at Sapient. “Volumes in the OTC space are at an all-time low, a lot of banks have gone down in value and successive delays to mandatory clearing in Europe have pushed potential investment returns further down the road.”
In the meantime, new Basel capital calculations, and the advent of the leverage ratio, has made clearing a much more capital-intensive and expensive business for banks.
“In response, we’ve seen some banks pull out of some aspects of the clearing market altogether while others are reviewing their client base and choosing to either turn away clients or even resign as clearing brokers for clients where there’s no potential for cross-sales or other commercial opportunities,” says Kevin Liddy of derivatives advisory firm Solum Financial. “In addition clearing costs, which have already risen by a factor of four to five in some cases, are on an upward path.”
As clearing business becomes concentrated into the hands of fewer larger banks not only does pricing power increase but, for the buyside in particular, a shrinking pool of clearing brokers also poses large risk issues around portability. In the event of a clearing broker going bust, some buyside clients could struggle to find another bank willing to take on their portfolio given the capital costs involved and find themselves closed out by the CCP.
According to Liddy, the changing clearing landscape means it’s time for clients to review their clearing arrangements and consider direct membership of CCPs.
“The decision about how clients should choose to clear was typically made about five or more years ago. But we’re looking at a very different landscape now. Clearing services provided by banks are more expensive and there are access and portability concerns,” says Liddy. “In my view, there are some sizeable clearing clients who could and should clear directly with CCPs”.
Technology eases the pain
New technology solutions could help those clients remove the strain of direct CCP membership. “There are now cloud- based clearing platforms that allow clients to interact directly with a CCP and provide all the tools and analytics needed to manage a portfolio, post collateral, exercise obligations under the fire drill or put in a bid on a defaulted portfolio if required. That infrastructure didn’t exist before and I expect it to gain more traction once OTC clearing in Europe is fully up and running.”
Creating opportunities to form more direct links with clearing clients, while at the same time making it easier and cheaper for banks to provide clearing services, has also become a focus for CCPs too.
At the end of March Eurex announced it is to launch a new access model this summer. ISA Direct creates a new membership type, allowing the buyside to have a direct contractual relationship with the CCP but facilitated by a member bank or clearing agent. It will initially be offered for Eurex interest rate swaps and repo transactions. Listed derivatives and securities lending transactions are to follow. Under the model, end-investors become responsible for posting their own initial and variation margin needing the clearing agent simply to contribute to the CCP’s default fund on their behalf.
Apart from helping to reduce clearing costs and widen the choice of provider, the buyside benefits from reduced risk, according to Philip Simons, global head of trading and clearing sales at Eurex. “Porting is much less of an issue in this model. The position accounts, collateral accounts and margin accounts actually belong to the buyside client. So in the event of their clearing agent going into default, the buyside is fully protected and they just need to find another clearing agent to take over the contribution to default fund and the role in the default management process rather than having to port or even liquidate their collateral.”
And because banks are left with just the capital charge from the default fund contribution, and not the client’s margin call, the model makes clearing a less capital-intensive business for them.
ICE already offers a similar direct access model – a halfway house between full-blown CCP membership and traditional clearing arrangements and other CCPs are known to be following too. Simons though says the Eurex model has distinctive features.
“It’s very important to note that in our model a clearing agent is not sponsoring the end-client from a risk management perspective. From the clearing angle, there is no counterparty credit risk to the buyside client. If the buyside client went into default then we, the clearing house, would step in and take over the unwind process. In other models, it is still the responsibility of the clearing member to do that and that’s why other models don’t attract the same capital release that ours does.”
Eurex says interest in the model has been strong and early movers include seven clearing agents and more than 10 buyside clients.
Cross margining options
For CCPs with a dominant position in related financial markets, portfolio cross-margining has become another area of innovation that helps banks cut costs and keeps clearing business flowing. Indeed a key benefit of Deutsche Börse’s proposed merger with the London Stock Exchange is that it would allow firms to reduce the collateral they needed to post against swaps and futures cleared by Eurex and LCH.Clearnet according to Deutsche Börse’s chief executive Carsten Kengeter and others agree.
“Bringing together the best available pricing and optimal execution along with cross-asset collateralisation and savings would be a hugely popular and valuable offer,” says Satten.
When CME became the first to offer clearing offsets between euro/dollar futures and dollar interest rate swaps after mandatory clearing began in the US, it cleaned up the market partly because of the margining benefits on offer.
Hoping to do something similar, LCH recently launched a portfolio margining tool to offset margin between OTC and listed interest rate derivatives. It will be available on an “open access” basis to any trading venue connected to LCH.
Instead of posting collateral for each trade, cross-margining allows firms to net the collateral requirement for trades that move in opposite directions and act effectively as a hedge for each other. Concerns have been raised however about a model that reduces overall collateral in the system and fuels a move towards fewer, “too big to fail” CCPs.
However, the pressure on CCPs to compete on services and particularly cost shows no signs of abating. “Based on the US experience, we expect to see widening basis spreads between CCPs in Europe and a widened spread between US and Europe where the same products are traded”, says Satten. “In the US we’ve seen a widening basis spread, specifically in the interest rate market between CME and LCH, where you can get better prices on LCH because there’s more liquidity.”
Competition can only drive CCPs in one direction. “There will be more consolidation in the CCP market and more innovation,” says Liddy. “The question is how low are CCPs prepared to go in terms of riskiness.”
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As 2015 drew to a close, the growth in primary issuance of corporate bonds, a constant since 2008, was in doubt for the coming year. Market volatility reared its head early in the first quarter, and as a result, 2016 was off to a bumpy start. One of the trends we observed was that as markets became volatile, new issuance slowed to a virtual standstill; however, as the volatility dissipated, often many issues in the pipeline came to market simultaneously. This created a stop/start pattern with a number of very busy days for both syndicate banks and investors.
