OTC clearing: decision time approaches
Clients have two clear choices as they prepare for the new environment
Investment market participants who have not yet decided how to approach the centralised clearing of over-the-counter derivative transactions really must begin to do so soon. Both the buy-side and the sell-side of the industry will be signifi cantly affected when the regulatory changes mandated by the G20 countries back in 2009 fi nally come into force. This is expected to happen in the USA (where the changes come under the Dodd-Frank Act) by end 2012. In Europe, which is expected to follow somewhere around the middle of 2013, the changes will be implemented as part of EMIR (European Market Infrastructure Regulation).
The changes will affect mandatory collateral levels in ways that will have clear implications for clients. Firstly, collateral levels will be set higher than previously, to refl ect the perception that the instruments are higher risk. The increase is related to the fact that OTC contracts have a longer lifecycle than most of the current cleared products. They are measured in years or decades rather than days, which increases the risk of a counterparty default and hence margin requirements. Secondly, costs will also be higher for those transactions that will continue to be cleared bilaterally rather than clear centrally (only interest rate swaps and credit default swaps will be cleared initially) and capital requirements will be higher. Thirdly, the processing of collateral will become more complicated, more sophisticated and possibly more fragmented as the number of potential service providers grows.
“Clients have two clear choices as they prepare for the new environment,” says Alex Buffet, in charge of asset services relating to OTC derivatives at SGSS. “One, they can do it themselves. Two, they can appoint a specialist provider. The fi rst route will almost certainly be more expensive and operationally diffi cult even for those institutions which possess the necessary expertise in-house. We believe, therefore, that all but the largest players will surely appoint an external provider. We see more and more demand for such services. They are being included in more and more requests for proposal. As clients become more educated in the detail of the proposed new regulations, demand will grow still further.”
The volume and value of collateral being moved around the system will rise dramatically from the current estimated $2 trillion annually, suggests Alex Buffet. “We expect that it will double to around $4 trillion,” he says. That estimate does not take into account any possible growth that might take place in underlying derivatives transactions if they become more standardised and easier to use.
“Clients will need collateral in the form of cash and stocks, and we will see important moves in this area as clients react to the need to reposition collateral and adjust margins in a costeffective and effi cient manner several times a day,” he continues.
SGSS already offers a full suite of services for collateral management and brings value to cash and securities assets, he adds, and is further developing its ability to offer these once the new OTC clearing regulations become operational. “We offer basic administration but also value added services such as the transformation and optimisation of collateral. Cross-margining is a good example of optimisation: as we have a global vision of our client portfolio we can for example measure the risk associated between two positions (one on a cleared instrument and the other one on non-cleared) and decide when the risk of the two positions matches, so cutting our client’s collateral requirements.”
Collateral comprises initial margin (at the start of a trade) and variation margin (adjusted daily as the value of the instrument changes). Premium quality securities can be used for initial margins but when it comes to variation margins clearing houses (CCP) will only accept cash. Most clients, however, simply do not have enough cash or premium securities available for collateral. In that case, SGSS can provide transformation by helping them to turn less liquid securities into eligible collateral.
“If we have responsibility for all of a client’s transactions we can keep costs to a minimum and save them a good deal of money,” says Alex Buffet. “At the same time, if a client prefers not to use our own nominated clearer, Newedge, we will be able to accommodate that preference.”
For those clients which might feel they face a bewildering, impossible choice, Alex Buffet has some familiar words of reassurance, even comfort. “A number of different players are scrambling to position themselves to offer post-OTC regulation change services to clients. But we believe custodians have an advantage because of the relationships they already enjoy with clients, enabling clients to have all the services they need under one roof rather than go to several providers.”