Riding the OTC rollercoaster
Under the European Commission’s European Market Infrastructure Regulation, enacted in the UK in January, the majority of OTC contracts will have to be centrally cleared and reported to a trade repository. In addition, contracts deemed sufficiently liquid will have to be executed multilaterally, i.e. on an exchange or organised trading facility.
The intention is to increase transparency and reduce systemic risk in OTC markets. A CCP acts as a central risk repository, reducing the danger to the market if a counterparty goes bust.
Major financial institutions such as CME Europe have positioned themselves to take advantage of the migration of large quantities of formerly OTC derivatives contracts on-exchange. An impending ‘futurisation’ of the derivatives markets has been widely touted, with participants expected to use standardised ‘vanilla’ futures to hedge their positions rather than more expensive customised contracts.
“There will be futurisation,” said Jaki Walsh, head of EMEA OTC product at CME group. “We recently launched deliverable swap futures in the US. It’s about ease of access to the market. If we can make futures that provide the kind of exposure clients want, perhaps that will provide them with an easier way to access the market than paying more for a complex bilaterally-traded OTC product.”
CME Group is currently planning to launch the CME Europe exchange later this year, which will provide it with a springboard to launch new contracts, including hybrid futures and products that combine elements of both exchange-traded and OTC derivatives. These will be marketed at participants that had previously used customised bilaterally traded derivatives for hedging purposes.
A lack of choice
However, many participants have objected that mandatory clearing of instruments and the standardisation process itself may remove choice from end-users and potentially increase risk as participants attempt to use instruments that do not cover their hedging needs as closely as an OTC contract would. According to Ido de Geus, head of treasury and client portfolio management at Dutch asset manager PGGM Investments, high initial margins will lead to less hedging – creating an environment where risk is no longer effectively controlled and minimised.
“As the buy-side we need to shout harder to be heard,” said de Geus. “Billions of euros of high quality assets will have to sit there doing nothing and that’s going to be very expensive. There’s no benefit to clear swaps yet, it’s only going to cost you initial margin. The fact that clearing members often ask for additional collateral on top of the already high initial margins is incredible. It says that clearing members don’t trust the initial margin levels of the CCPs. If they don’t trust, why should we?”
These concerns have been echoed by other long-term investors. “If you reduce the ability to absorb risk, you increase the amount of risk,” said Patrik Roos, managing director at Swedish hedge fund Vanna Capital at the TSAM conference in London last month. “In the current low volume environment, I’m not sure that’s something we should be doing.”
Lack of choice has also been cited as a problem by Anthony Belchambers, chief executive of the Futures and Options Association, who warned that high margin calls on illiquid contracts could make using a CCP uneconomic. “However, if the instrument is required to be CCP-cleared by law, market participants will have no choice,” he said. For Belchambers, the risk is that regulation may be going too far. Alluding to a speech in which former British diplomat and Barclays vice chairman David Wright called for a much more granular approach to looking at the economic impact of a super-safe regulatory agenda, Belchambers said that it may be time to call a sanity check on the regulatory reform agenda.
“Some form of increased cost is inevitable, after the financial crisis,” said Belchambers. “But the underlying question is, are we putting in so much safety into the markets that we are compressing innovation and the cost basis is going up to a point where we are going to damage other public policy objectives about our ability to manage risks?”
According to research published by BNY Mellon and Rule Financial in December, the amount of initial margin that will have to be sourced can be substantial – around 1-3% of the notional value of the contract for a typical 5-year vanilla interest rate swap. For long-dated or complex contracts, the amount of collateral required increases substantially because of the greater potential future exposure, to around 10% of notional for a 30-year and 15% of notional for 50-year tenors. In addition, the Investment Management Association has identified as “not unusual” the requirement for CCP-eligible collateral equivalent to 20% of the investment value of test portfolios to be able to meet initial and variation margin obligations on typical OTC derivatives strategies under mandatory clearing.
A lack of collateral
Other problems arising from the new rules include the difficulty of sourcing sufficient collateral to cover the clearing process. Many market participants expect that when coupled with Basel III requirements that banks should hold more capital, EMIR will result in a collateral shortfall. Research by analyst firm Celent has estimated the deficit could reach as high as $2 trillion.
“There will be a conflict between CCPs’ need to sustain high levels of safety for controlling risk, and pressures from intermediaries who need more collateral,” said Belchambers. “There may be pressure on regulators to accept collateral that is not quite as liquid as one might require, simply to keep the markets operating. Some clearing houses are now accepting gold, for example. At the same time, regulatory pressure on credit ratings agencies is pushing them to be super-safe in rating products. That means products will have low ratings – which automatically hits collateral. The problem is, a lack of access to the kind of collateral needed under the new regime may kill the ability of participants to trade in the market.”
In response, in December the Basel Committee on Banking Supervision agreed to broaden the definition of assets considered ‘high-quality’ collateral – a step intended to reduce the pressure on financial institutions struggling to source adequate collateral and ease fears of a liquidity drought.
However, the move has been criticised by some observers, who suggested that the concept of a collateral shortfall was misleading. “We could be sowing the seeds of the next financial crisis,” Bob Almanas, head of collateral management strategy at SIX Securities Services told Banking Technology. “Is it the case that there’s not enough collateral, or is it just that we need to use collateral more efficiently? Breaking down siloes and resolving inefficient usage of collateral should be a priority.”
Some efforts are already underway at using collateral in new ways. In January, central securities depositories in Germany, Spain, Brazil, South Africa and Australia formed the ‘Liquidity Alliance’. The five companies – Clearstream, Iberclear, Cetip, Strate and ASX respectively – will meet each quarter to work out the most efficient way of dealing with collateral and to discuss partnerships, commercial opportunities and key issues.
“The Liquidity Alliance believes that forging partnerships with other like-minded infrastructures is the most sustainable way of extending reach and enabling cross-border collateral optimisation on a short time-to-market basis,” said the group in an official statement. “This is key if market participants are to meet the new requirements and find effective global solutions to this ongoing global problem.”
Meanwhile earlier the same month, Citi established a set of alliances with Clearstream and Euroclear Bank that will enable the tripartite agent managing collateralisation to instruct collateral moves on behalf of broker-dealers, potentially making the whole process easier.
“Optimising collateral means creating and using the widest possible collateral pools without jeopardising individual and country-specific requirements and the liquidity alliance is a major step in delivering a truly global liquidity and collateral pool,” said Stefan Lepp, chief executive at Clearstream Banking.
For Andrew Lamb, chief executive at CME Clearing Europe, the argument that there will be a collateral shortfall does have some legitimate points – but he insists that any pain will be short-term and offset by greater transparency and market participation eventually.
“Although the new rules bring higher capital requirements for uncleared swaps, that does not mean banks cannot continue to offer those contracts,” he said. “The collateral requirement will be a shock at first, but central clearing will also provide markets with new confidence and ultimately lead to new business. Clearing will not reduce liquidity in the long term.”
A lack of clarity
Aside from the question of user choice and the availability of collateral, representatives of large global banks and brokers have also expressed serious concerns about the uncertainty that remains over exactly which contracts will be covered by the new rules. The difficulty of predicting what mode of business will prevail in the new regulatory environment has also been exacerbated by differences between the regulatory reform agenda in Europe and the US.
At time of writing, the final rules for swap execution facilities in the US still have not been released, meaning that US swap execution facilities may use an RFQ system, non-anonymous matching and even one to one interaction by voice. Meanwhile in Europe the technical standards for EMIR came into force on 22 March, but the actual mandatory obligation to clear is not expected to be in place until Q1 next year. Andrew Parry, head of derivatives business technology at Bank of America Merrill Lynch, recently estimated three possible courses for OTC derivatives reform: a gradual increase in the scope of instruments falling under the new requirements; standardisation of contracts through standard coupon and standard rollover dates; and a transformation of all products to become like futures, traded on a central limit order book. It remains unclear which scenario will be proved right.
“From a clearinghouse perspective, I find significant lack of clarity on the clearing standards in EMIR,” said Lamb. “The technical standards are not very well drafted. In addition, it’s actually the national regulators who will take the lead for the next six months until the CCPs have been re-authorised. That’s only going to add further complication.”
According to Peter Best, business manager at interdealer broker ICAP, many banks are hedging their bets based on which rule-set is considered more favourable – with some firms even offshoring parts of their business and arranging outsourcing agreements in preparation.
“The lack of clarity over the final rules on OTC derivatives is forcing financial institutions to spend more resources than necessary,” said Best. “At the same time, differences in the rules between EMIR and Dodd-Frank mean we’ll have to build different platforms to cope with differing regulatory requirements.”
Lack of clarity over pricing has also been highlighted as another potential pitfall for market participants struggling to understand the implications of the new rules. Anthony Belcher, head of pricing and reference data EMEA at Interactive Data, says there is a misplaced sense of confidence among many firms that EMIR will bring greater transparency by default. Banks rely on clear pricing to accurately calculate their risk exposure; fund managers also need to know that they obtained a fair value for products such as CDS contracts in their portfolios.
“Not every derivative instrument trades more than a couple of times a day,” he said. “Of the approximately 3,000 single-name CDSs that exist, only around 20 trade more than five times a day. The problem then becomes, how do you obtain any degree of certainty about pricing, with such an illiquid instrument? Participants really need to make sure they talk with their counterparties to understand where price transparency will come from, how initial margin is calculated, and what the methodology was to get that price.”
A lack of preparation
Perhaps relating to the lack of certainty over the final form of the rules, recent research by communications company IPC has highlighted a general lack of preparation among hedge funds, investment banks, broker-dealers and exchanges.
According to the study, released at the end of January, four out of five financial institutions are still not ready for the new regulations. Of the institutions questioned by IPC, some 36% reported that their company did not have a plan in place to deal with new regulations, while a further 62% said their firms were not well prepared, leaving only 19% who believed the industry was ready to meet the new rules. The lack of preparation belies the current scale of OTC derivatives trading; some 94% of the firms that responded to the survey are already trading OTC derivatives or plan to do so in the next six months, while 74% expect their firms’ trading volumes to increase in the next year.
The IPC findings complemented a similar study released by BNY Mellon and Rule Financial in December, which found that the situation is even worse among buy-side firms. According to the BNY Mellon/Rule Financial joint paper, To Clear or not to Clear … Collateral is the question, only 20% of asset managers have finalised their adjustments to meet the new rules.
The technical standards for EMIR come into force on 22 March, after which CCPs will have six months to apply for registration. Once that takes place, a 90-day period will follow in which market participants are given notice that they must clear all products covered by the new rules.