Iain Morse outlines the effect impending regulations will have on the custody industry and defined benefit pension funds
Over the next few years, US and EU regulations are due to have a major impact on the custody industry and pension funds. They will be affected because of their reliance on liability driven investment and consequent use of derivatives to hedge portfolio, interest rate and longevity risks.
“It may not be obvious at first but Dodd Frank, the European Market Infrastructure Regulation (EMIR), Basel III and the EU Capital Requirements Directive (CRD) IV will change the whole landscape of custody in Europe,” warns Stuart Catt, senior associate at Mercer’s Sentinel Group. Once fully implemented, these will create a new, much more capital intensive and regulated regime for banks and participants in the derivatives market. Dodd Frank and EMIR will also lead to a much wider use of central clearing parties (CCPs) for OTC derivatives markets. Buy-side entities will be obliged to use CCPs for most derivative transactions.
Once it takes force in 2013, EMIR will grant pension funds a three-year stay before they must comply with the regulation, but EMIR will have major cost implications. First, there is agreement that there will still be sizeable non-standard OTC market. Celent predicts that 60-65% of all trades will be via a CCP. Elsewhere, the estimate is closer to 50% of foreign exchange and interest rate swap markets via CCPs during 2012-13. There is also general agreement that, regardless of the regulator’s ambitions, there will be a natural plateau, yet to be discovered, for the percentage of all trades via CCPs. Some types of contract, particularly relating to foreign exchange, may also be exempted.
But after the three-year exemption ends, pension funds will be required to deal via one or more CCPs. At present, there are plans for between 15 and 20 CCPs to be set up around the world but it has been predicted that only six to eight of these will achieve sustainability.
The new CCPs and clearing brokers will have to shoulder the largest cost arising from establishing the connectivity for large-scale OTC derivative clearing. CCPs will be responsible for the post-trade pricing, valuation, and margining for unprecedented volumes of transactions. Trading platforms are expected to face significant expenditure to establish connectivity with the new CCPs.
“Custody providers are also planning to meet a significant cost share because of their role in collateral management effected on a daily, perhaps intraday, basis,” says Sonja Spinner, principal at Mercer’s Sentinel Group. Celent estimates the IT costs per participant, bank or broker to be in the $150-200m (€117-157m) range. Ultimately, these costs will be met by the buy side.
Another much-heralded consequence of CCPs will be their requirement for the buy side to place adequate initial margin and variation or maintenance margin with their custodians or brokers and hence the CCP. CCPs will accept initial margin collateral in highly liquid and marketable instruments such as G7 short-dated sovereign debt. This collateral must cover 99% of exposure movements in the relevant derivatives based on the estimated potential exposures until the liquidation of the relevant exposures. CCPs have not yet agreed the margin requirements for all types of contract; the expectation is that these will be around 20% of the notional value of linear products (ie, where value is a function of one or more variables such as interest rates, stock prices, commodity prices).
Variation margin collateral is also required for daily payment of profit or loss on derivative contracts between parties to a CCP-traded contract via the CCP. The main thrust of Dodd Frank and EMIR is to render the pricing of derivative contracts more transparent by marking them to market; the requirement to post variation margin collateral is a new, added cost in this process. In the past, custody banks with wider bilateral relationships with pension funds have been able to accommodate day-to-day cash flows from cash management and securities lending.
Custody providers have also been free to determine their own ‘risk weighting’ for the relevant derivative contracts and, if also providing custody services to the same pension fund, to determine the fund’s creditworthiness. European pension funds acting as buy-side investors with US regulated entities are already subject to Dodd Frank and must post this margin. The three-year exemption under EMIR means that they will not yet have to post margin collateral if dealing exclusively with EMIR regulated entities but trustees must not fall foul of US regulators by accident.
Worse still, CCPs will require variation margin collateral to be in cash. Custodians are already responding with collateral transformation. Essentially, custodians will accept non-cash collateral, like equities and non-sovereign bonds, then provide CCPs with margin collateral in cash. In return, they will charge clients a fee. Meanwhile, custodians may transform the non-eligible assets through the security lending and repo markets.
But their role needs to be set against the overall strength of their balance sheets and will reduce their regulatory or ‘free’ capital ratios at a time when regulators require these to be increased. Under CRD IV, bank capital is defined not by an accounting metric but as freely available capital to meet risk-weighted losses.
The formula for calculating the minimum regulatory capital that must be maintained under CRD4 is simple - free capital divided by risk-weighted assets must be equal to or greater than 8%. Within the 8% limit, however, the highest quality tranche of regulatory capital, the common equity share, must increase from its current 2% lower limit to 4.5% using the same formula.
These new limits are due to be implemented over a five-year period from 2013 to 2018. They are not the only changes to banks’ capital-free capital ratios. Capital conservation and counter-cyclical buffers will also be added, not to mention other, as yet undetermined, capital surcharges for what the directive calls “systematically important banks”. It is quite likely that major custody banks will one day fall under this rubric.
Transformation capacity will certainly become an issue and custodians are under no obligation to offer the service, even if clients request it. The pressure to meet capital adequacy requirements in banking groups entails that custody, as one among many competing lines of business, will be awarded a regulatory capital budget or allowance. Once this is used up for a relevant accounting period, custodians will be unable to transform more collateral. “The likely outcome is that they will ration the service based on their overall relationship with a client, looking at every revenue aspect of that relationship very closely,” says Catt.
This will strengthen the competitive position of some custodians against others. “Multi-line custodians like JP Morgan will see their competitive position strengthened because we provide an end-to-end service,” believes Benjie Fraser, practice leader at JP Morgan Worldwide Security Services. Could EMIR spark a new round of merger and consolidation among the custody banks? Only time will tell.