OTC Swaps Regulation: Betting on the house

EMIR could push huge volumes of OTC transactions into central clearing houses. But Cécile Sourbes finds that this is as big a challenge as it is an opportunity

There are no problems, the conventional wisdom goes, only solutions waiting to be discovered. This is more or less the promise central clearing counterparties (CCPs) make to pension funds when discussing the potential adaptation of their clearing platforms and business model under the new European Market Infrastructure Regulation (EMIR).

But putting such promises into practice often proves difficult. And a more in-depth look suggests that the cost drain imposed on pension funds by EMIR's mandatory clearing requirements for OTC trades also seems set to be a drain for CCPs themselves.

According to Ted Leveroni, executive director of derivatives strategy at Omgeo, a post-trade processing solutions provider, the main challenge CCPs will face will be dealing with new parties such as pension funds, which have not traditionally been primary users of central clearing services. "CCPs will have to think about what the institutional buy-side wants and adapt their business model accordingly," Leveroni points out.

The number of amendments to the current clearing model required is not insignificant. The primary one relates to margin calls. Under EMIR, market players will be required to post initial margin on top of variation margin for their centrally-cleared deals.

With regard to the buy-side's requirements, CCPs have set up new strategies to broaden the range of acceptable initial margin collateral over recent months. One of the latest examples came from the clearing house LCH Clearnet, which announced in April that it would accept Government National Mortgage Association (Ginnie Mae) mortgage-backed securities. The initiative was part of LCH's Collateral and Liquidity Management (CaLM) service, established last year with the view to offering centralised collateral management services to its clients.

Other CCPs are seeking to adopt similar strategies. However, as Eugene Stanfield, head of client clearing at Commerzbank explains, clearing houses should consider one key aspect before following this path. "Adapting such a model sends us back to the question of how robust clearing houses' management process around accepting different forms of collaterals is," he says. "And this refers to specific elements such as the liquidity level in the market, the price volatility of such collateral, as well as the haircut the CCP is willing to take."

The real preoccupation for clearing houses is nonetheless to be found elsewhere, in the variation margin requirements. While initial margins are retained by the CCP, the variation margin does not stay in the hand of the clearing house but is passed on to another party. This explains the need for CCPs to accept variation margin in the form of cash only - a model that is not well suited to pension funds, which tend not to sit on large pools of liquidity.

"I would suggest this is an industry-wide subject," says Stuart Heath, head of the UK representative office of the clearing house Eurex Clearing. "We heard those concerns from some of our buy-side contacts and we have taken this on board. We are working on potential solutions towards a non-cash variation margin solution or a buy-side variation margin solution."

Heath nonetheless concedes that the solutions are still in their infancy. In the meantime, and in the absence of non-cash solutions, pension funds and other end users have to count on collateral transformation services. Under this model, CCPs inject cash coming from margin calls into their own central repo market, providing pools of liquidity for pension funds to meet their variation margin obligations.

Some CCPs fear that such internal repo systems would lead to a serious extension of their business model. Providing this type of service could also imply taking more risk for CCPs at a time when EMIR aims to reduce the risk in derivatives transactions. In any case, it is questionable whether CCPs have the capacity to provide the necessary volumes of cash via repo to meet the demands of pension funds and other end users.

Another way to handle this issue could be so-called ‘interoperability': participants of the derivatives market would be able to net off their trades across several clearing houses that have signed agreements with one other. But there are doubts about feasibility here, too. Jamie Lake, principal consultant at GreySpark Partners, points out that an interoperability system would mean that, first, CCPs would be in direct competition.

Second, they would have to call margin from one other against clients' risks. CCPs will also need to look at the pre-trade risk checks, because client credit limits will need to be shared among the CCPs to ensure that they are not over extended.

"This gives rise to the ‘push-or-ping' model of pre-trade credit checking and, again, there is no consensus view on how this will be best achieved," Lake stresses.

The idea that CCPs might take on the responsibility for central risk mitigation seems unlikely, for all these reasons.

CCPs are also worrying about other preparations they will have to make to adapt to this new business from pension funds. Most of the challenges have to do with market infrastructure, explains Heath at Eurex Clearing. "As a CCP, we have to get the trades from a new platform," he says. "On top of that, there are different procedures in dealing with making sure that we can always settle and guarantee the delivery of OTC contracts."

In July this year, the Eurex Exchange Council, managing Eurex Clearing, approved the planned introduction of a completely new trading architecture that aims to minimise latency and data throughput, increase flexibility and provide a high level of reliability.

At Commerzbank, however, Stanfield downplays the infrastructure challenge. The new volumes will be mostly in plain-vanilla derivatives, he observes. "We are not talking about very complex derivatives where you have a debate over the input parameters or even the model," he says. "This is a simple linear model. So if you build the right infrastructure, which has got complete scalability to it as well as flexible functionality, the new demand remains feasible."

Indeed, the central clearing system will only be available for a number of derivatives contracts at first. While interest rate swaps (IRS) and credit default swaps (CDS) will be supported by CCPs, inflation swaps, swaptions and total return swaps will remain in the non-cleared OTC market until clearing houses develop new clearing solutions.

"For a product to be clearable, it must be to an agreed standard at a fundamental level," Lake explains. "This is one of the challenges facing the entire process, and the limiting factor for the transition to a cleared OTC market."

But this is yet another problem for pension funds. Given the lack of clearing solutions for inflation swaps and other products used by pension schemes for hedging, those end users will have no other option but to make both bilateral and centrally cleared trades.
"The issue relates to the netting benefit," Andrew Giles, co-CIO of Insight Investment explains. "At the moment, if you hold inflation swaps and credit default swaps in the OTC market, for instance, you can have a quite nice netting benefit. Typically, when interest rates go up, that's also when inflation is rising, which means that the two can net one another in terms of hedges. However, as soon as you split those swaps apart, you lose that netting benefit."

To address these issues, Omgeo has, for instance, developed a new version of its collateral management product to handle both cleared and non-cleared derivatives. "Our core goal aims to help users manage the two different flows in one process, with minimal disruption to their existing systems and operational personnel. We adapted our offering so that firms could monitor and view their risk exposures and process the movements of their cleared and non-cleared trades on one system to handle the two different flows," Leveroni adds.

Meanwhile, CCPs are also working on potential solutions to make their platforms available for other derivative contracts. "For now, our services will start with IRS, overnight index swaps and forward-rate agreements," says Heath at Eurex Clearing.
"However, instruments such as zero-coupon swaps, inflation swaps and, potentially, swaptions, are all important to the pension fund industry and we will look to extend our offering into those asset classes. It won't be this year's business but I'm pretty confident that we have identified what the issues are."

From a technology perspective, the post-trade flows between all those swaps remain fairly similar. However, as Heath points out, the main issues lie in the timing of any agreement to set up and enact the standardisation of swap clearing via the connectivity map of all of the central clearing houses.

"There are ongoing discussions surrounding the standardisation of these products", Lake explains. "Working groups within clearing houses are currently discussing the formulation of rules to determine unique product identifiers (UPI) and unique swap identifiers (USI) to allow for this standardisation."

All those adjustments will come over time - and market participants have that three to six-year exemption during which to come up with sustainable solutions to meet pension schemes' requirements.

Will they be able to use that time profitably, to establish or increase market share in a competitive environment? As with all new opportunities generated either by regulatory or market demands, new players are set to take their chance in the European central clearing arena, looking to grab a part of the business. However, the numerous requirements under EMIR to register as a CCP could, on the contrary, dissuade many potential new players from trying to compete with the well-established ones. Many will inevitably fall by the wayside as the bigger and better value CCPs increase market share.

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