OTC Swaps Regulation: Connecting the pipes
EMIR will introduce a huge range of new processes into both centrally-cleared and bilateral derivative trades. Iain Morse outlines the work custodians are facing
The European Market Infrastructure Regulation (EMIR) is with us, but has everyone heard the news? "It will test the custody industry," warns Jonathon Bowler, managing director and business manager for EMEA at BNY Mellon. "A lot of new systems need to be plumbed in to make it work smoothly."
It is too early to say how EMIR will play for custodian's profit-and-loss accounts, adds Stuart Catt, associate at Mercer's Sentinel Group. "But they need to generate new income to meet the costs of the new systems it requires."
Pension schemes will also have to understand its consequences and review their custody service providers to determine their competence to comply with EMIR. "This will play a role in custodian selection," adds Catt.
EMIR entails mandatory central counterparty (CCP) clearing for standardised derivative contracts and, as a consequence, also defines the rules for prudential organisation and the conduct of business by CCPs. Risk reduction for uncleared bi-party contracts is also included. Operational risk will be reduced by the use of electronic media for the confirmation of OTC derivative contracts. This is all part of a grand, long-term strategy of herding almost all derivatives from counter top to electronic exchange.
There are temporary exemptions to EMIR, including pension funds, but its reach is wide, applying to CCPs, their clearing members, financial counterparties (which captures pretty much any EU-regulated financial company), trade repositories and some non-financial counterparties.
These rapid changes are creating a challenging new environment. Use of a CCP entails the posting of eligible collateral, but also reporting to trade repositories. The collateralisation of uncleared trades has been optional but will now be obligatory. Back and middle offices will need to standardise around industry processes and electronic confirmation of trades will be required to create an audit trail. Independent valuation and portfolio reconciliations will also be required.
Custodians will need to enter into clearing agreements with OTC clearers or apply for direct membership of one or more CCPs. Some are direct members in multiple CCPs around the world. In Europe, for instance, BNP Paribas is already a member of LCH Clearnet, CME, ICE, SGX, and Eurex. LCH Clearnet's data requirements from full clearing members is worth listing: date of investment; name of person through whom such was made; amount of money or current cash value of same; a description including CUSIP or ISIN numbers; depositary identity; date of liquidation and cash received; name of person through which disposal was effected; and daily valuation for each instrument held with supporting documentation for pricing methodology. The costs of this, not just in fees and capital adequacy requirements, but also connectivity, may deter some from joining the club.
Reporting to trade repositories similarly requires investment in technology to create connectivity but also requires ownership and liability for the management of this process, again implying new cost and complexity. Custodians will also be required to manage daily independent valuation and portfolio reconciliations. The processing of collateral also has to be adapted to clearing. Custodians will also need to find and optimally manage eligible collateral pools.
Finally, custodians must manage the segregation of relevant collateral with third-party custodians. A typical global custodian's European division offering buy-side dealing and sell-side execution services will also need access to multiple execution platforms, including TradeWeb, MarketAxess, and Bloomberg, and matching utilities such as ICE, DTCC, and Markit.
The process of clearing trades is also far from simple. A block trade is executed on a swap execution facility (SEF) or via voice by the executing broker (EB). At this stage, a CCP is chosen. Next, the EB alleges the block trade to clients via MarkitWire and selects a clearing broker (CB). In the third stage the client affirms the block trade, allocates the trade to a unique client and selects a CB. In the fourth stage, a clearing-consent request is sent by MarkitWire to the clearing members. Last, comes intraday clearing. The CCP runs its risk filters on the trade, checking product, account and credit. Assuming the risk filters are passed, novation and confirmation of the trade occur simultaneously; a clearing notification is sent to the client via MarkitWire. The transaction is then allocated to the CB's account held by the CCP.
Thereafter, the trade requires daily servicing activity between the CCP, EB and custodian. The CCP daily provides a cash requirement which will be credited or debited from the EB account and the CB account while setting initial and variation margins. The custodian bank provides the client with a margin call notice to be paid into an account with the CCP or the custodian bank. It must also report daily on the client's trading position and any revaluation of the relevant contracts.
The custodian also has to report daily by 08:00 GMT on the following: trade valuation; initial margin; cash flow; collateral; transaction data to the CCP; trade activity; and, monthly, on interest accrued. This is all ‘new' reporting arising from the advent of CCPs; getting it right costs money and requires expertise.
EMIR will result in a significant increase in collateral requirements for CCP and residual OTC transactions. This opens the possibility of multiple margin calls from various CCPs. Custodians must manage up to three types of margin on behalf of clients. Variation margin (VM) is calculated per CCP, and is called daily in cash in the underlying trade currency. Initial margin (IM) is calculated and called daily in eligible cash or securities. Lastly, there is a liquidity margin (LM) set by each CCP according to its methodology.
Collateral will create new opportunities for custodians to earn fees and commissions. Acting as collateral agents they can offer to manage collateral agreements. They will also need to offer the valuation and calculation of exposures. This service component will include an independent valuation service, the valuation of collateral balances and calculation of net exposure per counterparty.
Margin-call management is another potential source of income for custodians. Margin calls must be determined, sent and received with counterparties, and agreements or disputes arising settled. Collateral transfers and substitutions must also be made; collateral needs to be selected, eligibility checks must be made, orders for collateral movement made, the whole process monitored, and pooled cash collateral managed in overnight and short-term instruments.
These are core, plain-vanilla services in relation to collateral; custodians will have the opportunity to offer value-added services. The most important of these are in collateral optimisation and sourcing, and the provision of segregated, tri-party custody structures to ensure collateral protection against default.
There is the possibility of netting collateral. "But where funds have to spread between clearing houses there will be no netting," warns Jonathon Southgate, head of derivative & collateral product development management at Northern Trust. At present different clearing houses are focused on different products. "This will only change when there is convergence in the market," adds Southgate. "We may see clearing houses carrying out more risk-based netting with margin calculation."
Meanwhile, collateral transformation is predicted to offer new revenue. "It can be done but at a price which may be higher than anticipated," adds Harry Raschen, head of market strategy at HSBC Fund Services. If there is inadequate eligible collateral, goes the argument, custodians will be able to accept non-eligible collateral from clients, ‘transform' this to eligible collateral and collect a fee or spread on the operation.
This argument may be overstated. Pension funds may decide to hold more cash in their portfolios; they can also use overdrafts. They can also avoid the need for posting collateral by using a third-party asset manager that deals with this on behalf of investors. If cash becomes the preferred collateral, custodians will be able to apply their existing cash-management expertise to the collateral pools.
"There is no standard model for cash posted with clearing houses," notes Martin Higgs, senior vice-president at State Street. "We are in favour of aggregating this cash to get efficiencies."
EMIR is set to revolutionise some of the largest and deepest financial markets in the world. The operational infrastructure beneath those markets faces similarly radical change. Its providers are only beginning to come to terms with the scale of the challenge.