Mandatory clearing requirements expected to be in place next spring in Europe leave the buy-side community with a number of challenges.
AFTER YEARS OF debate and deliberation, European regulators are poised to implement mandatory clearing for over-the-counter derivatives in the next 12 months. While the timetable is not yet set in stone, the expectation is that the mandatory clearing rules will take effect next spring, starting with clearinghouse members and continuing with other financial institutions later in the year.
Nigel Foster, former global head of derivatives at Blackrock, speaks out against margin haircuts during a one-on-one interview at IDX.
While many asset managers are already well down the road in terms of their preparations, the buy-side community as a whole is still coming to grips with the new clearing obligations. Among the challenges the buy-side faces in this new environment are setting up an agreement with a clearing member, selecting the most appropriate account structure with that firm and the clearinghouse, and assessing the best assets for collateral to be held against any derivatives cleared.
These and other issues were discussed by a panel of experts at FIA’s IDX conference in London, in June, which brought together a diverse group of asset managers, clearing firms and central counterparties to debate the current concerns as the industry prepares for mandatory clearing.
One of the key areas of focus is the assessment of the new segregated account structures on offer. As the panel revealed, there has been a split in the choice of preferred models between the individual segregated account and the omnibus segregated account. While the former offers more security for end-user assets, cost has been a factor in preventing a greater take-up of the ISA.
Europe’s largest asset managers warn that haircutting initial margin and/or variation margin will lead to perverse systemic consequences.
Tina Hasenpusch, the chief executive officer of CME Clearing Europe, described the current state as a transitional phase, with firms still working out which option is best. A key issue is cost, she said. “It is extremely difficult to determine the true price of individual segregation for the clearing brokers.”
Things are beginning to change, however. Eugene Stanfield, head of derivatives execution and clearing at Commerzbank, commented that there is now a larger take-up of individual segregated accounts as EMIR kicks in. But clients on the old OSA model have remained on that model and it is new clients who are opting for the ISA.
Matthias Graulich, chief client officer at Eurex Clearing, said that of the 150 or so clients that his CCP has signed up, more than half are now running under the ISA structure. Furthermore, many have set up so they can switch to an ISA at a later date. “I would expect individual segregation will pick up,” he predicted.
Customers coming from the OTC market who have set up with ISAs for that part of the business are now looking to ISAs for their ETD portfolio. Clearing members are also shifting, said Mark Woodward, vice president of corporate development at ICE Clear Europe. “The leverage ratio and VAR requirements are changing the picture.”
There are still many firms that have not yet made a choice, however. According to Richard Metcalfe, director of regulatory affairs at The Investment Association, “EMIR might still be news for some end clients.” For that reason his association is continuing a program of education to explain to its members the differences between the omnibus and individual segregated accounts. “A lot of firms on the buy-side are holding back a little,” he explained. “Partly because they are trying to work out where the liquidity is going to be in what products.”
Assessing the Options
Another concern is the cost of clearing. David Brown, head of derivatives operations at Royal London Asset Management, stated, “When we are assessing what models are best for our clients, we need to look at the type of protection they require and the cost of accessing those facilities.”
That cost is in flux, he added. The impact of Basel II capital requirements on clearing firms has resulted in a change to the pricing models that were being offered one or two years ago, he said.
“Due to capital requirements, clearing brokers would much rather us pledge stock as collateral as opposed to cash. This has tended to bring the comparative price between ISAs and omnibus segregated accounts closer together.”
Certainly a year ago, the gross omnibus structure was fairly cheap, and the ISA the more expensive, but preferred, option. Brown’s view was that “the ISA will probably become the structure of choice for most clients as the [relative] costs reduce.”
Collateral is a factor in this decision making process and bringing ETD and OTC derivatives into the same collateral pool through the ISA offers efficiencies. But there are other factors. Brown pointed out that the decision may depend on what the client wishes to receive back in the event of a default. Under a gross omnibus account, stock posted as collateral would be liquidated and converted to cash. In an ISA, the client would get the stock back.
Graulich agreed, adding that there should be an incentive to push people toward the ISA model and “avoiding the fire sale of collateral.” The issue is not the CCP’s ability to handle the default in a gross omnibus model, but that the volatility of the price of collateral could be an issue in the event of a default and the type of segregation model could have an impact.
Metcalfe is also concerned about the mobility of collateral. “Getting collateral to the right place at the right time might slow the process down and keep people within an omnibus structure.”
For Brown, the choice of segregation model is not as important, certainly initially, as simply getting a clearing arrangement in place. “The biggest challenge for most clients is agreeing a central clearing agreement with your broker, which can take a long time,” he warned. “The actual process of selecting the account structure is fairly simple once the agreement is in place. For any buy-side out there, they need to be looking at their agreements now, well in advance of the mandatory clearing deadline.”
Opposition to Margin Haircuts
While account segregation may offer end-users some comfort as they put more of their business through CCPs, the migration to cleared derivatives is not without concern. This was reflected forcefully by Nigel Foster during a one-to-one interview at IDX. As former global head of derivatives at BlackRock and a long-standing user of the markets, he pointed out that he was strongly in favor of segregation.
The market crisis of 2008 “gave us an opportunity to rethink what clearing was and what was safest for clients,” resulting in the introduction of the so-called LSOC regime in the U.S. and the segregated accounts in Europe, Foster said. However, he saw a paradox in the security provided by the introduction of segregated accounts and the haircutting of margin from investors for CCP recovery and resolution. “If segregation has made investors feel 10% better,” he said, “haircutting has made them feel 100% worse.”
Foster rejected the notion that variation haircutting in the case of a CCP collapse was “socializing the loss” in a valid way. He pointed out that the key issue for investors is to stay “money good.” The assumption that users of derivatives care about keeping their positions safe in the case of a default is not true for investors, who simply care about keeping their money safe. “If that means losing your positions [in the event of a CCP default] that is fine.”
Twelve Firms Speak Out
Foster’s comments were reinforced in July by a letter written to Lord Hill, the European Commissioner for Financial Stability, Financial Services and Capital Markets Union, signed by 12 of Europe’s largest asset managers–Allianz Global Investors, APG Asset Management, BlackRock, Capital International, Fidelity Worldwide Investment, Legal & General Investment Management, M&G Investment Management, Nordea Asset Management, PGGM, Schroder Investment Management, Swedbank Robur Fonder and UBS Global Asset Management.
Writing on behalf of investors in Europe and globally, the signatories stated that they believe central clearing of OTC derivatives brings many benefits, such as transparency and the elimination of many counterparty risks. But they also said that central clearing results in certain risks being concentrated in a handful of CCPs. In particular, they pointed out that users of CCPs are ultimately tax payers which have been required to use market infrastructure.
“A lot of firms on the buy-side are holding back a little.”
The Investment Association
“End-investors do not own that infrastructure and have deposited money in good faith – undermining that good faith by haircutting initial margin (IM) and/or variation margin (VM) will lead to perverse systemic consequences which will undermine financial stability. We recommend IM haircutting is taken off the table altogether and VM considered only as a recovery tool of the last resort, subject to strict conditionality of subsequently recovering the haircut funds to users.”
The asset managers also recommended “broader auction participation” as a viable alternative to margin haircutting which would increase the likelihood of CCP recovery. “One way to help mitigate risk would be to allow creditworthy market participants who are not clearing members to participate in the auction process,” the letter suggests. “In situations where a clearing member has defaulted, other clearing members may be hesitant to take on additional risk and may not bid aggressively or at all. We don’t see any meaningful downside to increasing participation and firmly believe expanding the participants eligible to bid in the auction process should be established and published as part of the CCP’s resolution and recovery plans.”
Additionally, they add, “end-users could be allowed, post-default, the possibility to substitute (‘buy back’) their initial margin in the form of securities and cash. This would be beneficial for the CCP because they would have cash available, whereas the end-users, which may be unable to transfer their positions to back-up clearing members and face liquidation of their positions, could preserve their securities and decrease replacement risk.”
Such responses from the buy-side are likely to grow as they become an increasingly integral part of the dialogue on changes to the clearing landscape. With mandatory clearing expected to start in April in Europe and the publication by the European Commission of proposals for CCP resiliency, recovery and resolution by the end of this year, end-users of derivatives may find themselves increasingly at loggerheads with regulators, CCPs and their clearing firms.
European clearing leaders discuss customer segregation and other issues impacting end-users during a panel at IDX.