Capital is a serious issue, or at least its preservation is. The crisis of ‘07/’08 exposed the financial services industry to tremendous losses to the extent that companies went bust, were taken over or bailed out by government. Ensuing inquiries concluded that excessive levels of risk had been taken in search of reward and that the risk takers were inadequately protected in terms of capital and provided for in terms of liquidity.
Regulators sought to address this by enhancing capital requirements along with asset and liability management regulation through, among others, the leverage ratio, risk weighted assets (RWA)A, liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR). These add up to a sizeable capital preservation requirement, which places tremendous strain on a bank’s balance sheet and naturally steers lenders towards attributing capacity towards activities, and clients, that return sufficient revenue.
According to the Commodity Futures Trading Commission (CFTC) the number of futures commission merchants has reduced from 126 to 73 in the five years preceding July 2015 and we can expect to see that number decline further in time as the activities those firms undertake become less and less profitable. In recent times we have seen the withdrawal of BNY Mellon, Nomura, RBS and State Street from the provision of derivative clearing services.
Any further withdrawals will leave a reduced number of providers potentially clearing the same level of risk, which simply leads to an increase in concentration risk while at the same time further increasing the capital and liquidity requirements for those remaining clearers.
While all of the above can be described as effects on bank we should remember that any cost on one side of the trade, or service, must be passed through to the other side and this is where the buy side comes in, making capital a serious issue for both sides of the street. In fact, as I write I can see a comment on Bloomberg that describes a price increase in US 10-year futures after a sizeable block trade, with one unnamed trader describing how month-end balance sheet constraints are preventing some risk trades while another adds that more exchange trading is required as a result of those balance sheet constraints.
What actions can banks take to reduce their capital exposure?
Given the relatively low returns available from the provision of clearing services banks are encouraged to allocate balance sheets to the more profitable areas of business. For example, it may well be the case that a particular client provides lots of flow business, and by virtue of that, is attractive as a clearing client. Regardless, the aforementioned challenges remain, so what can the banks do to try and negate this?
The most extreme strategy would be for a bank to remove itself from offering client clearing services, deciding instead to focus on its house business only. Those wishing to remain will likely implement a client optimisation strategy whereby they allocate balance sheet to higher revenue generating clients giving consideration to total value across business lines. This is where relationships become key.
Other tactics banks may wish to employ include (but are not limited to):
- The use of alternative central counterparty clearing (CCP) account structures, encouraging direct membership at CCPs for those clients whose portfolios are directional, long dated and therefore balance sheet intensive.
- Embracing the buy side-focused agency clearing model may also be effective. A senior representative from a U.S. bank mentioned to me recently that buy side CCP participation through an agency structure will only work if the banks are fully committed to the concept.
- Encouraging CCPs to contribute more of their own resources to the default fund potentially alleviates the need for banks to contribute so much themselves, thereby reducing their own capital exposure.
- There are also some lobbying opportunities to have certain regulations reworded to the extent that the capital impact is reduced. For example, a change in variation margin settlement to daily treatment and, perhaps more importantly, a change in the leverage ratio that allows banks to include the risk-reducing impact of segregated client initial margin in their supplementary leverage ratio calculations.
- Compression of derivative portfolios. At its peak, global over-the-counter (OTC) notional topped US$760 trillion, today that number stands at around US$400 trillion (source BIS May 2016). This is the result of voluntary portfolio compression to reduce gross notional and, therefore, capital exposure.
- Drive swap counterparties towards clearing regardless of client categorisation or whether a product is mandated. In a cleared environment offsetting risks reduces the gross notional number, whereas both legs of a bilateral swap are counted gross, regardless of any correlation. For example, the RWA associated with a cleared swap within an ISA is just 2% (OSA 4%) vs 20-150% for a bilateral swap.
- Where opportunities occur, a cross margining strategy should be employed. Any correlation in risk exposure leads to a reduced margin requirement which in turn leads to a reduced capital exposure both in terms of RWA and the leverage ratio. In terms of margin, clearing clients are being encouraged by many banks to provide securities as initial margin rather than cash.
How does this impact the buy side?
The capital challenges faced by the banks translate to a smaller pool of counterparties offering a reduced amount of balance sheet. This has a direct impact on execution in terms of liquidity, a function of which is wider bid-offer spreads.
In addition, some banks providing client clearing services are also reducing the amount of balance sheet made available. Consider for a moment an asset manager whose annual trade count is low, whose portfolio is directional and balance-sheet intensive. There is not much revenue associated with such an account and it may well be the case this particular asset manager is unable to find a clearer that will support their business. This asset manager will not be able to execute any swaps that have been mandated for clearing once the regulation is fully enforced.
Further impacts can be seen, given the current build-up of liquidity at a particular CCP. One of these impacts is that a basis has emerged when clients of clearing members have started to clear at alternative CCPs. This adds a direct and significant cost to a buy side trader when attempting to execute a cleared swap. This CCP is where the major banks’ cleared risk resides, therefore offsets for them are possible, and as such, they will charge a premium to clear elsewhere.
An emerging basis between cleared and non-cleared derivatives is also becoming more evident, regardless of a client’s categorisation under European Market Infrastructure Regulation (EMIR) any additional capital cost to a bank will be expressed in trade economics. This to my mind has been the key driver for clearing rather than the regulatory timeline and we should feel lucky in some way that the full force of Capital Requirements Directive (CRD) IV was suppressed for as long as it was. All in all, traditional OTC derivative products are becoming too costly to use, and a performance drag, due to the associated cost increases, this is a serious concern.
What actions can the buy side take to reduce their capital exposure?
The strategic response to these challenges very much depends on which type of buy side firm is behind it a pension fund manager may well choose to sit behind the pension fund exemption and indeed push for its perpetual implementation, although the merits of such a strategy are open to debate.
An asset manager running a relative-value DV01 neutral strategy will benefit greatly from the opportunity to cross product margin listed, OTC and financing trades within a single CCP. The greater the risk correlation the lower the DV01 number, which as described earlier, requires less margin to be provided for risk coverage.
Some asset managers may well choose to move away from the use of OTC derivatives as a hedging tool altogether, perhaps choosing to use a mixture of bonds, index-linked products and listed derivatives to cover risk exposures to the maximum extent possible. Employers of this strategy will of course have to be comfortable with running an element of basis risk.
There are also some straightforward techniques that can be used; deleveraging in terms of gross notional is as important to the buy side as it is to the banks. Therefore, it is imperative that gross notional exposures, in both the cleared and bilateral environments are compressed as much as possible. We have seen buy side traders switch to trading OTC swaps using IMM dates, which makes compression simple in terms of cash flow matching. We are also seeing more non-bank utilisation of the TriOptima functionality available within CCPs.
Pre-trade considerations have never been so important. Total cost analysis is fast becoming an inherent requirement in every derivative transaction and in my view, will be deeply embedded within many asset managers’ toolkits well before MIFID II enforces it.
Traders need to ensure the most appropriate product is traded, whether covering risk or using derivatives to earn alpha, consideration needs to be given to the product type prior to execution, an obvious example being a 10-year treasury future over a 10-year swap. With a significantly reduced value at risk (VAR) requirement, the margin and therefore capital cost of the future is significantly less than that of the swap. Assuming the risk characteristics to be identical, then one would opt for the future every time, particularly with exchanges now looking to add similar products along the curve, offering invoice spread trading opportunities and the like.
An additional consideration (be it for listed or OTC swaps) is where the trade should be cleared, and assuming any correlation is available, which clearing broker holds the risk offset that affords the trade a reduced margin requirement? It is also essential that firms are optimal in respect of collateral provision. Collateral optimisation has many guises and has been discussed at length in many articles, so I won’t embellish here other than to say that with the demand for high quality liquid assets increasing, asset managers with a high quality collateral inventory could potentially find their assets in demand, and therefore find themselves a revenue stream.
We are moving into a new world: new and innovative players are taking a foothold in the market, as some participants withdraw or retrench others arrive to fill the void. The potential for Citadel to engage the European swaps market as it has in the US cannot be ignored.
CCPs are working diligently on new clearing models. As mentioned earlier, in order to work for the buy side they must be built in conjunction with, and with the support of the clearing brokers. A collegiate approach is certainly required. Solving the capital problem for both sides of the trade is the priority here—get that right and the model will be successful.
Similar innovation is required in the deliverable swap future space. There are some existing products yet liquidity is not where it should be and swap futures haven’t yet taken off. So, perhaps it is time for both sides of the trade to work with the exchanges to develop new listed and deliverable swap products that are liquid, cost efficient and appropriate in terms of the risks they are matching.
These are tremendously challenging times for the buy side. However, we do have the opportunity to move centre stage and take the industry forward, for the common good of our clients and investors.
This article was first published in edition 7 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.
To save your address into your profile:
- Visit the home page
- Click Account (in the middle of the row of black buttons)
- Click Edit Profile (in the row of buttons at the top)
- Click Reader (top right)
- There you can see your profile, with a box for your address - complete it accurately, and click Save