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February 22, 2017

Direct Clearing – a perfect fit for the repo market?

Managing client protection in the new regulatory ecosystem can be achieved in a truly cost efficient manner by introducing a direct clearing model. The beauty of a well-designed direct clearing model is that all client driven capital costs for repo transactions are eliminated while clients receive “best-in-class-client-protection”. In other words, Direct Clearing has the potential to benefit the entire financial industry.

Managing client protection in the new regulatory ecosystem can be achieved in a truly cost efficient manner by introducing a direct clearing model. The beauty of a well-designed direct clearing model is that all client driven capital costs for repo transactions are eliminated while clients receive “best-in-class-client-protection”. In other words, Direct Clearing has the potential to benefit the entire financial industry.

Direct Clearing – a perfect fit for the repo market?

This fall it is eight years since Lehman Brothers went into default. Few would have thought that the financial sector would still be wrestling with the massive ripple effects created by this event, the ensuing uncertainty over double or triple dips and the efforts to prevent a new crisis. But the reality is that most market participants today feel the weight of increased regulatory requirements, while simultaneously trying to answer the demand for sophisticated client protection. As a result, a number of CCPs are in the process of looking in to or implementing a direct clearing solution. 

A changing market

“People think that the rules of the game have changed. The rules have not changed; it’s the entire game that has changed.” – Repo Trader

Repo markets are a key source of short-term secured funding in the financial system and are regarded as a basic building block of the financial markets.

The shifting regulatory landscape has placed existing business models under immense pressure. The question market participants must ask is, how will business models evolve in this new regulatory landscape?

Obviously, there is no simple answer to this question, but from market participant’s point of view, a direct clearing model could have a key role to play. This is especially true for repos, a product that has a large impact on clearing brokers’ balance sheets.

One effect of an efficiently designed direct clearing model is that client driven capital costs are minimized. This is done by moving the clients’ exposure, a component that drives capital costs, from the clearing broker to the CCP.

Another strong argument for direct clearing is the significant improvement of client protection in the case of a clearing member’s default. The main reason is that there is no need for porting of either positions or collateral since it is held on the clients’ own account at the CCP.

But how will this affect the role of the clearing broker? In our opinion, very little since all services currently provided by clearing brokers such as position and collateral management, collateral transformation, settlement, etc. will continue to be required by clients.

 

Responsibility of the CCPGuiding Principles

The purpose of the CCP is to contribute to the stability, credibility and efficiency of the financial system. But there is also an obligation to create a level playing field for market participants in gaining access to CCP clearing. In order to do that, you need flexibility in clearing models and not least local market knowledge. Experience shows that one single clearing model based on an omnibus and an individually segregated account (ISA) structure is not able to cover all needs in the market; especially not in a market with such specific requirements as in the repo market.

 

Characteristics of direct clearing

Taken from the top, the direct clearing model is based on two key components. Firstly, the legal relationship which is between the client and the CCP instead of between the client and the clearing member. Secondly, the relationship between the client and the clearing member, which acts as an agent for the client.

This basically means that the client is legally responsible for Initial Margin (IM), Variation Margin (VM), settlement and default fund contribution while the clearing broker takes responsibility for the entire transaction chain including, position management, collateral management, settlement, etc.

Keep in mind that even though the client is responsible for the default fund contribution it is possible to assign this to a clearing member through an individual agreement. This is an important feature since not all clients are willing or even permitted to contribute to a default fund. Financial stability is one of the cornerstones of CCP clearing and this naturally places high requirements on all parties involved in the clearing chain to secure that the clients meet the stipulated financial and operational requirements. In light of this, the supervision of members and direct clearing clients should be carried out according to the same principle. A direct clearing model must not in any way jeopardize the credibility and stability of the CCP.

 

Challenges

The key to implementing a direct clearing model in a successful way is to offer a model that creates efficiency for all participants in the transaction chain. Factors to look out for in particular are on the technical and legal side since direct clearing requires safekeeping and default fund contribution on client level. It should be remembered that there is not one simple solution that solves all types of issues, so the flexibility of the CCP is key going forward.

 

Drivers

But if those are factored in, a direct clearing model will basically remove barriers and ease market access so market participants can deliver capital efficiency as there are no client driven capital costs. On top of that, participants assume no fellowship risk and achieve full asset protection in order to deliver, what we call, “best-in-class-client-protection”.

Figure 1

Nasdaq Clearing as a partner

The need for Direct Clearing models has been debated in the industry, but direct clearing is a model that opens up new opportunities, in particular for the repo market where the current business model is challenged by new regulation.

At Nasdaq Clearing we have made it a tradition to challenge the old; we believe that a changing landscape creates new opportunities for everyone in the financial sector. Still, we have offered direct clearing to the market for more than 25 years and as always the new strides taken to enhance our offering happens as a result of extensive dialogue with both the buy side and the sell side.

That is why we will launch an enhanced direct clearing model in Q1 2017. A model designed to manage the coming challenges within the financial sector in the most efficient manner possible.


This article was first published in edition 8 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.Rocket 8

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