Following the 2008 Financial Crisis, multiple regional sets of regulations (EMIR, Dodd-Frank) mandated OTC markets migrate from bilateral to cleared processing.  As rules were written and regulations in the U.S. and Eurozone have come into effect over the past 7 years, the Basel Committee on Banking Supervision threw a levered wrench into mandatory client clearing for FCMs which has lead us to a crossroad in derivative market clearing infrastructure.

Following the 2008 Financial Crisis, multiple regional sets of regulations (EMIR, Dodd-Frank) mandated OTC markets migrate from bilateral to cleared processing.  As rules were written and regulations in the U.S. and Eurozone have come into effect over the past 7 years, the Basel Committee on Banking Supervision threw a levered wrench into mandatory client clearing for FCMs which has lead us to a crossroad in derivative market clearing infrastructure.

In 2009, while heading credit derivative trading for a large FCM, I began exploring clearing alternatives to the OTC membership model which was borne as a result of my firm not meeting the $5bn ANC requirement set by the CME and ICE for CDS clearing membership access.   Guided by CFTC Rule 22.11, I explored ‘leasing’ a membership from an existing OTC derivative clearing firm.  Via an omnibus limit and look-through membership structure, I would be able to divide my firm’s allocated omnibus limit amongst clearing clients. The CCP and clearing member would know the account’s identity and my firm would act as an intermediary for margin, reporting and recordkeeping. Multiple existing CDS clearing members at ICE and CME expressed interest and so I began the process of modeling an infrastructure, with a dual, bottom-up limit checking structure; until the CFTC reduced the $5bn ANC requirement to $25mm.  This significantly lowered threshold availed my firm the opportunity to apply for direct CDS clearing membership and perhaps delayed the onset of clearing model alternatives.

In 2011, I led an effort at a custodial firm to build a similar indirect CDS clearing model; this time the alternative to direct CME/ICE membership was being driven by the custodian’s inability to ‘pass’ direct membership requirements relating to the provision of end of day pricing, CDS curve construction, outlier pricing risk take down and assumption of defaulted CDS portfolios via CCP auction protocols – that was until Basel joined the regulatory reform party which sent shock waves through client clearing cost models. That’s right, if one set of regulations mandated the clearing of OTC derivative products, another set of regulations would make it so costly the net effect would be the elimination of onboarding new clearing customers while forcing FCMs to closely review the franchise value of existing ones.  I went so far as to present a quad party custodial structure to CCPs while mirroring aspects of European sponsored access models. But US bankruptcy law made those no different than a traditional model.

What wasn’t absent in both cases were customer demand for clearing access and the need to tackle a regulatory borne problem with innovative and cost effective solutions. 

Fast forwarding to 2016, the laundry list of reasons for alternative derivative clearing solutions has grown, while the number of FCMs has been more than halved.  The US Legally Segregated Operationally Co-Mingled model (LSOC) and an inability to rehypothecate customer collateral, global central banks maintaining a near zero or negative rate environment, Basel III capital rules regarding the leverage ratio and treatment of client capital are just a few of the reasons which have turned the once desirable annuity stream that was generated via client clearing into a platform that’s viewed at best as a necessary evil.

Enter the CME’s plan to allow a hybrid ‘direct clearing’ model for buy side participants.  Under this model, which shares similarities to European sponsored access options, the client would be able to post and receive collateral directly to/from CME. This option, while seemingly not affording any incremental protections to customer collateral given clearing members would continue to contribute to the CCPs guarantee fund and sponsor clients, it could considerably alleviate capital charges to banks, and if passed down to customers, costs associated with mandatory clearing.

And perhaps whilst undesirable to existing members, alternatives to the CME’s hybrid model do exist. Where clearing membership is thinnest, OTC derivative clearing firms come to mind in particular, tiered and weighted membership options seem like viable options. Here, a CCP could go a step further by permitting direct access and guarantee fund contributions by participants, while foregoing the requirements relating to providing pricing and participating in default auctions.  Contrary to mainstream opinion, I’d think a tiered membership option could be just as, if not more attractive to a smaller prospective clearing member (relative to the largest clearing customers) citing cost and significant barriers to entry experienced under the existing model.

Rates will undoubtedly rise? (I think), harmonization of cross-border regulation improved (I hope), and untraditional clearing solutions created (I’ve tried): all of which should improve the outlook for client clearing franchises and those seeking access to participating in cleared markets.

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.

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