There are many buzzwords in the OTC clearing lexicon at the moment. “Equivalence”, “resolution and recovery”, “cost of capital” among them. But one you don’t hear a lot is “portability”. In 2009 and 2010 there was plenty of talk on this subject, how it was supposed to work and how it is achieved. Today, after clients have gone live or have been briefed many times on the mechanics of clearing we all tend to take it for granted.

Establishing a port in a storm…

by Jamie Gavin

There are many buzzwords in the OTC clearing lexicon at the moment. “Equivalence”, “resolution and recovery”, “cost of capital” among them. But one you don’t hear a lot is “portability”. In 2009 and 2010 there was plenty of talk on this subject, how it was supposed to work and how it is achieved. Today, after clients have gone live or have been briefed many times on the mechanics of clearing we all tend to take it for granted.

It’s universally understood. It’s straightforward. There’s no mystery to what it means and the implications. Or is there? Over the course of this article we will explore what portability or “porting” means and what clearing clients should be aware of. Given the level of detail required to review the US Bankruptcy law and procedure we will leave that for the pur- poses of this exercise and focus on Europe.

In the aftermath of the collapse of Lehman Brothers and during the genesis of the OTC Clearing model, clients and practitioners alike sought to reconstruct a clearing model that focussed on the segregation model. This was a direct response to those clients aggrieved post the Lehman default when they found themselves at the mercy of mutualisation. These market participants found that it took time to get their assets back and that they had to re-establish their positions in difficult conditions. It was a painful and costly exercise for many firms.

So when building the new model the chief concerns centred on the removal of fellow customer risk, protecting and securing assets for clients and being able to move positions if a clearing member defaulted.

This last point is one of the cornerstones of the new OTC Clearing model – being able to achieve portability (truncated to the verb “porting” among hipster clearing geeks). In the event that a clearing member defaults, clients want to move their positions and their collateral to a new clearing member. They don’t want to have to re-establish positions in a volatile market nor source additional initial margin and cash variation margin.

So how does porting work?

In general, we can categorise the porting process in two broad ways: pre-default (“peacetime”) and post-default (“wartime”).

Pre-default porting is relatively straightforward but the difficult part of this story is that no two CCPs are alike. Clearing Houses each have different procedures for transferring trades from one clearing member to another: some are form-based, some via a GUI. They can rely on all three parties signing, or just the client and receiving clearing member. A clearing broker should be able to help clients navigate this process and delve into the minutiae based on the clearing house or houses that they choose. At its core the process should work something like this:

1. The client identifies trades/positions that they want to move.
2. The receiving clearing member reviews the portfolio against agreed limits and accepts (or rather, hopefully, doesn’t reject).
3. The client then notifies their current clearing broker (“broker”) that they want to move the trades.
4. The receiving broker will submit the transfer request to the clearing house, which will in turn reconcile the trade list and ask the broker to approve (the current broker will have a set time period in which to do this).
5. Trades are then transferred, normally on an intraday basis, relying on collateral on deposit at the clearing house.

At this point we should discuss collateral. Does the transfer happen with or without collateral? This is up to the client and broker. Questions at this point will be: does the client have enough collateral to double fund? Will the CB finance the first day’s requirement, either for free or at a charge? Or would the parties rather move the collateral at the CCP?

Once again, the mechanics are not the same. If clients opt to move the collateral at the CCP the process can take longer. In addition, clients may not be able to choose the collateral that moves, e.g. in some omnibus models the CCP will choose collateral within the pool to move, leaving the brokers and clients to sort out substitutions afterwards. It is all in the detail.

There is also the issue of fees. Depending on a client’s arrangement, transferred trades could be done at the same rate as any other trades, they could be at a discount or even for free. If a client is moving a small number of trades this may not be such an issue. Given the capital-constrained environment facing nearly all market participants transferring large portfolios could be costly.

Finally, on pre-default porting, we anecdotally hear that some clients within the industry are looking to push clearing houses to standardise their peacetime processes as soon as possible. Several asset managers are believed to be unhappy with the current landscape and want more STP to allow them to rebalance fund positions across brokers more efficiently. This is an encouraging sign that OTC clearing is maturing from the scramble to set-up services that characterised the inception of the industry.

In the post-default world, portability is quite a different animal. Here, the aim is to move clients to safe harbour as soon as possible, avoiding the disruption of clients having to re-establish positions. The derivatives industry wants markets to work in times of stress and an efficient porting process sits at the heart of this.

In a post-default situation speed is of the essence. All clearing houses have plans for wartime porting and aim to move all clients from a defaulted broker to a new home in 48-72 hours. This represents a Herculean task and one that remains to be seen how effectively it will work. The post-default procedure should look something like this:

1. A client is called by the CCP and asked what they want to do. Do they want to port and to who?
2. CCP calls the nominated backup broker and asks if it will accept the portfolio.
3. Broker does its due diligence, talks to the client and accepts the port request.
4. CCP transfers the positions to the back-up – with what collateral is dependent on the CCP and what it decides given the market conditions.

On point 4) we need to carefully consider what happens to the collateral. In the case of an omnibus, the CCP may decide to liquidate the collateral pool and distribute cash. Or, it may try to pro rata distribute to individual ISINs to clients.

Omnibus clients will also share any losses in that liquidation. For example, if a certain bond depreciates more readily than its haircut value in the ensuing fire sale, that loss will be mutualised by all clients in the pool.

So, surely, ISAs (Individual Segregated Accounts) are better? The idea is that a client’s assets are tagged in the client’s name and therefore should be readily identifiable and moved. Yes, that’s the premise. However, within most CCP rules the CCP has the ultimate right to liquidate. This seems to make sense given we have no way of knowing what situation a CCP may find itself in, and needs to leave itself options – but not all clients are aware of this. However, even if liquidated, that fire sale loss is not pro-rated amongst ISA clients.

So how should clients maximise their chances of porting? Whether in a gross omnibus or ISA structure clients will need to consider the following:

1. Have a back-up clearing relationship ready. When talking with clients any honest broker should always advocate that the client needs to have at least one other (back-up) Clearer.
2. Make sure the account is live. It’s futile establishing limits and negotiating documentation unless all the static data set-up, account opening and other plumbing has been completed and tested. In a time of stress clients need to know that they can rely on being able to clear immediately.
3. To clear or not to clear. Clearing broker views differ on this point – some will want to receive existing clearing business and will not want to serve as a “cold” back-up. Others will want another form of relationship, maybe via OTC execution or listed derivative clearing. They may act as “cold” but charge a fee. They may also set limits on how much they will accept against a percentage of what they are already clearing. If acting as a cold back-up, they will likely require a regular portfolio or credit review to ensure agreed limits are available when really needed.
4. How big is your portfolio? Given their size, some clients such as asset managers, insurers and pension funds will have more than one clearer. Clients should assess whether they are able to redistribute their portfolio amongst their other brokers, within their current clearing limits.
5. What does the small print say? Clients should understand what their clearing agreements say. What rights or obligations does the CB have in respect of accepting trades? How will their CCP porting process work and within what timings?

Underpinning all of this, clients should not leave their clearing broker set-ups to the last minute. We are, unfortunately, in an environment where a number of brokers have withdrawn clearing services or have closed their books to new clients. This concentration is not good for the market.

Have clients secured capacity with their brokers? Do they have enough CBs or back-up relationships in place? Will CBs be committed to honour those relationships in a time of stress?

At a time where we are still 12-18 months away from mandatory clearing in Europe and with a large number of clients still to on-board or complete their selection processes, clients need to ensure they establish clearing with the brokers that they want as soon as possible. Porting, or portability, in a default situation is all about being able to survive. Clients need to be able to ask themselves the question, “Can I port?”

This article was first published in edition 4 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to receive the latest hard copy editions as they become available.