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November 23, 2015

Readiness for Mandatory Clearing (or maybe “Ready… Set…Go!”)

How time flies when you’re having fun… or waiting for clearing regulations to finally start. It seems Bruce Lee was right when he said, “If you spend too much time thinking about a thing, you’ll never get it done.”

How time flies when you’re having fun… or waiting for clearing regulations to finally start. It seems Bruce Lee was right when he said, “If you spend too much time thinking about a thing, you’ll never get it done.”

Nearly six years to the day after the historic G-20 Pittsburgh summit, and five years after the introduction of Dodd-Frank, we are eagerly awaiting an announcement by the European Council that the latest draft of Regulatory Technical Standards on mandatory clearing is approved. Many sincerely hope this happens soon and that the countdown to start clearing will finally begin.

But where are we in terms of readiness? We’ve had all this time to prepare, is the industry ready?

The Client position

At a recent Buy-side conference held over the summer, in a room of large to medium size banks, asset managers and pension funds, 40% said they were ready now, with 47% stating they would be ready in 1-2 years. Many in the clearing industry report similar states of preparedness, with generally the more sophisticated, larger institutions having connected to their first 1-2 clearing members and now working on the next phase. There certainly wasn’t an imminent feeling of panic and a large proportion have started, or thinking about starting, to clear ahead of a clearing deadline.

But on the smaller end of the scale, more worryingly, there are more clients out there working through the details and still in the process of onboarding or choosing their first clearing member. In an environment where the number of clearing members has fallen in the last 12-18 months, as well as others raising their pricing or closing their books (some even “de-boarding” clients) the hope is that they are working quickly.

Is it all bad news, though? The latest statistics from ISDA show that approximately 82% of IRS and CDS notional is now cleared, though this is probably more due to the large banks and broker dealers who actively clear. Again the argument is that the smaller tail hides a large number of medium-to-small banks, institutions, and European clients that need access to OTC clearing and need it fast.

So what happens if you’re not ready to clear?

In this instance the choices are limited. If the products traded are mandated to clear (USD, GBP, EUR and JPY, IRS & FRAs) then clients cannot hold these bilaterally. Either they will need to use alternative products that may not hedge as effectively, such as futures products, or stop hedging altogether. If a client requires accurate cashflow matching or is managing a liability driven investment (LDI) portfolio, then trading anything other than OTC IRS may not be an option.

If the product isn’t mandated there are other, more costly implications. Bilateral margin rules may mean paying IM where clients hadn’t previously. The new IM and capital rules will make non-cleared trades more expensive than cleared. The widely covered CME vs LCH basis has given credibility to the idea that a basis will emerge between cleared and non-cleared pricing, meaning if you don’t clear at a CCP the executed price will become much more expensive.

On this last point, conversations with European pension funds highlight the opinion that even with a clearing exemption lasting into 2018, they will be forced to clear through pricing.

For most participants it may well be that staying bilateral isn’t a consideration.

We’re not alone

So what is happening in the rest of the World – internationally there is still mixed progress in Clearing:

US – streets ahead of other regions, the last phase of clearing was introduced in 2013 – clearing is now a mature and stable clearing market.

Europe begins mandatory clearing in late 2015 and follows a series of phases extending to 2018 for the smallest firms, but bringing most active participants in the OTC market into clearing by the end of 2016.

Asia – accounting for less than 10% of global OTC derivatives activity, countries are in different states of clearing:

  • China – on-shore RMB IRS between domestic banks subject to mandatory clearing
  • Japan – the largest IRS market in the APAC region, mandatory clearing (subject to thresholds) is in force
  • Hong Kong – Are carrying out market consultation with a deadline for submissions of 30th Nov 2015
  • Singapore – a recent consultation on introducing mandatory clearing ended in July this year, proposing a $15bn threshold for larger institutions to clear IRS through approved and recognised clearing houses
  • Australia – have completed a market consultation, and drafted rules defining the scope of products and affected parties. A start date for mandatory clearing seems to be 7th March 2016

Middle East – no official announcements on mandatory clearing, though local banks and institutions are looking to clear under either Dodd-Frank or EMIR due to their trading counterparts or the aforementioned basis concerns. Limited netting opinions make this a challenging region, even with clearing.

Market developments

While some participants are still gearing up for clearing, innovation in the market carries on and we can expect to see some significant advancements in 2016.

Sponsored Access

One European CCP is looking at a sponsored access model to solve the capital issue of clearing OTC trades for very large in stitutions such as pension funds. This would involve the pension fund becoming a direct member, with their default management process out-sourced to a clearing broker without the latter taking on the pension fund’s balance sheet, thereby keeping the clearing of positions more cost effective.

The solution is in its infancy but receiving very real and careful consideration by the clearing membership. Considering the massive reduction of capital on a clearing broker’s balance sheet it would free resources for other clearing relationships and make clearing a more realistic prospect for these clients (though VM cash requirements is still an outstanding problem).

For smaller clients a solution for indirect clearing, as demanded under EMIR, is not forthcoming with outstanding issues regarding the “leapfrog payment” in the event of the direct client’s default. Positively, there is at least one clearing member that has a solution to this, enabling those smaller users to get their OTC products cleared.

New products

IRS swaptions have been developed and a firm date for go-live is likely toward the end of Q1 2016, with pricing and pricing models under review.

FX NDFs can now be cleared and with two European CCPs offering the service the rumour is that they will be up for ESMA consultation again soon – if the decision is to make some currencies mandatory for clearing the question is how long before the CFTC follows suit.

Now that LCH.Clearnet and CLS have agreed a way forward on settlement, FX Option clearing is fully expected in 2016.

Cross-currency swaps are being advanced within at least one CCP, allowing clearing in the final significant sector of the IRS market. Data collected by ClarusFT from the US and EU sources indicates an approximate market size of $16trn, but the data isn’t reconciled cross-border so the exact figure is hard to come by from public sources.

Margin and capital efficiency

Cross-asset margin abilities on CME and Eurex allow clients to realise netting benefits between their OTC and Listed Derivative transactions and it has been widely publicised that ICE and LCH are working on similar products. Who will win is an interesting pub discussion.

Similarly compression has moved on from netting that relied on the same start date, maturity date and fixed coupon. Services have evolved to allow netting where only the maturity and future cashflow dates align and this has been taken further with CCP coupon blending also allowing compression across different fixed coupons. On one CCP alone, the benefits are that we have seen a 15:1 compression ratio on gross notional cleared.

The next step will be allowing “risky” compression services, such as TriOptima to allow further benefits in drastically reducing the gross notional of clearing portfolios, realising very material capital advantages, by replacing multiple lines with a handful of trades and a residual mtm.

Looking at the volumes of cleared business globally, the total size of the cleared market has dropped by 8% or $15trn. The majority of this drop is from SwapClear, CME and JSCC who provide compression tools via TriResolve.

Other challenges

Outside of just being ready to clear, another problem still concerning clients and the industry as a whole is whether there is enough collateral and whether that collateral can move fast enough to meet the VM and IM requirements that could occur in a market stress situation. If the interest rate curve jumps 1%, as it did twice in late 2008, in a cleared environment the requirement for cash collateral on VM across Europe could be materially significant, running into hundreds of billions of Euros. Many worry that the repo market could not support this, especially when viewing recent liquidity in the market.

In addition there is considerable focus on CCP robustness – how transparent should their risk models and stress-testing be, whether the default waterfalls would stand up, and has the CCP invested enough “skin in the game”?

As we approach clearing in Europe, participants are already looking ahead at the post-trade environment – for remaining bilateral trades there are several consortiums and industry bodies working on common goals of standardised bilateral IM modelling, non-cleared multilateral netting and centralised margin processing.

Set against a backdrop of MiFID II, Basel III, OCR, bilateral IM & VM, US-EU equivalence and electronic execution (SEFs and OTF/MTFs) the financial services industry is facing challenging times. Fitting in all these efforts and more, presents as many opportunities as it does obstacles.

Recommendations for clients

When looking at how clients should react to all this complexity and change, especially if they are not ready to clear there are some key points of advice:

  • Pick a committed partner – clearing resource is finite and you need to ensure your Clearing Broker will stay the course
  • Furthering the relationship – can your clearing broker provide the other services you need: execution, research, structured solutions, substitute products, cross-asset portfolio margin, etc.?
  • Choose a knowledgeable Clearing Broker – there are many facets to getting ready for OTC Clearing: operations, trading, legal, risk – your clearing partner should be able to help you navigate all these issues and more.
  • Do not delay – if you’re ready, all well and good. If you are still waiting to act then you shouldn’t panic, but do start planning your selection and onboarding process as soon as possible.

The final word

Probably more erudite than Bruce Lee, Geoffrey Chaucer wrote in the 14th Century that “Time and tide wait for no man” – it looks like our clearing wait may be finally over.


This article was first published in edition 5 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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