To clear or not to clear (directly): that is the question
With third-party solutions and outsourcing becoming nowhere more prevalent than in the OTC derivatives space, the conclusions of many financial counterparties to become direct clearing members seem to be somewhat counterintuitive.
To clear or not to clear (directly): that is the question. A comparison of a direct membership with clearing through an intermediary
With third-party solutions and outsourcing becoming nowhere more prevalent than in the OTC derivatives space, the conclusions of many financial counterparties to become direct clearing members seem to be somewhat counterintuitive. In the following we compare opting for a direct membership with clearing through an intermediary for a small regional bank with no clearing infrastructure in place. Should we consider an asset manager, a non-financial counterparty above the clearing threshold or a regional bank that already has a connectivity to any CCP for a single product (e.g. Repo, etc), the results of the below analysis might be different.
We present the main considerations for direct members and clients of clearing brokers in the Table 1 below.
Clearing through an intermediary
Default Fund Contribution
RWA (Basel III)
Clearing Broker fees
Intraday calls 
Default Management Process 
Default management fire drills
Onboarding/project timeline 
The default fund contribution and the so called assessment rights constitute one of the biggest burdens of a direct membership. Cash contributions to the Default Fund (DF) across different CCPs vary in the range of 10 to 15% of the clearing member’s Initial Margin. Moreover, in case of a clearing member’s default, the CCP is allowed to request further drawings from the remaining members should it not be in possession of sufficient liquidity to manage the default by itself. Additional strain stems from the regulatory treatment of the above commitments. Under Basel III, a direct clearing member is required to hold sufficient level of capital to cover the risks from potential future drawings on default fund commitments. The above is not applicable to clients of direct members since all default fund contributions will be managed by the clearing broker of their choice.
A client can also consider alternative membership structures at the CCP (e.g. sponsored membership model), that exempt them from certain requirements such as default fund contributions but retain other benefits of direct membership such as reduced RWA (refer to Table 1 for details). Clients of clearing members, on the other hand, can only qualify for 2% risk weight if certain conditions are met such as porting ability and sufficient segregation, amongst others. However, although these alternative memberships are available today, they are not yet widely supported by clearing brokers and are likely to come with higher cost implications and operational challenges. As a result, one needs to run a cost comparison of lower risk weight versus increased clearing broker fees for using such a model.
When it comes to cost differentials, the intermediary option reduces the required initial and to some extent on-going investment due to lower set up and CCP risk costs. The set-up costs for clearing brokers’ clients can be significantly less than those of becoming a direct member due to lower IT investments, operational costs and headcount requirements. The CCP risk costs, which include components driven by the amount of the default fund contribution and Initial Margin, are also lower for clients of clearing brokers. The cost components that should be considered when clearing through a broker are clearing and maintenance fees.
In light of the leverage ratio impact on the client clearing business model, clearing members are reviewing commercial terms, in relation to client cleared business. The rising costs of supporting OTC client clearing have already forced a few clearing brokers out of providing the service, while other brokers have been reducing their businesses by managing the number of new clients they accept subject to the overall relationship.
Notwithstanding how you access clearing some costs cannot be avoided. For a client portfolio of €1.1 billion gross notional, generating an Initial Margin requirement of roughly €20-30 million and whose monthly volumes are in the range of 50-60 trades, the estimated cost for a clearing broker to support this portfolio would be in the region of €200,000 per annum. Direct members will see these costs in capital and funding, clients of clearing brokers will see them imbedded into their clearing fees. This is assuming – as widely expected by the industry – a change to the capital rules’ treatment of clients’ Initial margin and exposure calculation for the cleared derivatives in the future (i.e. segregated clients’ margin excluded from the calculation of exposure for the purpose of the leverage ratio). Should the rules remain unchanged, costs and clearing fees may increase by more than 60% for the same portfolio described above.
Operational costs and considerations
Clients also need to carefully consider operational prerequisites of both membership options. If an organisation opts for a direct membership, it will need to demonstrate its ability to participate in an auction in the event of clearing member’s default. During the so-called fire drills, which in some instances can take place as often as twice a year, clearing members are required to submit live executable prices in cleared products and currencies. This has a resource availability impact.
A further operational consideration of becoming a direct member would be the need to open and maintain payment accounts with each Clearing House to facilitate margin payments. This relies on relationships with multiple cash correspondent banks. A client that uses a clearing broker, on the other hand, can pay the margins via SWIFT payment as for the existing bilateral transactions and could use the existing infrastructure and operational process of the clearing broker.
The requirement to manage multiple intraday calls from the CCP which sometimes can be issued late in the evening is another burden which will not apply to clients in the standard set up for client clearing as they will receive a single margin call in the morning covering intraday changes from the previous day. Given that the majority of small organisations do not have a collateral management system that could process multiple calls from the CCP in a timely manner, building such an infrastructure would require material IT spend and headcount investments.
With the clearing obligation to come into effect in 2016, clients may find it less time consuming to go through an intermediary route rather than direct membership option which, in a best case scenario, will take many months to implement, with a degree of uncertainty on the project end date, given the complexity and dependencies on CCP’s membership requirements. The direct membership model is more complex and resource intensive for systems and operational set up, which means unless a client is able to outsource one or both, the timeline for set up is greater and arguably not possible unless already started.
It is difficult to make a one size fits all conclusion as a lot of factors need to be considered. However, one could argue that the impending deadline for the clearing mandate turns most arguments and considerations on their head. This being the case the aspect that should be the primary concern of all market participants who have yet to initiate a project to select a clearing provision, whether that be direct or clearing broker, is certainty of time to market.
 Assumption is that the clearing broker funds intraday calls  Execution capability required to participate in an auction means trader headcount and systems that can price an IRS portfolio independently  Minimum timeline required to get onboarded