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Sep 26 2011

Clearing & Settlement - The Long Game

 

The cost/benefit analysis for the migration of OTC derivatives to on-exchange trading and central counterparty (CCP) clearing is far from compelling for institutional investors at present, but Chris Ekonomidis, director, Sapient Global Markets, says there may be long-term advantages.

“A main challenge for the buy-side arising is retaining yields while having to post additional margin and come up with increased levels of high-quality, liquid collateral. These are substantial costs and no one has yet put a number on them,” he says.

Investors’ anxieties were apparent at last week’s Sibos banking conference in Toronto, where Guus Warringa, board member and chief counsel for Dutch pension fund manager APG Asset Management, which administers approximately €279 billion in pension assets, complaining about the lack of detail on the proposed changes to OTC derivatives trading. “The buy-side is not awake to what is going on, but those that understand the situation are not happy,” he said. “We don’t even have information on liquidity and pricing in the market so how can we know the true context of the proposed regulation."

Speaking to theTRADEnews.com at Sibos, Ekonomidis agreed that many questions remain unanswered and that CCPs are far from a panacea for the perceived ills of the OTC derivatives market. “Use of CCPs for OTC derivatives does not remove risk; it just shifts it. Moreover, the proliferation of CCPs raises concerns about whether their risk management methodologies are capable of addressing tomorrow’s risks not just yesterday’s,” he says.

The Group of 20 political leaders and central bankers have demanded systemic risk in the OTC derivatives markets be reduced by standardising OTC derivative instruments, trading them on exchange, clearing them via CCPs rather than bilaterally and reporting transactions on trade repositories to aid supervisory oversight by regulators. The US is implementing the G20’s objectives through the Dodd-Frank Act, while the European Commission drafted the European market infrastructure regulation to establish a new pan-European framework. Both pieces of legislation grant considerable latitude to regulators to define details such as precisely which instruments can be standardised and are therefore suitable for clearing. They are also both subject to delay as legislators and regulators wrestle with the minutiae, while other jurisdictions, including Canada, try to balance the G20’s requirements with the realities of existing market practice. Many fear a fragmented picture, with different requirements across markets adding to the inherent difficulties for the buy-side of shifting from bilateral, and often informal, arrangements with brokers to much more rigid collateral and margin requirements once OTC derivatives trade on exchange. Even if consensus were achieved between different geographic markets, moving OTC derivatives on-exchange requires the establishment of many new processes in the front-, middle- and back-offices of buy-side market participants as well as the various market infrastructures asked to take on new roles by the G20.

“The workflow for OTC derivatives being cleared on CCPs has not yet been defined. There may be a role for the ISO 20022 message standard,” says Simon Greig, vice president, Sapient Global Markets, referring to possible synergies arising from the work being done by standards-setters, market infrastructures and market participants on automating and standardising corporate actions.

For buy-side firms, one of the decisions forced upon them by the new rules for OTC derivatives could be how to access CCPs to manage new collateral requirements. Smaller firms will look to their custodians to support them with solutions that enable them to link indirectly to CCPs and some banks have already made acquisitions to meet this need. Larger asset managers may buy their own platforms to facilitate direct membership, suggests Ekonomidis, potentially allowing them to benefit from long-term cost savings. “For the buy-side, direct membership of a CCP for clearing derivatives requires a number of upfront investments. Larger players could recoup these costs over the years through lower trading fees instead of paying higher spreads or additional fees to intermediaries,” he says.

Sapient Global Markets, a provider of integrated advisory and technology services to capital and commodity market participants, was engaged by the Canadian Market Infrastructure Committee to coordinate governance and project management in support of its efforts to deliver a consolidated Canadian market response to the G20 reforms. The firm is also working with several major Canadian banks on projects focused around regulatory readiness.

Canada has appointed the Canadian Derivatives Clearing Corporation to act as central counterparty in repo and fixed income markets, but it is still weighing up the pros and cons of opting for a national or offshore provider of CCP services for OTC derivatives transactions, including Canadian dollar-denominated interest rate swaps, the market for which includes both global and Canadian market participants.

“The solution we choose must come to grips with the systemic importance of OTC derivatives to Canada and the globalised nature of the market,” Tim Lane, deputy governor of the Bank of Canada, told delegates at the opening plenary session of the Sibos conference on 19 September. Lane also emphasised the importance of wider access to international CCPs to avoid concentrating risk among the relatively small number of global broker-dealers that conduct the vast majority of business on CCPs via direct membership.

The need to balance local and global considerations is not restricted to choice of CCPs. Many have argued in favour of a single trade repository to hold data relating to derivatives transactions globally to facilitate equal access by regulators, but local priorities may endanger the levels of access envisaged by the G20. “We’re already seeing a fracturing in the trade repository arena. Data has to be normalised and trade repositories need to be harmonised. Otherwise we might have a great view of the next crisis, but we won’t be able to do anything about it,” warns Sapient’s Greig.

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