HEDGE FUNDS REVIEW: What impact will regulations covering the exchange clearing of over-the-counter (OTC) derivatives have on the market and market participants?
Renaud Huck: The European Market Infrastructure Regulation is going to be the big ‘elephant in the corridor’. Consequently, as we’re getting close to the final delivery of the text and its implementation, it is fair to say the wish of the regulators is to push OTC trading towards exchange clearing, including the shift to central counterparty clearing. It is going to be the most impacting element of the financial world in the years to come on both sides of the pond.
The regulation is catching everything in one net. The regulators favour a future environment that is cleared rather than a bilateral environment, as it was before. Of course, it is easier to clear plain vanilla OTC trades. Therefore, the more complex, tailor-made OTC trades could end up being a bit more difficult to clear and, as a result, more expensive for the end-client. As a clearing house, we take an agnostic view of the structure of the trade.
HEDGE FUNDS REVIEW: Is regulation going to protect assets or create greater counterparty risk?
Renaud Huck: This is a key area of this new regulation and a major concern for the industry. Yesterday, things were bilateral. As a buy-side entity you had to take on board a counterparty trading and credit risk. Then you were given the amount of collateral according to the nature of the trade you had conducted.
Tomorrow, buy-side entities that don’t have a direct relationship with the clearing house are going to be forced to have one. As a consequence, they have to make a risk assessment of clearing houses, entities that they are neither members of nor in a direct relationship with. That’s one element.
However, the key is, as a clearing house, we have definitely identified the need to protect collaterals and the positions, mainly in the case of a default of a clearing member.
There are two schools of thought on this. The first supposes a credit event where the collaterals with the positions are liquidated. The second is that, in some circumstances, they are protected. We are definitely on the side of the latter. Via our client asset protection model, we have made a lot of effort to have a very buy-side-oriented solution to protect the positions and the collaterals in the case of a default.
HEDGE FUNDS REVIEW: What can you do to help hedge funds with collateral management?
Renaud Huck: This is also a very important area. This is key for the buy-side industry and definitely key for asset managers who have buy-side clients behind them. They have a duty to protect the collaterals they are given.
Our view is that it is important to protect and make sure that, in the case of a default, these collaterals are well segregated. That’s why our clearing model offers full segregation. As a clearing house we have to be in a position to offer a broad range of collateral.
We have taken the view of adopting two benchmarks: the first is the European Central Bank eligible collateral list; and the second is the Swiss National Bank eligible collateral list. These are the two benchmarks.
We accept around 25,000 ISINs in terms of securities collateral. We also accept equities, cash and gold certificates. As we are a very conservative clearing house, we make sure that, for whatever we accept, we are in a position to make a valuation and to get independent pricing for those collaterals. We also have very specific haircuts to ensure there is a good correlation with market conditions.
HEDGE FUNDS REVIEW: What is your view on the potential race to the bottom with exchanges cutting fees and potential to be less rigorous on the risk management?
Renaud Huck: This is a direction that Eurex Clearing will never take. We will never lower our guard in our clearing conditions and in some of the requirements that we have. This is purely because we consider this would jeopardise our business model and definitely the financial stability of the clearing house and, therefore, the very services we want to deliver to the industry.
HEDGE FUNDS REVIEW: Is there any way you can promote this attitude to the rest of the industry or influence behaviour?
Renaud Huck: We are vocal about this concern. We are conscious about the fact that, if anybody were to implement this, it would be opening a big Pandora’s box. There is more to it than purely appealing levels of margin requirements. Margin requirements have to be appropriately calculated according to the profile and the risk of the position and the trade. We have a very strong view and position on this. Hopefully our approach will also inspire others to follow in the same direction.
Users should be looking at the robustness of the platform and how solid the financial and margin requirements are.
HEDGE FUNDS REVIEW: What are the main elements of risk management in this context?
Renaud Huck: With the regulations, the buy-side industry will have the possibility to have more transparency in pricing and in some of the processes as everything is going to be shifted and sent to a clearing house.
Clearing houses by nature are very transparent. We are very transparent in our risk model, very transparent in our processes. Daily, during the course of the clearing cycle, we will definitely send lots of information to market participants to ensure they have proper visibility of their positions at any given time.
For the hedge fund industry, this is also an opportunity to receive better feedback and gain a better understanding about what it is to clear, particularly on some of the pricing elements that are sometimes invisible.
Generally, the buy-side industry realises the rules of engagement are going to be very different in OTC and that the market will rely less and less on bilateral, and more and more on OTC clearing. This is a new world.
HEDGE FUNDS REVIEW: What can you do to help hedge funds keep costs low without sacrificing quality and risk management?
Renaud Huck: The approach we have and decided to have in terms of OTC clearing is that we do not charge for the implementation of the new OTC clearing structure. We only charge for the trades that will be cleared.
There isn’t any additional surcharge to what we’re going to implement and to what we have started since mid-November 2012.
It’s more between the hedge funds and the clearing members. It’s a bilateral relationship and possibly an opportunity for the hedge fund to get a better understanding of the pricing models that their clearing members have.
HEDGE FUNDS REVIEW: Will some hedge fund strategies be challenged or become too costly because of the move to exchange clearing of OTC derivatives?
Renaud Huck: That could potentially be the case. However, the reality is that within the buy-side you have entities that are big users of OTC instruments and some that use them on a more occasional basis. Potentially, the cost associated to OTC trading and clearing could push some of the smaller buy-side second- and third-tier entities out of the OTC space and more towards the listed space.
HEDGE FUNDS REVIEW: Is futurisation something we should be concerned about?
Renaud Huck: I don’t think we should be concerned. It’s a good opportunity for the marketplace. We are in tomorrow’s world – it will have a more flexible environment. In the exchange-listed world they will have the possibility to trade listed proxy products for those they used to trade OTC, but with a more standardised approach and with associated costs with futures instruments rather than OTC products.
The ones that are occasional users of those OTC products will have the possibility, for capital efficiency purposes, to go more towards exchanges and clearing houses. Obviously, like other exchanges and clearing houses, this is an opportunity for us.
We have embarked on two roads. One is the bread and butter of the exchange, which are listed futures instruments, and we have also embarked on OTC clearing. We will definitely explore the OTC products under a futures format.
HEDGE FUNDS REVIEW: Will the move to exchange clearing lead to market growth or contraction?
Renaud Huck: I don’t think it is necessarily going to be the case either way. It’s more the possibility of having a safer, more flexible environment and for buy-side entities to have choice as to whether they want to go OTC or exchange listed.
It’s true that the limitation of that choice is controlled by the regulators who want to catch within the net most of the OTC world. It’s hard to say whether it will make the market grow. The economic conditions are quite difficult. The market in itself won’t be in a position to resolve all the problems, but there will be a new environment and the industry will have to adapt to it.