Hedge Funds Review: What are some of the issues you’ve seen with the move to central clearing?
Renaud Huck: We are just at the beginning of this – the start of a new story for the industry. Regulators have been working a long time with the industry – market participants, as well as service providers and exchanges – to implement this, firstly in order to deliver the new landscape. This includes the Markets in Financial Instruments Directive II and European Market Infrastructure Regulation (Emir) in Europe and, in the US, the Dodd-Frank Act, which was implemented a year ago. Europe is slightly behind the US in this.
The landscape is going to change. The rules of engagement are also going to change between the buy side and the sell side, and between the trading community and exchanges. Regulators want to have the upper hand and they want a strong oversight of the situation. They are leading on this. However, it is a very big ask for the industry to digest this regulation; the plate is full and there have been some obstacles.
It has been a bumpy road and we are not at the end of it. As an exchange, we have recently been reauthorised by the European Securities and Markets Authority (Esma) so we are a qualifying central counterparty (QCCP). The other exchanges have to go through the same process and there has to be uniformity within the industry in order for the buy side and sell side to have choice and to be in a comfortable situation to trade and clear their business in the future.
Hedge Funds Review: Are you concerned about market liquidity and fragmentation?
Renaud Huck: Previously, if you wanted to trade an interest rate swap, you needed a bilateral relationship with the dealer. This situation will continue; we do not see any intention from the regulators or exchanges to disintermediate the relationship between the dealers and the buy side. However, with the introduction of the over-the-counter (OTC) clearing mandate, you introduce an element of security. In the case of a default, it is handled at a level where the exchanges know how to do it with a listed business.
There is also capital efficiency. The fact that regulation such as the Capital Requirements Directive IV and Basel III, which are constraining for the banks, will place them in a situation where their balance sheets are going to be much smaller. They are not going to be able to extend credit lines as they used to do.
The trades of a client will no longer sit on the balance sheet, but at an exchange, at a clearing house, which is something that is going to free up capital for the banks. Capital leverage is an important element to be considered by banks. Whenever they trade with buy-side entities, capital factors will have to be factored in. It is a bit more complex.
To make things easier, we have introduced several components. For example, we decided it was important to be active in OTC clearing, but that is just the beginning of it. We launched our OTC clearing initiative a year-and-a-half ago. We see volume now on a daily basis and we are onboarding market buy-side and sell-side participants. It is taking time, but everybody recognises there are going to be benefits. As for the magnitude of these benefits, it is hard to say, but definitely the security and safety element represented by the clearing house is important.
Hedge Funds Review: Are changes going to encourage new products?
Renaud Huck: This is an opportunity for exchanges to launch a new set of products. But the sad reality, and perhaps an unintended side effect of the regulation, is that, for the large buy side, it is going to be difficult adjusting and adapting to this new environment. It creates some difficulty, but they will overcome this because they have strong structures.
For the smaller buy side, second and third tier and smaller dealers, this is going to be more of a struggle, purely because the clearing members are not going to be in a position to accommodate everybody. This means that we as an exchange have to provide solutions for that situation – for players who might trade a few swaps occasionally. If you do not trade on a regular basis, economically speaking it becomes difficult to justify still being active in that space. The banks are going to struggle to accommodate smaller clients. That means we have to offer new trading avenues and products. We will be launching these but more in the traditional listed space. The change opens the gate to a new theme, which is the futurisation of the industry.
Renaud Huck, Deutsche Börse Group-Eurex Exchange
Hedge Funds Review: Where do the ideas come from – or how do you develop a new product? Is it just from your side? Do you have traders come into you and say, ‘we need something like this’? Is it joint projects, and which ones do you decide to do and throw out?
Renaud Huck: It is true that, traditionally speaking, exchanges and research and development teams have been thinking on their own about new products. I think that now because of the new – incoming – regulation, there has definitely been more back-and-forth discussion and more collaboration with the sell side and with the buy side about the products, which would make sense, to be created. And, I think we received a lot of feedback from the buy side, from the sell side as well, on what the products were that they would need tomorrow, and what were the products that would be needed in the toolbox?
I think that, equally, it is a good thing to have the listed business and the OTC clearing business, but it is even better to have innovative products, and to have products that can really help the asset managers and the hedge funds, to mitigate the risk or to get the asset class exposure that they wish to have, which tomorrow might be more difficult for them to achieve with the new regime. And, it might be easier to get through a traditional listed product with a capital efficiency that we know, and the margining policy that we know. So, I think it plays in favour of the different parties, but it is true that there has been a lot of collaboration, a lot of discussion. We have taken time to deliver, purely because we wanted to make sure that what we were going to structure and what we were going to launch was definitely meeting the needs of the industry.
Hedge Funds Review: Is there anything else in the pipeline?
Renaud Huck: Yes, in fact, on 7 July we launched FX futures, thereby extending and adding a new asset class to the fixed-income and equity index asset classes that we already have. We are very enthusiastic about it, because it is a massive asset class and it will offer the buy- and sell-side industries the possibility to access the foreign exchange market under a European regulated regime. So, once again, if you are concerned about the jurisdiction or the supervisor that you could face, well at least this will be completely European and, if you are a European buy side entity, that could meet your regulatory needs.
But, equally, there is also the possibility to offer, once again, cross-margining and capital efficiency between what we already have, so the fixed-income futures, the equity index futures, and when there is obvious correlation with these new foreign exchange futures.
Hedge Funds Review: So are we looking at the futurisation of the industry?
Renaud Huck: Yes, definitely. There is no doubt about it; there is no way out. But this is also a massive opportunity for exchanges like us because we can prove how innovative we are, and can bring tangible and interesting products to the forefront. In September we will launch swap futures as well as secured lending futures, a sort of repo futures. Ahead of implementation of the regulation, we will help the industry have a choice between trading a traditional swap OTC product or going to the listed space and transacting on a two-, five-, 10- or 30-year interest rate swap.
The benefit of the regulation is the creation of new trading and clearing opportunities, as well as risk-reducing opportunities for a lot of entities. However, it is a challenge for us because we have to be up to this challenge; we have to pick up the ball and not just run with it, but deliver. We have to deliver interesting products.
Hedge Funds Review: When the dust settles, what will the new landscape look like?
Renaud Huck: There is a lot of worry about regulators actively trying to curtail the OTC space, or at least massively cutting that space, which was the norm of the marketplace. Listed business was the negligible part of the market. Now it is going to be the other way round. The exchange-listed and cleared business is going to be the major part.
Most likely, a strong buy side and sell side will continue to be active in the OTC space. The liquidity will suffer, but you will still find liquidity in the main areas of transaction and interest rate swaps.
It has always been difficult in the credit space because of some illiquid names to find liquidity. I do not think this will change. What will change is that there will be increased liquidity in new products because there will be a new range of players who were not there before. There will be the emergence of new listed products, while some traditional players of the OTC space will have to go to the listed space.
It might rebalance between the OTC and listed-exchange spaces, but that will not be to the detriment of one versus the other. Both are on a parallel route and both are complementary. What is important is having the possibility to jump from one avenue to another one and to help your business. That is where we want to be in order to help buy side and sell side, in order to access both the listed and the OTC markets.