Secretive start-ups eye uncleared OTC risk reduction

Dividing the over-the-counter market into cleared and uncleared products creates extra risk and inefficiency, critics claim – it also creates an opportunity for services that can repair the damage. Start-ups and established firms alike are now jockeying for position. By Duncan Wood

Outside a small circle of dealers, few people have heard of LMRKTS and NetOTC, but these secretive start-ups hope to become some of the biggest players in the reshaped over-the-counter derivatives market. They, along with established firms such as TriOptima and CLS Bank and a couple of other players currently unwilling to show their hands, are vying to recreate the risk efficiencies lost in the move to mandatory central clearing, which breaks up currently offsetting positions and subjects them to separate margin and capital requirements.

The costs of this new regime are likely to be substantial. A quantitative impact study published by the Working Group on Margining Requirements (WGMR) in February estimated that new margining rules for uncleared derivatives would result in €0.7 trillion in initial margin being locked down, although some dealers believe the figure could be far greater, with estimates as high as $10 trillion (Risk April 2013, page 7). This is the opportunity the new services have their eye on.

"We think the big number publicised by the WGMR in February is the most accurate number out there in terms of the impact, so if you can genuinely reduce risk – and thereby minimise the impact of that potential cost for the world's biggest banks – you're providing a very valuable service," says Bob Wigley, chairman of NetOTC.

Wigley's involvement is testament to the size of the opportunity – until 2009, he chaired the European business of Merrill Lynch. Now, he is helping convince banks to listen to NetOTC. Not that the new services have to try too hard. "There's a definite need for this," says the head of counterparty portfolio management at one US bank." Even the positions you have with collateralised dealer counterparties are capital hogs, so if you can reduce the close-out risk by reducing the greeks – finding situations where I'm long with one dealer and I'm short with another and charging margin and capital against the net risk – then everyone benefits."

This is translating into some serious behind-the-scenes discussions. One European dealer is said to have convened a meeting of six peers at its New York offices earlier this year to talk through the LMRKTS service, while NetOTC says it also has the industry's ear.

If you can genuinely reduce risk and thereby minimise the impact of a potential cost for the world's biggest banks, you're providing a very valuable service

"We're talking to the global, systemically important banks. We've had bilateral conversations with most of them, and set up a risk working group that includes 11 of the G-14 dealers, where we've been talking about our risk and margin model," says Neeraj Sharma, NetOTC's chief executive.

So, how exactly would the services work? All these companies claim to be doing something slightly different from their budding rivals. As a result, none of them want to speak openly about their plans – in fact, the start-ups have not spoken to the press at all up to this point. "This is not going to be a market where lots of rival services can exist and the winner will be the guy that builds the best mousetrap. I think I have better ideas on that than some of the others," says one former banker who has been planning his own venture for over a year.

Others are equally tight-lipped. "I do not have anything to add to the discussion at this point, but would be pleased to speak with you at some point in the future. We have been looking at ways in which we can assist in a solution," says David Puth, chief executive at CLS Bank in New York, in an email.

The LMRKTS website consists of a single page showing the reduction of exposure across a web of bilateral trades, while NetOTC's site is accessible to members only – although networking site LinkedIn offers some details about 13 employees, most of whom previously worked at a dealer. Beyond that, little information is available in the public domain.

That said, the basic idea is much the same – boil down different product types and asset classes into a single, fungible exposure measure, such as the sensitivity to a one-basis-point change in interest rates, then find or create offsets among a group of participant banks. This could be done within the universe of remaining bilateral trades or, as in the case of TriOptima's triBalance service, across cleared and uncleared positions (Risk August 2012, pages 19-21).

"In the past, if you wanted to bring down your exposure to other dealers, then you had a few options – perform traditional compression, get a close-out value to terminate trades, or novate and assign trades. But there are real problems with those as they are all line-item based and require agreement on valuation and movements of collateral," says Lucio Biase, New York-based founder and chief executive of LMRKTS. "What has more potential is to move to a paradigm where exposure is fungible. And what you need then is a third party with perfect information that can basically shepherd parties through this process, given they are not willing to show their exposures to each other. That's what we do."

TriOptima's offering is the only one to have launched to date – it unveiled the triBalance service in April 2012. The idea is to assemble a big circle of dealers and have them submit portfolio information to a central utility, which calculates the bilateral exposure each has to every other and then employs an algorithm to suggest two rounds of overlay trades that would flatten the risk. One problem facing the platform – as Risk reported last year – is that some of these overlay trades would need an exemption from central clearing requirements.

LMRKTS would do something similar – as well as facilitating the reduction of notional exposure through terminations – and Biase says he has been exploring the idea since leaving the buy side in 2005. "The market is calling for a solution to reduce exposures for and among all parties – buy-side firms, central counterparties (CCPs) and dealers – for various asset classes. We're designed to do that," he says.

Another way of getting to the same place is to centrally pool and margin uncleared exposures in the hope of finding significant netting efficiencies – the NetOTC pitch.

"We want to deliver the same benefits a clearing house does, but for non-standardised products. So, multilateral netting and margining, but across all asset classes and counterparties, so you maximise the netting benefit and the risk reduction potential," says Sharma.

These approaches could be complementary – a netting facility combined with overlay trades to provide further savings. And NetOTC points out other benefits that can be offered in parallel, such as a robust default management process in the bilateral market, for instance.
The obstacles facing the services, though, are significant. The former banker identifies three key issues: valuing the trades in a way all parties can agree on; working out how to share out the benefits of a pool of netted trades; and coming up with a watertight process for handling a member default.

A more fundamental obstacle is convincing regulators that the service would genuinely reduce systemic risk, and not just generate savings for users. "It's one of the paramount specifications for the project – having something you can sell to the regulatory community as safe," he adds.

This will probably require each service to obtain some kind of regulatory approval. NetOTC says its own conversations, which started with regulators in the UK and have more recently encompassed counterparts in the US and elsewhere, are ongoing, and centre on what kind of authorisation a netting facility might require.

"Regulators have adopted an extremely constructive approach, and the sense we get is that they appreciate this platform would have benefits for them, partly because they would get transparency and aggregated risk data on a part of the market they haven't previously had a window on. But conversations are ongoing. They are analysing where we sit," says Wigley.

Dealers need to do something similar, and it's not helped by the fact that some are in conversations with multiple would-be service providers.

The head of European swaps trading at one large US bank says he has spoken with two firms about their plans, and has heard of a third prospective service, but is loath to commit much time to any of them at this point.

The US bank's head of counterparty portfolio management, while being convinced of the merits of the service, has a similar take: "I would love to get more involved, but it's hard to pick a winner – for now it's about staying involved with all of them, but do you want to take a big part of your team and spend a lot of time on something that faces some real challenges and may not even work?"

That appears to leave the services in a bind: dealers want to see them succeed, but are reluctant to embrace an offering until the service has been fully defined and won broad support. Without engagement from the banks, however, the services will struggle to achieve that kind of maturity.

Some dealers are even sceptical about the scope of the benefits on offer. The US bank's European swap trading head, for example, says the majority of his business is already being cleared – as a result, there is no dramatic loss of efficiency. Most demand for the new services will come from less standardised products, minor currencies and smaller banks, he suggests.

"From our perspective, there's definitely a market for this, but we've been aggressively backloading the core interest rate swap currencies into LCH.Clearnet and CME Group for some time now, meaning a lot of our business is cleared – more than 90% of the euro-denominated business that is eligible. In the minor currencies, it's taken longer, so there might be more demand there, and I'm sure there are a lot of smaller banks that can't clear at all and might see some benefit," he says.