Dealers like to describe reform of the over-the-counter derivatives market as an evolutionary step. In fact, it’s an evolutionary leap – a sudden transformation that is creating huge uncertainty about future volumes, profit margins and competition.
At the heart of the reform agenda is a major shift towards central counterparties (CCPs) that will sit in the middle of formerly bilateral trades, using default funds and margin requirements to mitigate the counterparty risks that paralysed the market during the financial crisis.
That might sound simple enough, but it requires a huge change. It took London-based clearing house LCH.Clearnet 10 years to build a clearing service that today has $106 trillion notional in interest rate swaps outstanding – a 17.5% slice of the OTC market, according to the latest figures from the Bank for International Settlements. Depending on who you ask, anywhere from 50% to 70% of the market is eligible for clearing – meaning trades are fairly standardised and could be risk-managed by a CCP – and regulators want that shift to happen within the next few years.
On the record, bankers make reassuring noises. “We are supportive of the changes. We see them as evolutionary – it’s something the clients were looking for anyway,” says Harry Harrison, global head of rates trading at Barclays Capital in New York.
Across the Atlantic, Citi’s London-based head of credit trading, Tim Gately, is similarly sanguine: “I think everybody sees this as a good thing. We’ve been reporting the vast majority of our trades into a repository for a number of years and have been working towards clearing for some time too. This kind of progression is a natural thing for the market, similar to what’s happened in other markets in the past.”
In the rose-tinted version of reform, a small number of successful clearing houses will accept a similarly small number of hand-picked dealer members, allowing banks to act as gatekeepers to the system and creating a big new client clearing business. Customers that want to benefit from the reduced counterparty risk and improved operational efficiencies offered by central clearing will need to pass those trades through the banks for a fee. As it becomes easier and safer to trade, volumes will increase, more than offsetting any decline in profit margins. At the same time, the industry will benefit from capital relief and, because there aren’t too many CCPs around, much greater margin offsets. Finally, because of the investments required in IT, the barrier to entry will remain high and dealers won’t have to fend off a flood of pesky new competitors.
This fairytale ending is far from certain, though. Take client clearing as an example: the IntercontinentalExchange (Ice) and the Chicago Mercantile Exchange Group, the leading credit default swap (CDS) clearing providers, started offering the service last year and have since cleared around half a billion dollars combined. Some observers claim the lion’s share of that total was put through in the days after client clearing began, simply to prove it worked – but it would be unfair to see the modest volumes as a portent, says Michelle Neal, global head of electronic markets at Royal Bank of Scotland (RBS) in London: “Client clearing has been out there and available for three months, but I think it’s common knowledge people are taking a wait, watch and see approach.”
This waiting and watching is at least partly due to uncertainty on dealers’ part about how much to charge for the service – or whether to charge at all. “You can look at it as a fee-based opportunity to offset the costs of some of these initiatives, or you can look at it as a value-added service to your customers where the benefits accrue from increased flow, better and deeper relationships and a concentration of flow among the largest clearing brokers,” says Neal.
The no-fee approach might be necessary if dealers want to fight off competition from outside their ranks, says Robert Urtheil, a partner at Oliver Wyman in Frankfurt. He anticipates a split between the execution and clearing portions of derivatives trading, with different firms playing to their own strengths. Today’s dealers may well be able to offer the best quotes and snappiest execution, but they might find banks with huge trade-processing businesses, such as State Street and Bank of New York Mellon, can do a better job of clearing, one observer claims.
It doesn’t end there. One European bank fears the putative client clearing business could fall foul of accounting rules. Banks would act as agents in these trades, taking the client’s half of the transaction, passing it along to the clearing house and leaving the dealer with none of the risk, but there are questions about whether accounting standards would see it that way. If banks were forced to report client trades as part of their own balance sheet, it could kill the business off before it gets started.
“Just to put a number on it, let’s say the credit derivatives market is $40 trillion in notional and we generally think of the present value being 2–3% of that, which gives you a value for the market of up to $1.2 trillion. Then let’s say you want to do a good share of client clearing business – you could be looking at putting an extra $500 billion on your balance sheet, which is a very relevant number. We don’t want to be showing a big balance-sheet increase,” says the head of a team set up by one European bank to co-ordinate its response to market structure reforms.
Other banks say they haven’t thought about the accounting angle. A spokesman for the US standard-setter, the Financial Accounting Standards Board (FASB), says the treatment of client clearing business would be covered by standards on netting, and confirms there are differences in treatment between its own approach and that used by the International Accounting Standards Board (IASB): “All I can say at this time is that a joint education session on the issue between the FASB and IASB was held recently and we are discussing a converged solution.”
So, if client clearing is no cash cow, what will other elements of reform do for the OTC business? The industry’s dearest hope is that volumes will increase sufficiently to more than offset any decline in margins. “The greater emphasis on client clearing is not inconsistent with operating successful businesses. We’ve seen this kind of thing before – the advent of electronic trading was going to destroy margins and make plain vanilla derivatives unprofitable, but all people want to talk about at the moment is the success of the flow businesses,” says Jerry del Missier, the London-based co-chief executive of Barclays Capital and the corporate banking business of Barclays Group.
The head of market structure at one US bank sees it the same way: “I do think the business will grow on the back of this. Over time, all products see lower and lower margins but higher and higher volumes – so we’d expect the volume increase to offset any decrease in margins.”
Not everyone agrees. Kian Abouhossein, a bank analyst at JP Morgan in London, says the shift towards central clearing is expected to go hand-in-hand with an increased use of single-dealer and multi-dealer electronic platforms, as well as – in the case of some products – a shift to exchange trading. These moves haven’t always worked in banks’ favour. Abouhossein points to dividend swaps, which started trading on Euronext in July 2008 and subsequently saw bid/offer spreads squashed from 4 basis points to 1bp. His take is that spreads for OTC products traded electronically will drop by half. “The idea that margin compression will be fully offset by volume increases is questionable. Volumes might increase but margins generally would decline further,” he says.
However, banks feel they have a trump card. Even if volumes don’t increase as much or as quickly as hoped, reform should make the business less capital-intensive and less draining in terms of initial margin. Because most of the trades currently being cleared are the simplest, most standardised products – vanilla interest rate swaps, index credit derivatives and some single-name CDS contracts – they tend to be interbank transactions done to hedge the more bespoke client trades that are currently uncleared. As a general rule, that means trades cleared through CCPs today express a similar market view and there will be few offsets between them. Adding a greater proportion of uncleared trades to the mix could produce a big margin saving, dealers argue.
“In extremis, you could imagine initial margin would go down to zero, because broadly we all run pretty much a flat book,” says the US bank’s head of market structure. “We tend to deal with clients in one way then hedge with the Street, so if everything was cleared, the offsets would leave us with no initial margin requirement. That’s unlikely to happen in practice because we’re not going to see mandatory clearing for all clients and all products.”
Capital will also play a big part in post-reform performance. The requirements for cleared trades should be minimal, or even zero, according to proposals published by the Basel Committee on Banking Supervision in December (Risk January 2010, page 9; February 2010, pages 19–21). That should generate some big capital savings for dealers. But what proportion of the market will remain uncleared, and how much capital will those trades attract?
“There is significant uncertainty here,” says David Elsley, G-10 rates counterparty risk head at Citi in London. “The revenues we need to generate from trading outside of clearing will be determined by capital requirements, but at this stage it’s too early to say what those requirements will be.”
It’s not too early to take a stab at it, though, and the European bank’s market reform head warns the capital savings won’t be huge. The firm started with an assessment that 50% of their derivatives would be eligible for clearing, which would imply a halving of the credit risk capital requirements for the business. But because regulators are proposing much higher capital to cover the counterparty risk of uncleared trades, the overall capital relief would only be around 15%, he says: “Regulators have been telling us clearing will reduce our capital requirements, but the impact looks marginal to us.”
There are other big question marks hanging over the future health of the derivatives business. Regulators could accompany the shift to central clearing with tough new requirements for pre- and post-trade disclosure (see pages 33–35). In Europe, the work is being led by the same team that drew up the Markets in Financial Instruments Directive, and some bankers fret that could mean a similarly intrusive set of rules, requiring near-immediate disclosure of trade sizes and prices. In the more illiquid corners of the derivatives market, that would be problematic, says the head of market structure at one US bank: “We don’t have any problem with pre-trade transparency continuing to be enhanced, but post-trade changes could be an issue for client-to-dealer business, certainly on larger, more structured trades. If we had to announce an extremely large pension fund transaction within 10 minutes, people will work out who the client is, and the price from the dealer will be much worse because we won’t have time to hedge the position.”
Dealers also have to fend off attempts to curb their influence on market infrastructure. In the US, some politicians support a proposal known as the Lynch amendment, which would prevent dealers from collectively owning more than 20% of a clearing house. In Europe, even tougher language was used in a draft advisory that will help politicians decide how to vote on the European Commission’s own proposals. If signed into law, these restrictions could force banks to divest strategic investments in a number of CCPs, says the head of market structure at one bank. The industry currently has a big collective stake in LCH.Clearnet and CDS clearer Ice Trust, while State Street and Bank of New York Mellon have minority stakes in International Derivatives Clearing Group, a US-based interest rate swap clearer.
Politicians fear dealer-controlled clearing houses could hamper progress towards a less-risky market by being picky over the trades they clear. But dealers say those fears can be tackled by giving regulators the ultimate say on clearing eligibility – and argue the risks of shutting dealers out far outweigh the potential conflicts of allowing them some control.
“We’re very concerned. It’s extremely short-sighted and demonstrates a lack of understanding around exactly how utility models and risk mutualisation works,” says RBS’s Neal. She points to the example of LCH.Clearnet’s SwapClear service, which requires a rotating panel of six dealer members to put forward senior traders and risk managers to help handle defaults – an arrangement that proved its worth in the days and weeks following the bankruptcy of Lehman Brothers. If dealers don’t have oversight of the CCP’s risk management practices and policies, they’ll have less confidence in the integrity of the system and be less willing to sacrifice that kind of time and effort, says Neal.
Simon Grensted, head of business development at LCH.Clearnet in London, puts it more colourfully: “In SwapClear, the surviving clearing members were all in the same boat and they had to row it, bail it and navigate it because they didn’t want to drown. There was a big community benefit in supporting the infrastructure. If, on the other hand, you have a world where users don’t quite have those incentives, they might say ‘look, you’re a for-profit public company, and we’re profit-motivated guys so we’re going to make you a price’. And it could be expensive,” he says.
The Lynch amendment isn’t expected to survive the passage into law, which will delight dealers. But it highlights another problem banks face: the difficulty in building an effective IT infrastructure when the reform landscape is continually shifting. “There’s a lot of talk about looking for business opportunities in this, but I know a lot of big, big firms that – at least from a technology and operations perspective – have no clear guidance from the front office,” says Luke Gunnell, partner and founder at New York-based IT consulting firm Mosaic Financial Markets. “As a result, people are just trying to figure this out for themselves and ask ‘how do we do this in a way that disrupts our business model as little as possible?’”
Unfortunately for banks, the extent to which their business model is disrupted is not something they control, but they all have the same hope – that tomorrow’s OTC market will be as profitable as today’s. “Change creates new opportunities and it’s our job to find those. There are things to worry about, but I also think it creates situations for us to be able to generate those revenues,” says Citi’s Gately.
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