The complexity of client clearing

The closer you look at the new rules governing over-the-counter derivatives, the more blurry and uncertain they appear. Put them alongside new Basel III regulations, and they become hazier still.

Take client clearing, for instance. Central counterparties (CCPs) usually ask for initial margin to be met with cash and sovereign bonds, but insist on cash only for variation margin. The problem is buy-side end-users claim they don’t hold enough eligible assets to meet these requirements. There are various solutions. End-users could simply decide to hold more cash or liquidate parts of their portfolios as margin calls arrive – not ideal for fund performance in the first case, and financial stability in the second, as numerous end-users could be selling less liquid assets to meet huge margin calls at the same time in a period of stress. The CCP could accept a broader array of collateral for variation margin – something that would weaken risk management and also potentially change pricing practices, CCPs claim. Or the CCP could offer a repo facility to transform ineligible assets into cash – something few CCPs have experience of, and which may require central bank liquidity support.

Dealers are now gearing up to provide their own solution. The idea is to offer collateral transformation facilities as part of their clearing member service – in other words, the client would post ineligible assets from a pre-agreed list, and the clearing member would repo those out and meet the cash margin calls on behalf of the customer.

It sounds like an elegant solution, but it exposes the bank to a potentially sizeable contingent funding liability. If a large margin call comes through and the client is unable to post collateral, or the repo market is shut, the clearing member would ultimately be on the hook for the margin. If the dealer offers these kinds of facilities to multiple clients to win market share, the liquidity squeeze in a crisis could be disastrous if the initial margin posted by clients is not enough to offset what is owed. Of course, banks say they will put strict limits in place – which raises the question of whether there will be the capacity for all buy-side clients to clear in this way.

There is another complex issue arising from the Basel III liquidity rules. Under the liquidity coverage ratio (LCR), the clearing member would probably have to hold high-quality liquid assets against this contingent funding liability – and that would come with a cost. If the clearing member is reliant on the repo market to finance the ineligible assets, this may also fall under the LCR. However, no-one – including those on the Basel Committee itself – can give a clear answer on how the LCR should be applied in this context, only that it should.

Regulators and dealers agree this is one important issue among many that needs greater clarity. However, the clock is quickly running down to the end-2012 deadline for central clearing imposed by the Group of 20.

On a personal note, after more than six years at the helm, this will be my last issue of Risk as editor. From this month, I’ll be editor-in-chief of Risk, but the magazine will have a new editor – Duncan Wood. Thanks to everyone who has supported the magazine over the past six years.