Access denied: Hundreds of firms could be unable to use CCPs

Thousands of firms are likely to be caught by the over-the-counter clearing mandate – but banks offering client clearing services say they can only take on a limited number of customers. As things stand, those frozen out would be unable to trade. Joe Rennison reports

"It's like setting fire to a cafe full of elephants. There’s very little time, they’re not exactly nimble and they all need to get through the same door at once,” says Nicole Grootveld, chief operating officer at Cardano, a risk management and advisory service. It’s not the most conventional analogy – but there’s nothing conventional about the race to centrally clear over-the-counter derivatives, mandated by the Group of 20 (G-20) nations in September 2009 for an end-2012 deadline.

Grootveld’s elephants are the thousands of OTC derivatives users that are not members of a clearing house, but will still be subject to the clearing mandate – if they want to continue trading, they will have to sign up as clients of big, international banks that are clearing members. Unfortunately, clearing members say they have limited capacity. And there are an awful lot of elephants.

Dealers estimate around 20 clearing members will initially offer OTC client clearing, but not all of them have the same kind of ambitions. At the lower end of the spectrum, some banks expect to take on 20 to 40 clients. At the upper end, clearing members could take on anywhere from 200 to 400, with the biggest firms saying they could take more later on. But the total capacity will be lower than the sum of these numbers – most clients are expected to sign up at least two clearing members as an insurance policy in case one collapses, and the largest derivatives users could sign up five or more. In other words, there will be a lot of overlap between client lists at many of the clearing firms.

Grootveld says the last estimate she heard for the number of firms that will be subject to a clearing mandate was in the region of 5,000. Others have suggested 7,000 firms in Europe alone will need to clear.

“We’re assessing the market right now and we have had discussions with the banks, but they are blunt, saying they will only provide clearing for a small subset of those they have a strategic relationship with,” she says. “So they might have 1,000 counterparties they do derivatives trading with, and they might provide 50–200 clearing relationships. The banks are openly concerned there is insufficient capacity to support clearing services for all end-users. The regulator is going to try to penalise institutions for not clearing, but the smaller ones are going to say ‘I have tried but no-one wants to clear my business’. You can’t force the law on these parties. There is going to be an impasse.”

Those affected will be smaller derivatives end-users – firms that trade less frequently or in smaller volumes, such as small funds, asset managers and insurers, plus the raft of public banks, savings banks and mortgage banks that exist across the US and Europe. That’s because client clearing is a fee-based business, and each customer comes with additional administrative, capital and liquidity costs. If a client is unlikely to generate the kind of fee income that would offset these costs, banks say they have no choice but to turn them away – and some are already doing so.

“Have we been in a position where clients have asked us to pitch for their business and we have declined? Yes. That’s not just because they wouldn’t be a good client, but because it puts strain on your resources in an environment where cost is an issue,” says one head of OTC clearing at a large US bank.

There are potential solutions. The European Securities and Markets Authority (Esma), which has to write the technical standards that will bring to life the clearing rules contained in the European Market Infrastructure Regulation (Emir), has proposed rules for indirect clearing – in which clients of a clearing member could sign up clients of their own, thereby expanding coverage to smaller firms. But the rules – which Esma hopes to hand to the European Commission for approval by the end of this month – have been condemned as unworkable. Indirect clearing is still seen as the answer by some of these critics, but not without radical changes to rules that currently require clearing members to guarantee the trades of indirect clients for at least 30 days in the event of a direct client defaulting.

Alternatively, more clearing members could begin offering client clearing services – or existing clearing members could find ways to grow their businesses. But this takes time, a commodity that is in short supply.

Raiffeisen Capital Management, the Vienna-based asset management arm of Austria’s Raiffeisen co-operative banking network, is one of those firms struggling to find a clearing member. Harald Frodl, head of middle-office management, says it cannot avail itself of Emir’s clearing exemption for intercompany trades because of the structure of the group. Therefore, it recently started speaking to four banks about client clearing. “They are reluctant to take us on. We are not very big. We want to set up two agreements, but I think it will be difficult. I am hopeful but also concerned,” he says.

To weed out the smaller clients, banks say they have minimum thresholds – certain profit hurdles customers must meet each month, or minimum volumes they have to put through. Luke Zubrod, a director at Chatham Financial, a risk advisory firm, points to private equity funds as an example of derivatives users that may look like poor clearing clients.

“They don’t seem to be accommodated in the current clearing model. These firms might not trade for two years but then they will do one large interest rate hedge related to an acquisition. The concept of setting up a clearing relationship seems to be on the assumption there will be ongoing volume, which is why you have minimum monthly targets,” he says. Chatham Financial works with around 1,000 end-users, and Zubrod estimates around 150 of them will struggle to set up clearing agreements in the coming months.

The problem is amplified for end-users that lack an existing relationship with a clearing member. While volumes matter as a criterion, bankers say their firms will make an effort to accept unattractive clearing clients if they are a valued customer for other businesses.

“Volume is the starting point, but we will look at what other stuff they do with our fixed-income business,” says the head of OTC clearing at a European bank. “Maybe they do a lot of unclearable business in swaptions or foreign exchange. Maybe they have a broader relationship with the bank in custody services, or they are involved on the banking side, giving us bond mandates or advisory mandates. You certainly start with volume, but if someone internally is desperate for us to support the client, then we’ll make allowances.”

After meeting with four banks, Raiffeisen’s Frodl confirms there seems to be a better chance of setting up a contract with acceptable conditions when there is already an existing commercial relationship. In other words, if a firm is giving business to a clearing member’s trading desks, it’s more likely it will be accepted as a clearing client.

From the banks’ point of view, they face various types of constraint, most obviously the capital required to run the business, the legal and educational rigmarole involved in signing up clients, and – some argue – the operational burden once clients are on board.

Clearing members stand between the clearing house and the client, and as such are the counterparty to two offsetting trades, both of which have to be separately capitalised. Collateral offsets each of these positions, but not fully. Under rules finalised by the Basel Committee on Banking Supervision in late July, banks also have to hold capital against their contribution to the default fund of a central counterparty (CCP) – and although the final version of those rules was far less punitive than two earlier, much-criticised iterations, clearing members say the resulting charge will still be burdensome – especially if CCPs rely more heavily on the default fund to absorb tail risk than initial margin (Risk August 2012, page 4). Only clearing members contribute to the default fund, while clients are responsible for their own initial margin.

“It’s questionable at the moment whether clearing in its own right will be a profitable offering for us. And that’s because of the capital it absorbs,” says the head of clearing at a second large European bank. “You may want to offer it as an additional service, but you would offer it to clients in a hierarchy – without huge revenues coming from the service, but to add to the product suite. With smaller clients, if the overall economics of the relationship do not warrant investment, it’s hard to justify doing it.”

The first European bank’s head of OTC clearing adds: “We all went down the road saying we’ll build a clearing platform for clients and now we’re thinking we may not want to be in this game. It’s just mind-blowing.”

Another obstacle is setting up the documentation that creates the client clearing relationship. Attempts are being made to standardise these agreements – the Futures Industry Association (FIA) and the International Swaps and Derivatives Association jointly published a client clearing contract on August 29 to be used by US clearing members, known as futures commission merchants (FCMs). But a previous FIA-Isda clearing document ran into fierce buy-side opposition shortly after its June 2011 publication. Key elements were subsequently banned by the US Commodity Futures Trading Commission (Risk September 2011, pages 52–55). Unless a standard document emerges, clearing agreements will continue to be hammered out on a bilateral basis, as has been the case to date.

“I’m not sure enough lawyers exist to get everyone ready in the current time frame. There is a limitation on how many legal negotiations you can go through at any one moment. That is the biggest roadblock to getting lots of clients live very quickly,” says the head of OTC clearing at the US bank.

It was fears of being last in line that contributed to the decision of Denmark’s FIH Erhvervsbank, a corporate lending and advisory firm, to approach clearing members early. “We started this process a year ago after discussing the risk of being left out. We are now about to close on our first agreement,” says Michael Hansen, head of capital markets operations at the bank. In comparison, Raiffeisen Capital Management began speaking to banks several weeks ago, after Esma’s draft technical rules on clearing had come out, says Frodl. But in Austria, at least, the firm is not a laggard. “I would say we are the farthest in front, in the leading position in the fund management industry in Austria. But we are still very concerned,” he says.

Many other derivatives users haven’t even begun to address the issue. Ray Kahn, New York-based head of OTC clearing at Barclays, says the bank had a conference call for clients interested in clearing OTC derivatives in late August that attracted 600 participants – some firms were asking when they should start to get ready for central clearing. Thomas Zibuschka, a senior adviser at Austrian asset management association, the Vereinigung Österreichischer Investmentgesellschaften, says the sector is not talking in earnest about OTC clearing because the regulations are still being finalised.

The association is holding a conference this month, where a law firm has been invited to present to the member firms and answer questions – less than four months from the intended G-20 deadline for all standardised OTC derivatives to be cleared through CCPs by the end of 2012. Zibuschka adds that some of its members have been in discussion with German banks but could not proceed because of legal uncertainties.

The fact that many end-users have yet to even start setting up clearing agreements does not surprise early adopters. FIH Erhvervsbank’s Hansen admits he relies heavily on prospective clearing members to explain the rules to him, because it is difficult to stay on top of the issue at a smaller institution.

But it may not be the end of the road just yet. If there is more demand than supply, some dealers believe clearing members could begin to increase capacity – at a cost. “The problem we face is that OTC clearing is in the early stages of evolution and we are driving it at a very fast pace,” says one European head of clearing at another US bank. “What you are hearing from the banks is about prioritisation rather than access. It’s a case of who do you target first – but you can then look to broaden it out.”

Other clearing members could also emerge, outside the usual dealer banks. BNY Mellon and State Street both have ambitions in this space, as does Newedge, a leading FCM, which became an interest rate swap clearing member at CME Group on September 4 (Risk25 July 2012, page 26 and page 28). Smaller dealers, such as Danske Bank and Skandinaviska Enskilda Banken, have also indicated an interest in offering client clearing for some asset classes. And the potential exists for some of the large asset managers and hedge funds to step in.

“A lot of the funds already have broker-dealer structures, so it is absolutely possible to extend that. As the supply-demand mismatch appears, there is scope for new players to explore and see if it is a viable option,” says Sanjay Kannambadi, global head of derivatives clearing at BNY Mellon.

Others are hoping for a regulatory solution – such as an improved set of indirect clearing rules. “It is important Esma amends some of its rules and regulations, because what you are trying to do here with OTC clearing is give broad unfettered access. But at the moment, there is a bit of a wall being put up that makes it hard for smaller users, such as regional banks, to access clearing for their clients. Indirect clearing is really important,” says the US clearing head.

Alternatively, regulators could go further. The European Fund and Asset Management Association (Efama) is lobbying Esma for an exemption from clearing for end-users that are left out in the cold.

“There shouldn’t be a penalty when infrastructure does not permit clearing, or when no-one takes that trade on, or when the volume is too small and so on,” says Vincent Dessard, regulatory policy adviser at Efama. But he admits granting exemptions on these grounds could be tricky. “How many clearing members do you have to go to before regulators accept you cannot clear? It is something to be tested.”

Regulators themselves are keeping quiet for now. Esma declined interview requests, saying final rules are still being developed. National regulators were similarly reluctant to talk – deferring to Esma in some cases, and in others saying they had not encountered the issue. “We have spoken to some smaller end-users but we have not heard they will not be able to clear, just that it will be costly and that the cost could prevent them clearing,” says Stig Nielsen, a director at Finanstilsynet, the Danish supervisory authority.

For now, it seems, the problem remains. Sitting down for coffee in late August, one of the first European bank’s clearing heads says: “I turned someone away just this morning, in the sense that I declined to respond to a request for proposal. Now, there’s a price for everything, so other clearing members may respond, and that client may find a provider – but there are going to be some clients that are left out completely.”

The client in that example was a small asset manager that had little existing business with the bank. For Cardano’s Grootveld, cases like this lead her to call for, at the very least, a phased implementation of the rules. “Let’s get the model working for the bigger players for a few years,” she says. “Meanwhile, implement the reporting obligation for everyone. This seems like a fair way to both provide a more factual understanding of who really contributes to systemic risk, as well as understand how both the derivatives and collateral markets will be affected.”