Client clearing: Soaring volumes disguise scary workload

Not clear yet

arrows merging

After three years of work, client clearing volumes have started to rocket in recent months – but it may not be enough to avoid a last-minute stampede. Tom Newton reports

On the face of it, champagne corks should be popping. At the start of September last year, the two big interest rate swap clearing services – at CME Group and LCH.Clearnet – had cleared a total of $270.7 billion in notional for clients of their member firms. Twelve months later, that number had risen to $3.6 trillion, and the rate of growth is not slowing. In August, cleared client volumes at CME jumped 27%, from $567.8 billion to $721.2 billion; LCH.Clearnet’s SwapClear added almost $1 trillion in volume during the same month (see figures 1 and 2).

risk-1012-client-clearing-fig1

risk-1012-client-clearing-fig2

It’s the same picture at some of the clearing members – or futures commission merchants (FCMs) to use the US term – that carry client trades to the clearing houses. Barclays cleared 25 times more client volume in August than it did in January, says Ray Kahn, the bank’s New York-based global head of over-the-counter clearing – or, to put it another way, August saw the bank clear a greater notional value of trades than in 2010 and 2011 combined.

But the bubbly will be staying on ice. That’s because there is another, sobering number that deserves more attention. According to a senior figure at one central counterparty (CCP), the industry is somewhere in the low, single-digit percentage points in terms of its progress towards the goal set by the Group of 20 (G-20) nations in September 2009 – the clearing of all standardised OTC trades. Depending on who you speak to, that could mean anything from 50% to 80% of a market that stood at $648 trillion at the end of last year, according to the Bank for International Settlements.

That looks like a bigger problem with every passing week – there has been widespread acceptance for some time that the G-20’s end-2012 target will be missed, but regulatory deadlines in Europe and the US are still expected to take effect at some point in the next six months, and banks are making increasingly blunt appeals for clients to get a move on.

“If everyone thinks they can walk through the door at the last minute and find a spot, then that’s just not the way it’s going to work,” Andy Ross, European head of OTC clearing at Morgan Stanley in London, told attendees at an industry conference last month. “If you want to influence the outcome for your firm, don’t be part of that melee of thousands of people trying to beat the deadline – you need to move now. And if you haven’t moved now you’re late in terms of squeezing a better deal, price structure and efficiency out of your clearing provider,” he added.

Some clients have moved, of course – as the numbers reported by the central counterparties testify – and FCMs say they are increasingly busy. “Clearing has become very, very real for us. We’re not seeing ceremonial trading any more, we’re seeing full-blown trading,” says Christopher Perkins, global head of OTC clearing at Citi in New York.

But this still represents a small number of early adopters – big asset managers, hedge funds and regional banks – and while many FCMs have signed up dozens of clients, some admit privately that none of their customers are using the service, except to test it. “The true number of clients that are actively clearing is a handful,” says the head of OTC clearing at one European bank.

Given the extent of the overhaul being forced on the OTC market, industry sources say this was inevitable. Clients have to choose an FCM from among 10 or more competing dealers, each of which is still finalising its offering and, until the end of July, did not know what capital rules would apply to the business. Two earlier iterations of those rules, published by the Basel Committee on Banking Supervision in December 2010 and November 2011, caused some banks to argue the client clearing business would become uneconomical – in large part, because of the capital treatment for default fund exposures, which is based on an approach known as the current exposure method (CEM).

The final rules, published on July 25, addressed many of those fears – introducing an alternative to the CEM, for example – but the Basel Committee noted the document is only an interim standard and suggested it could amend the requirements (Risk August 2012, page 4).

In addition, CCP margin and default fund methodologies are still a work in progress – the greater the reliance on default funds to absorb excess losses, the greater the risk borne by member firms, and the higher the resulting default fund capital charge. Some or all of these costs will be passed along to clients, but FCMs still don’t know for sure what the final figure will be.

Writing in Risk last month, Mariam Rafi, Americas head of OTC clearing at Citi, noted that SwapClear had revisited the relative weight given to the various components of its financial defences – the ‘risk waterfall’ – and capped the size of its default fund as a result (Risk May 2012, page 6). “Other clearing houses have not capped the size of their default funds, which makes it challenging for members to plan their liabilities – particularly in light of the uncertainty around default fund calculation methodologies,” she wrote (Risk September 2012, pages 81–83).

From the client’s perspective, this can result in wildly divergent pricing from one FCM to another. “We’ve gone through the process with clients, and the amounts that are quoted can vary by up to 500%,” Samuel Ely, a partner at consulting firm Gamma Derivatives Solutions, told a clearing summit organised by Risk in New York last month.

Another reason for the delay is the difficulty in putting the new business on a firm legal footing. Until August, standard client clearing documentation did not exist. One early adopter that went through the process of finding an FCM prior to this point – Dutch asset manager Robeco – says it was tortuous.

“Clearing members fear the unknown – they tie things up as much as they can to avoid having any liability whatsoever. And because the documentation is written in stone, from their point of view, it’s extremely difficult to get a word changed. They have to go back to their own counsel first, and then to their external counsel and then they come back. It’s a very tiresome process to go through,” says Paul Kat, a lawyer at Robeco in the Netherlands.

That kind of story should soon be a thing of the past – or, at least, the process should be less of a headache. In Europe, a standardised clearing addendum, to be used in conjunction with an International Swaps and Derivatives Association master agreement or a futures customer agreement (FCA), was due to be published at the end of September but now faces a delay of up to three months. In the US, clients must use a FCA with a different addendum. But switching from existing OTC market documentation is still expected to result in a lot of bilateral negotiation between buy-side and sell-side lawyers, slowing the client onboarding process.

“Clearing members are traditionally firms that relied on relatively standardised futures-based documentation. Now they’re signing up a lot of clients who never really traded futures before, but who traded Isda-based products. Culturally and traditionally, some of these firms spent a lot of time negotiating terms in their Isda agreement. That’s just not necessarily how the futures world has worked,” says Laurent Paulhac, senior managing director for financial and OTC products and services at CME Group in Chicago.

The ambiguities around indirect clearing rules are another roadblock. The idea is to allow smaller market participants to route trades through their existing relationship banks – for example, the Landesbanks that act as regional hubs for networks of small savings banks in Germany – that would in turn have a client clearing relationship with an FCM. In other words, clearing members would have direct clients, and that outer circle of firms could then sign up customers of their own – indirect clients.

But while this model already exists in futures markets, it is completely untested in the OTC world, and an attempt by the European Securities and Markets Authority (Esma) to write rules governing this business ran into immediate problems. Under the proposed regulation, published in June, clearing members would have been compelled to offer the service – and would also have been forced to accept indirect clients as customers of their own if the relevant direct client collapsed. Some FCMs warned that, far from expanding access to clearing – the regulator’s intention – the rules would prompt some banks not to offer clearing at all (Risk September 2012, page 9).

Final rules were published on September 27 and saw Esma backtrack on both points. But indirect clearing remains a new concept, and the appropriate capital requirement is not clear. If smaller firms find it difficult to become a direct client – because they are not active enough to be an attractive customer for one of the big FCMs – then they may have to wait until indirect clearing beds down. “It’s probably not holding up a vast volume of tickets going through the system, but certainly a vast volume of small clients,” says Gavin Dixon, head of market initiatives and OTC clearing at BNP Paribas in London.

Only users who have a paid subscription or are part of a corporate subscription are able to print or copy content.

To access these options, along with all other subscription benefits, please contact info@risk.net or view our subscription options here: http://subscriptions.risk.net/subscribe

You are currently unable to copy this content. Please contact info@risk.net to find out more.

Switching CCP – How and why?

As uncertainty surrounding Brexit continues and the impacts of Covid-19-driven market volatility are analysed, it is essential for banks and their end-users to understand their clearing options, and how they can achieve greater capital and cross…

You need to sign in to use this feature. If you don’t have a Risk.net account, please register for a trial.

Sign in
You are currently on corporate access.

To use this feature you will need an individual account. If you have one already please sign in.

Sign in.

Alternatively you can request an individual account here