Late nights and illegality – but start of clearing in US goes well

The days either side of the first US clearing deadline saw last-minute decisions by clients and regulators, operational niggles and some illegality. The industry expects breaches of the rules to get a pass for now, so the first phase of the new regime is being seen as a success. The second phase is already causing some angst, though. By Joe Rennison, with additional reporting by Matt Cameron and Duncan Wood

Forty-one months after the Group of 20 summit in Pittsburgh set the process in motion, the clearing of over-the-counter derivatives became law in the US on March 11. The law was broken immediately. In the first week of mandatory clearing, a number of futures commission merchants (FCMs), which provide their clients with access to a clearing house, breached a Commodity Futures Trading Commission (CFTC) requirement to accept or reject client trades in less than a minute.

“There have been some trades that haven’t been cleared in under 60 seconds. A small percentage, but it technically contravenes the law. Some of these are down to operational niggles, while others are due to limits being hit, and calls having to be made to clients. But we haven’t rejected any trades so far. That is not what you want to do in this situation,” says a head of clearing at one US bank.

It is, probably, no big deal. The industry’s expectation is that the CFTC will not be strictly enforcing this and other requirements in the early days of clearing, as the new regime beds down.

And it’s not hard to see why, given the uncertainty either side of the mandate’s start. On March 4, some banks were still receiving calls from firms saying they wanted to clear via their FCM when the mandate took effect less than five working days later, triggering a frantic rush to get them on board.

There was also widespread confusion about the scope of the clearing requirement – it applies to newly executed CDX index trades and some interest rate swaps – but dealers were unsure whether it would also catch new transactions associated with legacy trades, such as compressions, novations and partial terminations. The International Swaps and Derivatives Association asked for clarification, but it would not arrive until March 19 and 20, in the form of two no-action letters from the CFTC. In the meantime, market participants were unsure what they could, and could not, leave outside a central counterparty (CCP).

There have been some trades that haven’t been cleared in under 60 seconds. A small percentage, but it technically contravenes the law

Meanwhile, big users of credit default swaps (CDSs) were campaigning for a last-minute rule change that would enable them to offset single-name and index contracts – and got it late on March 8 – but not in the form they wanted. As a result, Ice Clear Credit chose to suspend plans to offer client clearing for single-name CDSs.

There were also simpler questions. Barclays, for example, was not certain exactly when the clearing mandate would take effect – after midnight US time on March 11, or after midnight in whatever jurisdiction a client subject to the mandate was based. As a result, the bank’s New York-based global head of clearing, Ray Kahn, was in his office at 1.30am on that Monday – the earliest time any of the bank’s clearing-mandated clients in Asia would be able to use the clearing services offered by LCH.Clearnet in London.

And that’s why, ultimately, breaking the law may not count for much right now. Getting mandatory clearing off the ground required a huge commitment from the FCMs that stand at the crossroads of the new market structure. By and large, dealers and other market participants, such as CCPs and middleware providers, made that effort in good faith, and with no little skill. The verdict from many participants is that it went as smoothly as could have been expected.

The industry is now looking to June, and the second of the three US clearing deadlines. March 11 applied to so-called category 1 firms only – active funds, major swap participants and swap dealers – and caught less than 100 market participants, according to some estimates. In part, that’s because some funds that would be subject to the clearing requirement in all other respects were given an exemption in December, on the grounds that they are not incorporated in the US. When this exemption runs out in July, many more derivatives users may have to begin clearing, in addition to the hundreds of category 2 firms that will have started a month earlier. In total, some observers expect up to 2,000 firms to begin clearing during this period.

It could prove traumatic. “If you had to clear on March 11, then every clearing house and every FCM would bend over backwards to help you. But all the guys that do one trade a month and aren’t top of anyone’s list are going to find this very lonely, and they will get less support,” says Jeff Gooch, chief executive of middleware service MarkitServ.

 

Key dates:

February 15

A leaked list shows more than 200 funds belonging to 77 fund managers have certified themselves as active funds, using an industry portal run by the International Swaps and Derivatives Association and middleware service Markit. As many as a third of these are not yet ready to start, dealers claim.

The list causes an uproar, with Isda and Markit receiving complaints about the breach of confidentiality – although the document was leaked to Risk by a bank. Three funds also contact Risk to say they should not be on the list. In at least two of these cases, that is because the funds had incorrectly selected the active fund option from a drop-down menu. The accuracy of the list is still disputed today – a senior figure at one futures commission merchant (FCM) says he estimates only half the names on the list should qualify as active funds.

February 26

With less than two weeks until the clearing deadline, queries over which trades need to be cleared are beginning to emerge. Jeff Gooch, chief executive of MarkitServ, raises doubts over whether novated trades need to be cleared – an issue that will snowball as the deadline approaches.

“People need to check they have cleared what they are supposed to. It isn’t straightforward to work out what category you fall into and what trades are subject to clearing. Novations are particularly tricky. If you do a trade with a buy-side firm that isn’t subject to clearing and it’s then novated to another dealer, you effectively end up with no extra risk but the new trade could be subject to clearing. Those trades have historically not been cleared,” he says.

March 4

One week to go. Speaking at a conference in Washington, DC, Gary Gensler, chairman of the Commodity Futures Trading Commission, claims the industry is ready for the clearing deadline and says preparations have been running “very smoothly”. He alludes to some confusion over compression trades.

March 5

Angered by Gensler’s remarks the previous day, one hedge fund manager complains it is not yet clear whether single-name and index credit default swaps (CDSs) can be cross-margined.

The issue arises because single-name CDSs are regulated by the Securities and Exchange Commission (SEC), while indexes are regulated by the CFTC, meaning the two have to be held in separate accounts. The SEC released an exemption in December, allowing FCMs to portfolio margin across the two products, but only if the SEC has vetted the firm’s margin model. No models have been approved, potentially resulting in a dramatic leap in margin requirement when CDX index positions have to be loaded into clearing houses on March 11.

March 6

With the clock counting down, market participants are worrying some category 1 clients will not be ready. Ensuring documentation is complete has been the big issue, says Bob Pickel, chief executive of Isda. “I think many – if not most – customers are going to get across the finish line, but it could be that we will not have everyone ready in time,” he says.

Peter Barsoom, chief operating officer at Ice, says he still does not know how many new clients will clear through the firm’s CDS clearing service and how volumes will be affected. “Of the 700 firms that trade credit, it is unclear how many are going to be caught by the first wave and how many will be caught later on. There are a number of firms that have been well prepared and there are some that are rushing to the door and we have been working with the FCMs to get them through. Despite this, I am expecting March 11 to come and go smoothly,” he says.

One US head of over-the-counter clearing at a European bank confirms there are still a number of accounts left to onboard but adds that the clients it is still working on already have an existing FCM. “We do have some category 1 guys outstanding, but in most cases they already have a primary provider. They are not in dire straits, but there is definitely a good deal of work left,” he says.

If some clients or trades are left behind when the deadline arrives, the expectation from Isda’s Pickel is that the CFTC will be flexible. “The CFTC understands. It needed to have a deadline. It needed a date to say clearing is happening. It will have that and the vast majority of trades will be cleared on Monday. The CFTC will declare success – and I think the industry will declare success – even if there are some trades that aren’t being cleared immediately,” he says

March 7

Pressure is growing as, with two working days until the deadline, some category 1 firms still do not have final agreement with their FCMs. “It is really nuts over here. We’re making last-ditch efforts to get documents executed and clients onboarded. I am flabbergasted at the number of clients that showed up on Monday asking us to onboard category 1 accounts for next week. We had close to 10 of them. We are doing our best to get them set up, but it is a mad dash,” says a clearing expert at a US bank.

March 8

Michael Davie, chief executive of LCH.Clearnet’s interest rate swap clearing service, SwapClear, echoes the comment from Ice’s Barsoom – no-one can say, on the last working day before March 11, how many entities will be covered by the mandate.

Elsewhere, the first complaints directed at middleware providers begin to emerge. Bob Burke, head of global OTC clearing at Bank of America Merrill Lynch (BAML), says breaks have been seen on test trades as a result of affirmation problems – the process by which the counterparties to the trade agree the details of a cleared transaction. He says the identifiers used by the banks, the clients and the central counterparties to refer to each other often differ, resulting in difficulties when trying to match up trades.

“The account mapping issues are a little messy,” he says. “You may be client 006 at BAML but an affirmation platform may have you down as client 123. There are many account codes that need to be set up, but if they aren’t set up properly, trades will be rejected. Sometimes you don’t find those things out until trades are about to go through.”

Late on Friday, the SEC rides to the rescue of buy-side firms that are seeking to cross-margin their single-name and index CDSs – sort of. In a letter to FCMs, the SEC grants temporary approval to offer portfolio margining for client trades but only if the bank charges at least 150% of Ice’s own margin requirement. That multiplier can only be applied to clients with “virtually no credit risk”. All others would have to post twice as much as one of Ice’s member firms.

Within a week, Ice has decided the terms of the SEC’s offer are so punitive – and criticism from buy-side firms so fierce – that it will not offer client clearing for single-name CDSs at all. As a result, firms that had been enjoying offsets in the bilateral OTC market will lose them.

March 10

No official guidance has been provided by the CFTC on how to treat novations, compression trades and partial terminations, but some banks have had conversations with the CFTC and are giving advice to clients on that basis – as shown in one note that is shared with Risk.

The note says that if a legacy trade is terminated by executing an exactly offsetting trade, then the new trade will be subject to mandatory clearing, therefore requiring the legacy trade to be cleared as well in order to achieve the desired offset.

For partial terminations or partial novations, where a portion of the exposure is unwound or novated, the bank says the remaining risk, known as a stub, would not need to be cleared. “Until the industry receives formal guidance from the CFTC, please proceed on this basis. The CFTC has indicated that it will consider this position further and Isda has today submitted a letter requesting formal guidance and no-action relief,” the note says.

March 11

The clearing mandate takes effect. Speaking at various points of the day, clearing experts at three banks say everything is going smoothly. The US bank that had a number of new category 1 clients to onboard during the previous week managed to do so successfully, says an executive at the FCM. One head of clearing at a European bank says he spoke to a few clients during the early part of the day and none had any problems to report. One partner at a buy-side firm says the institution has not encountered any trouble.

However, the European bank’s clearing head is wary of the potential for trade breaks to result from mistakes in the data submitted by dealers’ trading desks. Those concerns are echoed elsewhere. Michael O’Brien, head of global trading at investment management firm Eaton Vance, says his experience of sell-side traders and sales people is that they still lack detailed knowledge of the new regime. Eaton Vance is a category 2 firm, but is clearing trades in preparation.

“The people I talk to seem not to know anything. It’s probably not their job yet and they will be more up to speed in June, but I ask every trader when I get the chance. None of them are that helpful, they just say they don’t know. That’s scary to me,” he says.

Concern also begins to build around the middleware providers. The US head of OTC clearing at a European bank says the introduction of mandatory clearing has been smooth, with middleware platforms being the source of the only problems.

“Volumes were relatively muted in the first few days, consistent with what we saw on a voluntary basis. We anticipated lower volumes in the first days as people become acclimated with the new processes and expect volume to pick up over the upcoming weeks,” he says. “The only issue we saw was with the middleware – the support from them has been weak. There are a number of issues that keep popping up,” he says.

March 14

Although cleared CDX index volumes have increased at Ice, total market volumes across cleared and uncleared products nosedive in the week after clearing, much to the confusion of Ice’s Barsoom. Explanations given a week later from sell-side participants suggest clearing was not to blame – it was just a slow week, with an approaching roll date also contributing to the depressed volumes.

Volumes were also lower than expected for cleared interest rate swaps, according to Barclays’ Kahn. The bank has been clearing the biggest share of client business prior to the mandate, and many of these early adopters are category 1 firms, so Kahn says he was not expecting Barclays to see a huge jump in volume, but the actual increase of 10-20% was lower than estimated. In part, that is because trading volumes have been low, he says, but he adds that the mandate appears to have caught fewer firms than the bank expected, specifically in the active fund category. Of the 70-plus fund managers on the active fund list published by Risk, Kahn says maybe only 30 to 40 have started clearing.

Other banks say that is partly because some FCMs have told firms they would not be required to clear, according to one senior clearing specialist. “Some of the other banks have been advising clients on whether they are required to clear or not. I’ve told our guys we’re not doing that – we’re just not getting involved – and we’ve seen more than a handful of cases in which firms that had thought they were category 1 later turned round to us and said they had been told by another bank that they would not need to clear,” he says.

Meanwhile, MarkitServ’s Gooch responds to claims that middleware services have been the source of broken trades during the early days of clearing. There have been trade breaks, he accepts, but Gooch says he is unaware of performance issues, such as delays in trade processing, that stemmed from MarkitServ itself.

“In a normal process, if a trade has been done by voice, then the two parties put the info into the system, we do a comparison and then send it to the CCP. Breaks occur when the trade details don’t match. If you think about it logically, that could be caused by one party not loading the trade data up, there could be a disagreement that needs to be resolved, or it could be a performance issue on our part – but I’m not aware of the latter happening,” he says. Barclays’ Kahn seconds that. Some breaks will always occur, he says, and the first few days of mandatory clearing have seen nothing out of the ordinary.

March 15

The first suggestion that market participants have breached CFTC rules: the head of clearing at a US bank says his institution has not accepted or rejected all client trades within 60 seconds.

Dealers have been campaigning against this requirement – often called rule 1.74 – in part because there will be occasions when the components of a multi-legged trade arrive in a sequence that causes a client to breach its credit limit, they argue. In those situations, the trade as a whole may be risk-reducing, but the FCM would be forced to reject it. To avoid trades being unnecessarily rejected, banks have tried to persuade the CFTC to allow a certain number of daily or weekly exceptions to the 60-second rule. So far, the agency has been unmoved.

March 18

The CFTC issues no-action relief for compression trades. Specifically, relief is given to swaps that are amended in order to reduce notional value as part of portfolio compression exercises and swaps designed to replace the original transaction. Relief is only given to swaps between the original executing counterparties

March 20

The industry’s unanswered questions on novations and terminations are tackled in a further no-action letter from the CFTC. The relief applies to swaps executed before the mandate kicked in and to the stub left over after a partial novation or termination. The novating swaps, which see a new dealer step into the trade between the original counterparties, must be cleared, if they would be subject to clearing in any other context. The same is true of trades put on to wholly or partially terminate an existing position.

The CFTC no-action relief letters for partial terminations, novation and for compression trades mirror the guidance apparently provided to Isda by the CFTC before the mandate took effect. A buy-side lawyer confirms he received guidance from a US bank before March 11, which was reporting back from industry discussions with the CFTC.

The same lawyer says he felt the mandate passed with little impact, but adds that some FCMs were in violation of the 60-second rule. He also says bank trading desks – rather than the clearing side of the business – have been a source of problems.

“When I speak to clients, they say the execution desks are a complete nightmare and have been taking a long time to submit their side because they don’t always know if a trade needs to be cleared. Sometimes, when people are not subject to a mandate, the execution desks are just sitting on their hands waiting to the end of the day. Generally, though, these are growing pains,” he says.