Fails could jump as category two clearing starts in US, FCMs warn

Hundreds more firms will be required to start clearing in the US today, and FCMs are warning there could be an increase in rejected trades as a result


The number of trades rejected for clearing could jump this week, futures commission merchants (FCMs) have warned, as the second phase of US swap clearing rules takes effect, drawing in hundreds of new firms. FCMs are required to accept or reject trades within 60 seconds of receiving them. Their performance following the first clearing deadline, on March 11, is already being scrutinised by the Commodity Futures Trading Commission (CFTC).

Clients are also watching closely. If a trade is rejected – which can happen because a firm has breached the clearing limits set by its FCM, or because of a technology or operational glitch, for example – its dealer counterparty may choose to terminate the transaction, potentially forcing the client to trade again and also to shoulder any breakage costs incurred by the dealer.

"There was an educational process that had to happen with clients pre-March 11 to make sure they understood these rules have to be adhered to and to avoid screaming phone calls from clients saying: ‘Why did you reject my trade?'. This rule now applies to trades with far more firms, and they are not always used to the limits process. There is a risk of a larger number of rejections – but there is also a larger number of trades going through," said Piers Murray, global head of fixed-income prime brokerage and OTC clearing in the markets prime finance unit at Deutsche Bank in New York.

That was echoed by Ray Kahn, global head of OTC clearing at Barclays in New York. "I think the percentages will hold, but the absolute number of rejections will increase because there will be far more trades coming through all of our pipes," he said. Kahn and Murray were part of a panel discussion last week at Risk's OTC Derivatives Clearing Summit in New York.

The CFTC asked for logs of acceptance and rejection timings from FCMs in late April after a Risk article reported that some clearers were trying to resolve issues with clients rather than rejecting trades within the 60-second limit specified by the commission's rule 1.74. Panellists warned that even where clients are within their credit limits, it may be impossible to accept trades 100% of the time – as a result, they will be automatically rejected before the 60-second threshold is breached.

The absolute number of rejections will increase because there will be far more trades coming through all of our pipes

"We are being held to a very stringent standard to accept or reject within 60 seconds, and we can't guarantee we'll be in a position to accept in that time, whether that's because of a hurricane or a power outage or some reference data that was incorrectly set up – there are going to be instances where things are out of our control, in which case trades will end up being rejected automatically," said Andrés Choussy, co-head of OTC clearing at JP Morgan in New York.

Some clients are trying to mitigate this risk by negotiating clearing limits far in excess of their expected requirements, noted Chris Perkins, global head of OTC clearing at Citi in New York – but that implies heavier credit and funding risks for FCMs.

"We're going to face some challenges around calibration with clients getting a little bit nervous because they have never operated subject to this limits regime before. So, sometimes they come in and ask for these massive limits just to get themselves comfortable with it. It's a natural state of affairs, but it may involve some back-and-forth before we can calibrate it effectively," he said.

Another remedy is to resubmit a rejected trade – the industry's standard execution agreement for cleared trades states that a transaction can only be terminated 90 minutes after the details of the trade have been confirmed by the two counterparties, therefore allowing a period during which teething problems can be remedied. One audience member, representing a firm subject to the June 10 clearing deadline, asked the panellists how quickly this process of resubmission and acceptance was typically completed.

"I'd say within 30 minutes, tops. For most of the clearing and execution agreements, there's a 90-minute window within which those trades need to be resubmitted and cleared to avoid having the executing broker trigger a breakage. So we try to do it within 30 minutes, and most were way quicker than that," said JP Morgan's Choussy.

In response, the audience member asked whether panellists had seen any failed trades subsequently terminated by a dealer.

"As far as I know, we have not seen a trade broken by the executing desk. Resubmitting the trades usually happens very quickly," said Barclays' Kahn. He added that only a small percentage of rejections take place because a client has breached its limit with an FCM – the bulk istechnology related.

Panellists warned they have also recently rejected a number of trades because the executing dealer had not lodged enough funds with LCH.Clearnet's SwapClear service – a consequence of changes announced by the clearing house on May 13, which now requires extra default fund contributions from members to cover its own switch to real-time acceptance of trades.

"The fact is, if you clear with someone and the executing broker doesn't have enough money in place then the trade is going to break. There is nothing the FCM can do to make that trade clear – it is going to be rejected by LCH.Clearnet. That is a dynamic that did not exist on March 11 and it's just reality – it's a process that's in place and people are going to have to get used to it," said Kahn, although he added the new process had been going more smoothly than he had expected and there had been a limited number of breaks so far.

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