OTC derivatives clearing throw up questions for future of some hedge fund strategies

Mandatory clearing of OTC derivatives contracts by 2012 is having a mixed impact on hedge fund strategies. Main worries concern costs and the possible difficulty in maintaining viable strategies.

The imposition of central clearing of over-the-counter (OTC) derivatives could spell the end of some existing hedge fund strategies while opening the door to a rash of new techniques. Overall, however, the diktat from the G20 to have standardised OTC derivative contracts traded on exchanges or electronic trading platforms by the end of 2012 is barely causing a ripple in the hedge fund industry.

There are two reasons for this. Most funds assume the switch will have little or no effect on the way they conduct business. In short, it will be someone else’s problem. Fund managers are also reeling from regulatory fatigue and trying to make sense of, and money from, erratic volatile markets. For most, the 2012 deadline is not at the top of the priority list.

In the US the mechanism for implementing OTC derivatives clearing is contained in the Dodd-Frank Act while the main legislation in the Europe Union is the European market infrastructure regulation (Emir) and through reforms of the markets in financial instruments directive (Mifid).

None of these regulations has yet been finalised. This uncertainty has led to some confusion as to what impact the change will have on the hedge fund industry as well as the wider ­financial community.

Emir aims to increase transparency in the OTC market and to reduce counterparty risk. “The financial crisis highlighted a lack of information on positions and exposures of individual firms in OTC derivatives,” states a European Commission impact assessment published this year. “On the one hand this lack of information prevents regulators from a timely detection of risks building up at individual institutions and in the system as a whole. It also prevents them from accurately assessing the consequences of a default of a market participant and therefore from responding in an appropriate manner should such a default (Lehman’s case was a clear demonstration of this). On the other hand, it helps fuel suspicion and uncertainty among market participants during a crisis.”

Specific measures in the proposed regulation include reporting and clearing obligations for eligible OTC derivatives, measures to reduce counter­party credit risk and operational risk for bilaterally cleared OTC derivatives, common rules for central counterparties (CCPs) and for trade repositories, and rules on the establishment of interoperability between CCPs.

In effect this means asking participants to disclose more information about the positions they hold and in theory should also reduce counterparty risk by requiring trades are made with a central counterparty.

When finalised Emir will apply directly to the 27 EU members. In key respects Emir should be similar to those parts of Dodd-Frank covering OTC derivatives clearing. Both will make clearing mandatory for standardised contracts, provide exemptions from clearing for end-users and require the reporting of cleared and OTC transactions by most financial counterparties.

Transatlantic differences

While the scope of both is largely the same, there are some crucial differences in approach that are worrying and could cause headaches for hedge funds.

For example, Emir raises a number of issues around OTC derivatives trades, with the devil lying not so much in the detail but in its practical implications.

According to Richard Metcalfe, head of global policy of the International Swaps and Derivatives Association (Isda) in London, one of the main objections to Emir related to whether or not it will actually reduce systemic risk rather than how it will affect costs. Risk will depend on where central clearing takes place, something not yet clear from the proposals.

“We don’t know exactly which OTC derivatives will be subject to central clearing regulations and even so central clearing parties [CCPs] are not necessarily going to be willing to administer all [transactions].”

The regime will apply to standardised derivatives. “It is probably those kinds that are of the most interest to hedge funds – for example, standard five-year interest rate or credit default swaps via which they could open and close positions relatively easily. Isda research suggests that transactions in standardised OTC derivatives are not high turnover but occur only once every four or five minutes,” says Metcalfe.

Emir in its present form implicitly creates new per transaction costs. What the effect of this will be is not known. “If there is a charge to have transactions centrally cleared, that might work against having more, rather than fewer, transactions. On the other hand once investments have been made in required systems, infrastructure and staff, it might be an encouragement to undertake more. We simply don’t know yet,” comments Metcalfe.

There are other potential challenges for hedge funds arising out of Emir. One known unknown concerns the amount of collateral that will need to be posted to meet the conditions of a centrally cleared trade. Currently there is not necessarily an obligation to post initial margin. However, a centrally cleared trade would need collateral. Who will post it and on what terms is an interesting question. This cost, and the source of the posted margin, is something hedge funds will need to assess.

Strategic changes

The changes are expected to have a bearing on the kinds of strategies used by hedge funds. For example, the rules will affect funds holding illiquid OTCs such as inflation swaps, typically used in pension and life insurance funds, according to Jeremy Bezant, an independent adviser to hedge funds.

“There will be higher capital charges to trade these kinds of OTCs since they will not be liquid enough to trade on an OTF/SEF [organised trading facility/swap execution facilities] or via a CCP. That will make these strategies expensive,” notes Bezant.

Banks, he believes, will be forced to pass on the cost of higher capital charges to funds while overall some markets may be changed for the worse: “For example, if you currently trade $50 million interest rate swaps, you may have to trade 10 times $5 million swaps if the market becomes fragmented,” he says.

But there could also be opportunities, at least initially for prime brokers, he says. Some primes are starting to reinvent themselves as clearing brokers for funds. “Clearing at the moment is offered as a low-cost service used to attract flow or other business. Adding clearing for OTCs may be an opportunity to revisit fees.”

Under any forthcoming regime, compliance will play a larger role in the way that business is done, according to Neil Robson, a regulatory lawyer in the London office of Schulte Roth & Zabel. “Until recently compliance wasn’t a major focus for traders whose attention has been and remains very much on doing the deal. But if all derivatives trades are effectively going to be ‘on market’, that is going to have to change as there will be greater reporting requirements etc,” he says. However, the deals themselves will not be radically altered. Hedge funds may cautiously welcome the requirement for CCP as it should “create greater certainties” and reduce the risk of default, Robson notes.

Central clearing raises the need for collateral. While a posted margin reduces counterparty risk, there is always the possibility of a CCP going bust. “Will central counterparties be ‘too big to fail’? Quite possibly the risk will simply shift from multiple counterparties to one big-party counterparty?” argues Robson. Ultimately, he thinks, this will depend on whether they possess sufficient capital.

Isda’s Metcalfe has also thought about this. He wonders what new capital requirements would mean for hedge funds. “Typically, CCPs require cash. Where would that come from? Would hedge funds be able to arrange repo-style finance with clearing members to achieve ‘collateral transformation’?”

Emir option

While Emir says there would be an option for collateral held by clearing members to be segregated, by implication it might also be held collectively (netted) with margins posted by other institutions. Metcalfe says at one level segregation would always apply between collateral posted by institutions trading on their own account and that posted on behalf of customers. Further segregation, at the level of individual customers, would be more secure but there would be costs associated with it.

There is also what Metcalfe describes as the “lurking issue” around the portability of positions. “In the event that a clearing member goes bust, can a fund transfer its position to another clearing member? Can it move the collateral? Will another member be happier to take all the transactions held by a clearing member with one or more of its customers in one go? Or can I move individually, separately? Article 45 of Emir says that there should be portability arrangements, but it doesn’t say what they should be,” he points out.

Recent proposals for Mifid II, published in late October, are now being scrutinised for their potential to alter European markets. The European Commission says a key component of the changes will be regulating OTFs. At present these venues are not regulated but play an increasingly important role, for example, as platforms for trading standardised derivatives contracts.

Mifid II, says the commission, “will continue to allow for different business models, but will ensure all trading venues have to play by the same transparency rules and that conflicts of interest are mitigated.”

According to a response to the Mifid proposals issued by PricewaterhouseCoopers, the proposed transaction and reporting requirements will impose substantial costs and have a “detrimental effect on bottom-line profitability… squeezing trading margins” while proposals to move derivatives onto regulated venues and central clearing “will make it more difficult for companies to sell bespoke solutions to clients [and] enhanced collateral requirements could further contribute to the decline of OTC trading” .

In the US, Dodd-Frank is further along the road to finalisation than Emir, although the Securities and Exchange Commission (SEC) has yet to write many of the rules that will affect implementation and operation. Nevertheless, many elements are sufficiently certain to allow hedge funds to make a fairly good assessment of its impact.

Marc Katz, head of OTC strategy at Newedge, says Dodd-Frank will require certain interest rate derivatives, credit default swaps (CDS) and some foreign exchange derivatives to come into the fold of central clearing. This will impose costs as well as have possible capital efficiency implications for those that trade these derivatives.

“There’s a move toward unbundling operational support costs,” he says, adding “There’s an opportunity for traders to eventually net margin requirements between listed and OTC derivatives.”

It will not be difficult for funds to find clearing members, he believes. A number are already proactively offering their services. “Within our client base, we’re seeing some early adopters [of OTC clearing] and some funds which are waiting for the dust to settle before they make their choice.”

Katz says there has been increased interest in OTC clearing on the part of the buy-side for commercial reasons. “That’s largely been driven by their renewed concerns about the banking system in general,” he notes. Meanwhile, the industry is still waiting to discover which kinds of funds are going to be subject to clearing mandates in order to determine the full roster of expected participants.

Clarifying the issues

John Jay, a senior analyst at the Aite Group, says it is important to distinguish between operational/compliance issues and the potentially profound long-term impacts of Dodd-Frank that could threaten jobs and possibly even individual companies.

The greatest threat, he argues, is levelled at hedge funds with very arcane investment strategies, for example, those that will not be subject to central clearing. Depending on the form of the final ruling, Dodd Frank may force those funds to come up with more capital as collateral against non-­clearable contracts.

“So for those funds that use the more liquid contracts, I suspect that things will be the same as today in terms of volume. No huge difference. If they do decide to pursue those arcane strategies, someone will make them a market. But it will be a lot more expensive. And that’s going to change risk and return calculus,” Jay comments.

He says hedge funds must take on board the fact the new regime will dramatically change market structure by enshrining an exchange traded approach as opposed to OTC. “Whether a product is exchange traded or traded OTC really affects the structure of how that market trades.” Unless there are going to be “massive exemptions, massive workarounds or carve-out provisions”, the legislation will force a model on OTC derivatives that is completely different to the status quo.

The post-Dodd-Frank ecosystem will, he suggests, have a number of key characteristics. Among these he numbers a compression of the bid/ask spread on standard and liquid contracts when they are traded on swap execution facilities “simply because there’ll be more eyeballs on the spread”. The change will underscore the difference between trading on an exchange and the current request for quote model that currently applies to bilateral trades.

Jay has some ideas on what steps hedge funds should be taking now in expectation of the final legislation. The first, he counsels, is to start speaking to those companies with which the fund already has a bilateral relationship. “The question to ask is this: ‘In this new world what are those things that I will need in relation to the trades that I want to conduct in the OTC derivatives market?’ Talk to those counterparties who are market-makers who are liquidity providers and say, ‘Look, I know that there aren’t any hard rules at the moment but let’s start to figure out and have things in place so that when the rules are finally signed off, we don’t hit any speed bumps.’”

Possible changes in capital requirements, he advises, should be top of the discussion agenda. This will be a major determinant of how the new regime affects the ability of hedge funds to trade derivatives. “Inherent in the strategies of many hedge funds is the use of leverage. So if a fundamental component of leverage is the cost of capital and if capital requirements are too high, that will certainly jeopardise the very existence of hedge funds with such a strategy if it turned out that they couldn’t afford to maintain it in the face of those requirements. It may sound like an extreme scenario but from where I sit, the cost of capital will determine the survivability of some of these markets,” states Jay.

He has also spotted another potential unintended consequence. “By placing everything on an electronic platform, there’s no room for voice – for people to actually talk to each other. This is actually a pretty important thing when liquidity dries up and that’s when problems come into play.”

If everything is electronic, you run the risk of a blank screen, he believes. “If some crazy news item comes out and no-one knows what’s going on, you really do need to be able to start speaking with people and incorporating that as part of the trading system,” he cautions.

Failure to allow that to happen, he suggests, may just precipitate exactly the kind of disaster the G20 wants to avoid.

Inconsistent regulators

The extraterritoriality of some US regulatory initiatives and a lack of focus on global reforms that deliver real systemic risk reduction for the OTC derivatives industry are two major challenges facing financial services companies, according to Stephen O’Connor, International Swaps and Derivatives Association (Isda) chair and global head of OTC client clearing at Morgan Stanley.

“With regard to extraterritoriality, there are today large and growing concerns regarding the applicability of the Dodd-Frank Act outside the US,” says O’Connor. “These concerns have been raised both by US and non-US entities. There is a great deal of uncertainty among market participants about whether and how to implement a new regulatory framework that might duplicate or conflict with that of their parent country.”

New margin requirements as published by US regulators include the extraterritorial application of elements of those rules. “These rules would create significant issues for swap dealers affiliated with US holding companies,” notes O’Connor.

“The extraterritoriality proposals are also inconsistent with Congressional intent. Congress included provisions in Dodd-Frank that explicitly instruct regulators to impose the regulations outside the US only if there is a direct and significant connection with the US economy,” he says. O’Connor was speaking at the 2011 Isda Annual Asia-Pacific Conference at the end of October.

O’Connor also says he believes regulators are looking at the wrong market structure solutions to fix the systemic risks they perceived could harm the financial system. “Isda’s view is that too much time, resources and attention is being spent discussing, debating and formulating rules that don’t centre on meaningful risk reduction,” he said. “Greater focus instead needs to be placed on ensuring a globally co-ordinated, properly phased regulatory approach centred on reducing systemic risks,” he notes.

O’Connor says Isda is trying to address all the regulatory challenges the OTC derivatives markets face using a constructive and ­factual approach.

“We continue to be engaged with policymakers, working with a proactive, positive approach aimed at addressing the key systemic risk issues that have been raised. Clearing, compression, collateral, data repositories – these are the tools for reducing counterparty credit risk and we are hard at work on all of them. This work is being conducted in partnership with global regulators,” he states.

According to O’Connor, Isda is also undertaking research that explores and quantifies the impact of proposed regulations and changes: “This ranges from the basic, such as comparing the structure and trading volumes of OTC versus exchange-traded markets, to more in-depth analysis. The OTC and exchange-traded markets are very different,” he says.

“One is a high-volume market with many small trades executed by thousands of counterparties. The OTC market, by contrast, has much smaller volumes, with many fewer market participants, but much larger trade sizes.”

Justin Lee, Asia Risk, wrote this article.