Clearing portability under threat as FCM pool shrinks

Failure of big clearing brokers could see clients unable to move to stable competitors

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Dwindling pool of clearing providers is giving rise to fears over systemic risk

The decline in the number of banks providing clearing to the over-the-counter derivatives markets – and attendant concentration of client margin at the five largest swaps clearing banks – is causing increasing alarm among senior policymakers and regulatory advisers, who question how the market would cope if one of these firms were to default.

“It is a serious, unintended consequence of regulation that this could be a problem in a crisis,” says Darrell Duffie, professor of finance at Stanford University’s Graduate School of Business. “Under the leverage ratio rule, even though those margins are segregated and held away from the bank – and are not the bank’s money – the bank is charged a capital requirement based on those margins.”

That means that if customers seek to move positions from a defaulted bank to a healthy one in a crisis scenario, the second bank would see an increase in its minimum capital requirements.

As a result, the healthy bank “might refuse to accept this porting of customer positions”, says Duffie.

An analysis of Commodity Futures Trading Commission data shows that over 75% of client margin is held at the five largest FCMs, or futures commission merchants, and over 97% is held by the top 10 – the highest concentration since the commission began reporting this data in 2014. If one or two of these firms were to default, the surviving FCMs would need to absorb huge amounts of client margin.

“It is a matter of concern,” says Craig Pirrong, professor of finance at the University of Houston. “It hasn’t gotten quite to the point where cover two means ‘cover everybody’, but we’re getting there. It means porting is hard; that mutualisation of risk, which is one of the benefits of clearing, is of limited benefit now.”

Though the composition of the top five FCMs has changed, the level of concentration has increased incrementally since banks first began reporting this data at the start of 2014, when the top five held around 72% of client margin for cleared swaps.

Since then, the amount of client margin for cleared swaps held at FCMs has grown by 214%, from $25.5 billion in January 2014 to $80.2 billion at the end of 2016. Margin concentration is now at its highest level since these reports began, with 75.35% of client margin held at the top five FCMs and 97.22% in the top 10.

“The whole idea of the clearing mandate was to diffuse risk and spread it more evenly, and the dynamic here is that it’s concentrated again. It’s really hard to see an upside from a systemic risk perspective,” says Pirrong.

Porting client positions is difficult at the best of times – let alone in a crisis, when speed is of the essence. In addition to financial stresses and capacity issues, new anti-money laundering and know-your-customer requirements also make it harder for FCMs to quickly take on new clients. But the situation is exacerbated by the shrinking number of banks able to handle this business.

“A failure to port means that those customer positions would need to be default-managed by more drastic means, such as liquidation,” says Stanford’s Duffie. “Stress on the underlying market would be increased, and of course, the customers themselves would be affected. Many of those positions would be hedges, and losing those adds to the stress, especially if these are, for example, large hedge funds that are no longer able to risk-manage their positions because they are unable to be ported to another clearing member.”

Survival of the fattest

On some levels, the degree of concentration is unsurprising. Regulatory capital requirements have squeezed profits and driven smaller firms out of the FCM business. The clearing landscape is now dominated by the very largest banks: Citi, Morgan Stanley, Credit Suisse and JP Morgan top the list of biggest FCMs in the US, measured by the amount of segregated client margin for swaps they held at the end of 2016.

FCMs have hiked fees to cover the extra cost of holding cash margin on their balance sheets – though many complain they are still struggling to turn a profit. Some have offloaded unprofitable clients, while others – such as RBS, Nomura and Bank of New York Mellon – have exited the OTC clearing business entirely – further narrowing the field of available clearers.

It hasn’t gotten quite to the point where cover two means ‘cover everybody’, but we’re getting there
Craig Pirrong, University of Houston
Photo of Craig Pirrong

Deutsche Bank is the latest – and by far the largest – FCM to quit the business. Bloomberg reported on February 8 that the bank was shuttering its US swaps clearing business. Deutsche declined to comment on the report. A person familiar with the bank’s thinking says it is not withdrawing from client clearing as a whole, but that it will no longer service US counterparties.

“The banks who left the clearing business prior to Deutsche were not big players to begin with,” says a Washington, DC-based regulatory expert at a large US hedge fund. “Generally, you see the same guys trading places each month, because it’s not something everyone can do.”   

A source at a US regulatory agency sees only one solution. “You have to fix the core of the problem, and that’s the fact that return on equity sucks,” he says. 

That’s easier said than done, however. Regulators will have to make radical changes to post-crisis reforms to improve the economics for clearers – specifically offering a fix to the additive effect client margin has on a dealer’s leverage exposure under the Basel III leverage ratio.

“The leverage ratio is at the heart of the issue, and reforming it would be the most direct way to go at it. In some respects, it’s hard to understand why the Basel Committee is being so obstinate about this,” says Houston University’s Pirrong. “That would be the natural way to go, and it would go a long way to addressing these issues.”

European legislators are consulting on revisions to the Capital Requirements Regulation which include proposals to allow FCMs to allow netting of client margin in their application of the leverage ratio exposure method. But without reciprocation, such a move would leave Europe out of step with other jurisdictions.

“Focusing only on financial stability without recognising there are other important policy goals – competition, innovation, economic growth and so on – actually undermines financial stability, in the sense that it gives rise to conflicting mechanisms of public policy: the capital rules, the leverage ratio and others. It contributes to concentration, which exacerbates the too-big-to-fail problem,” says the US prudential regulator.

Despite widespread industry support for the change, a London-based economist at an industry association does not believe an offset for client margin will be included in the forthcoming revisions to the capital rules – an outcome he describes as “disappointing”. 

Indeed, most in the industry expect concentration to increase as clearing mandates for credit and interest rate derivatives come into force in Europe over the next few years – further fuelling concerns over the systemic impact of an FCM default on customers.

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