Frandt or foe? FCMs hit back at Esma buy-side clearing salvo

Esma pushes dealers to publish standardised fee schedules amid clearing capacity fears


Dealers are on the defensive about proposed new regulations that could force futures commission merchants (FCMs) to disclose sensitive commercial terms – constraining their ability to negotiate complex and sensitive clearing arrangements with buy-side clients in Europe.

FCMs tell they are concerned about a new consultation paper from the European Securities and Markets Authority, published on October 3. In it, Esma aims to advise the European Commission (EC) on new rules to make clearing terms with clients “fair, reasonable, non-discriminatory and transparent” – or Frandt.

Esma proposes publicly disclosing standardised contract terms – and that clients be categorised into buckets and offered cookie-cutter pricing and terms based on their assigned category. It also seeks to ensure technology requirements listed by a clearing firm for the onboarding process are not “disproportionate and cumbersome”.

Nathaniel Lalone_Katten Muchin
Nathaniel Lalone, Katten Muchin Rosenman

The paper stems from Esma’s concerns that smaller firms could be locked out of clearing – potentially caught in the final waves of Europe’s threshold-based clearing mandate or pushed into clearing by the delayed final phase of the non-cleared margin rules.

“The Esma proposals are worryingly intrusive, in particular as regards the disclosure of the terms clearing members offer to different clients,” says Nathaniel Lalone, a partner at Katten Muchin Rosenman in London. “They may substantially increase compliance costs that will erode the economic viability of providing clearing services in the first place,” he adds.

Dealer reaction

Dealers see the focus on how pricing and contract terms are offered as regulatory overreach – not to mention, anathema to the negotiation of any private contract.

Two separate FCMs tell that banks have been holding crunch calls about the consultation. Some of these are said to be hosted by the Futures Industry Association. The FIA did not comment on any calls, but said it was reaching out to members and other industry associations in preparing a response. An Isda spokesperson said the trade body’s response would be aligned with the FIA’s.

One US FCM source suggested that some of the new requirements were “transparency for the sake of transparency”, and that the requirements, if implemented, would not work to increase market access to clearing.

If you require pricing and terms to be based on crude categories, you lose the nuanced and tailored aspect of clearing agreements

Source at a large US FCM

Esma claims markets already use standardised contract terms and that additional language in a delegated act would merely be codifying this further – an assertion FCMs disagree with. They also suggest that Esma’s consultation makes incorrect assumptions about how FCMs assess client risk and that categorising clients into broad buckets is troublesome.

“I think Esma thinks that a client would figure out what broad category it fits into – for example, a low-volume user – and then could just go across the street and see how much they would be charged by another FCM,” says the source at a large US FCM. “But at the moment, pricing is much more tailored, with driving factors including volume, any bespoke operational processes or tech required by the client, agreed margin processes and whether we will be required to operate in markets where we don’t have economies of scale. This is all nuanced, and doesn’t lend itself to three or four buckets.”

“If you require pricing and terms to be based on crude categories, you lose the nuanced and tailored aspect of clearing agreements,” adds the source.

A source at another FCM explains that Esma may have underestimated the complexity of risk assessments taken by banks, suggesting that their recommendations around categories stem from a questionnaire attached to a delegated act related to Mifid II.

The delegated act, which was released in July 2016, suggests that clearing firms must make an initial, then annual, due-diligence assessment of prospective clients for clearing, based on a number of criteria. These include credit strength, intended trading strategy, operational resources and payment systems that will allow it to transfer margin in a timely fashion.

Risk assessments of clients are not standardised in the format of the terms in the July 2016 delegated act, says the first US FCM source: “Our risk assessment of the client is proprietary and quite sensitive. The way we look at counterparty credit risk, anti-money laundering and know-your-customer concerns, is not disclosed for good reason.”

“I think in their heads, the regulators think it would work like this,” says a source at another US FCM. “We try to onboard a client; a due diligence questionnaire is sent; they respond based on the relevant fields as required; it’s reviewed by the business and then placed in a category. Once that is done, we can provide pricing, interest collateral schedules and other terms based on that category. In reality, there are so many different types of clients out there, it’s difficult to offer five or 10 standardised buckets.”

Nuance and scope

Conversely, some clients of clearing banks are understood to prefer greater transparency to the negotiating process. For example, fees for clearing services can be broken down on a per-transaction basis. But the majority of the cost of clearing can often come from the capital cost of taking on positions. So, charging a standardised price on individual transactions is seen as unhelpful when trying to gauge what is pushing the limits of a clearing bank’s balance sheet.

One argument suggests that more transparency around the methodology for categorising clients and working out pricing will enable FCMs and their clients to work in harmony to ensure FCMs are not pushed too hard from a balance sheet perspective. This in theory could reduce potential evictions of clients when markets are volatile.

The ability to negotiate better terms is also not necessarily contingent on the size of the institution, and larger institutions that bring more directional or complex derivatives positions to an FCM can get unfavourable terms compared with a smaller client that brings a better hedged book, market participants say.

Clients of different types have very different portfolio profiles. This can lead to different pricing methodologies being appropriate

Clearing executive at a European FCM

But FCMs make the counterargument that this nuance in dealing with different clients is exactly why a category system with standardised contracts and pricing may not work. At the very least, FCMs tell, there should be a lot more detail on how the category system would work.

“I think you need to have so many categories to find the right terms for all of our clients,” says the second US FCM source. “Everything from west coast asset managers, with whom we have long-standing relationships and a real understanding of their risk, to small start-up hedge funds. We would certainly not expect them to get the same terms.”

A clearing executive at a European FCM notes the need for nuance in dealing with the wide variety of risk profiles at different clients. “Clients of different types have very different portfolio profiles,” he says. “This can lead to different pricing methodologies being appropriate. Considering the over-the-counter business of the client as a whole would be the right methodology, rather than trying to assess a ‘per-trade’ or ‘per-million’ price.”

There is also some confusion around exactly which clients the Frandt transparency rules would apply to. The European FCM source wanted clarification from Esma that Frandt would apply only to European Union clients and not for all clients of EU-based clearing brokers.

FCMs also appear to have different interpretations of the proposed rules. While one believes they would apply to all business done with European clients, another says they would apply only to those products mandatorily cleared under European rules. This may be moot, however, says the first, as once a higher level of transparency around categorisation and pricing is established, clients would naturally demand this standard for all business done with that FCM.

Doubling down

In its proposals to amend European Market Infrastructure Regulation last year, the EC appeared to double down on introducing transparency to negotiations between FCMs and clients. The amended legislation, which passed all approvals in March this year, mandates Esma to come up with additional detailed suggestions, which the EC will consider. The EC may then pass delegated regulations to clarify and better telegraph the intention of the Frandt principles.

The Emir refit also created the new category of small financial counterparty (SFC) for financial firms that would otherwise have been caught in June 2019’s category 3 clearing deadline, but whose aggregate annual OTC derivatives exposure averaged less than €1 billion ($1.1 billion) for credit and equity trades, and €3 billion for interest rate, foreign exchange and commodity derivatives. Firms exceeding these thresholds must notify Esma and their national regulator and begin clearing within four months. Taking the July 21 deadline as a starting point, the latest an SFC exceeding the threshold could have commenced clearing would be this week.

Esma’s concerns over capacity include the fact that the FCM market has consolidated significantly in past years as providers struggle to deal with the capital costs of clearing, including the leverage ratio, which limit clearing capacity. A decision by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions to allow segregated client margin to count against leverage measures, however, is expected by market participants to increase competition in the clearing space, as smaller clearers spot an opportunity to grow volumes.

Esma acknowledges the importance of capital changes to the leverage ratio in providing greater clearing in the consultation.

The regulator did not respond to a request for comment to clarify the scope of Frandt, and declined to respond to complaints relayed via, but said it was gathering industry feedback. Esma’s consultation on Frandt closes on December 2. It intends to submit its technical advice to the EC in the first quarter of next year.

Additional reporting by Samuel Wilkes


Editing by Louise Marshall

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