New Collateral Transformers To Emerge
New non-bank counterparties will offer credit and collateral transformation services to clients considering self-clearing in response to the decline in the number of derivatives clearing firms.
Capital markets and commodities consultancy Contango Markets said in a white paper, The Changing Face of Client Derivatives Clearing, that client derivatives clearing has been constrained by regulation and higher capital requirements which are affecting how banks provide services to clients.
The regulatory restrictions on the bank leverage ratio and the proposed capital requirements under Basel III and CRD IV take no account of the nature of client clearing. In addition, the low rate environment means clearers have lost the ability to earn interest on client collateral and the interest rate spread on margin cover.
The report said: “Without offsets for client initial margin balances, even more firms are likely to exit the client clearing business, resulting in a concentration of risk amongst the larger Futures Commission Merchants or General Clearing Members – an unintended consequence that runs contrary to the G20 objectives. We are pleased that industry lobbying, notably by the FIA, has resulted in a delay of the implementation of the rules.”
The white paper added that in May last year, there were just 70 FCMs left in the US compared to 171 in 2005.
As the cost of providing client clearing has increased, banks need to either earn more from their customers, exit the listed derivative brokerage business, accept lower returns on capital or be more selective about their types of client.
Contango said: “As a result a number are ‘reassessing’ their client base and some clients just don’t fit any more.”
One response has been clearing houses beginning to offer direct clearing models so end-users can post margin directly with CCPs and bypass the use of existing GCM’s/FCMs. “Despite the differences between each clearinghouse’s plan, all are offering alternative, direct payment procedures for capital to be allocated by clearing end users,” said Contango.
Last year Eurex Clearing, Deutsche Börse’s central clearer, launched ISA Direct which allows buyside firms to have a direct contractual relationship with the CCP.
Daniel Berner, chief investment officer of Swiss Life Switzerland, said in a statement: “By enabling us to become a direct member of the CCP, our concerns regarding counterparty credit risks, clearing costs and portability of our assets are much better addressed compared to the traditional client clearing model.”
The relationship is facilitated by a clearing agent, who has to be an authorised clearing member. However clearing agents face lower capital requirements, and can increase return on equity, as the ISA Direct member maintains legal and beneficial ownership of the collateral they place at the CCP. The clearing agent covers the default fund contribution to the CCP and default management obligations as many buyside firms generally have restrictions against mutualizing assets in a combined risk pool.
CME Group is slated it launch a buyside clearing membership called Direct Funding Participant this summer according to the exchange’s website. To become a member clients must meet certain conditions including obtaining a guarantee from an existing clearing FCM, buying memberships for any CME exchanges where they trade and passing an operational and liquidity review by CME Clearing.
Contango continued that ICE Clear Europe has developed a similar model called Sponsored Principal where the end-user has a direct relationship with the CCP in all respects except the payment of the default fund contribution, which is met by the sponsor member.
“From a client perspective, direct funding models ensure there is no transit risk involved in the transfer of margin, as it moves directly from client to CCP,” added Contango. “From a GCM/FCM perspective, the direct payment model removes the balance sheet implications whilst ensuring that they are still responsible for key operational clearing functions (e.g. trade & position management, expiry and delivery processes etc.) and are not being disintermediated.”
However some end-users considering self-clearing will not be able to perform all the required functions or do not have the credit or collateral available to them to become direct members of clearing houses.
“We believe that the demand for self-determination from these clients will lead to the emergence of a new type of market participant – a non-bank credit and collateral counterparty,” said Contango. “The potential to take collateral that is not compliant for clearing house use and transform that (with a haircut of course) into clearing house-compliant collateral is a powerful service when it is combined with a credit counterparty that could also be utilised for default contributions.”
The consultancy continued that a credit and collateral counterparty combined with a utility operations provider delivers the optimum solution in terms of value and access to markets.
“Given the conversations we have had with market participants, we cannot see the demand for much more in-house operational risk, so the benefit of outsourcing all of these functions – albeit for a fee – not only challenges the status quo, but brings a new dimension of participants and service offerings to the cleared derivatives industry,” added Contango.
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