The clearing mandate arrived earlier (2013) in the US than in Europe (2016), but “hedge funds everywhere have been early adopters of clearing for reasons such as operational efficiency, margin efficiency, compression and treatment of credit lines” says Jamie Gavin, Head of EMEA and APAC OTC Clearing at Societe Generale. So hedge funds, already familiar with margining, went live well before the ‘category one’ deadline in Europe (category 2 applies from December 2016, and category 3 from 2017, and clearing for some smaller counterparties may be delayed until 2019, ESMA proposes). Societe Generale’s OTC clearing group mainly deals with financial counterparties, as non-financial counterparties start later or are exempt from clearing requirements.
OTC clearing dovetails well with the multi-asset class, cross-asset class margining approach that Societe Generale Prime Services (SGPS), which received The Hedge Fund Journal’s 2015 award for ‘Best Global Multi Asset Prime Brokerage’, is renowned for. SGPS operates a holistic, multi-asset class, margining model whereby all portfolio exposures are netted out. FX Prime brokerage, interest rate swaps, and repos, for instance, all feed into the risk model. Capital efficiency appeals to banks as well as clients: “cleared OTC is less intensive from a margining perspective relative to the upcoming required uncleared initial margin requirements, partly because it uses 5 to 7 day MPOR, rather than 10 day, margining” says David Marcus, Americas Head of OTC Clearing at Societe Generale, who recently joined Societe Generale from Deutsche Bank. SGPS is working with “some household name hedge funds trading very high volumes in the relative value space, who appreciate our low touch operational environment and benefitfrom cross-asset servicing and financing” he adds.
The volatility around the Brexit shock saw “record numbers in several areas of the business and we are pleased that all of our operational infrastructure and technology worked perfectly – in terms of intraday reporting, risk monitoring and margin calls – throughout this period of high demand” reflects Gavin, who spent 19 years at Morgan Stanley and Goldman Sachs before joining Societe Generale in 2014.
Marcus agrees that “hedge funds have wholly embraced clearing and want to be able to clear the majority of products that are eligible at the respective CCPs, well beyond the mandated scope of DF and EMIR”.
SGPS is seeing strong volume growth, mainly in the US, Canada and Europe, but also in Central and South American countries. “Mexico now has a clearing mandate and Brazil has been heating up for some time with the CME go-live of the Brazilian Real cleared IRS product” notes Marcus. Indeed, voluntary clearing of products is now one of the fastest growing areas. SGPS is also actively engaged on several fronts in Asia.
The extra-territoriality of clearing obligations has become widely understood over the past year as Gavin notes “third country jurisdictions appreciate they may be caught by the rules when trading with an EU or US counterparty”. SGPS is also garnering business from the Middle East and Far East, for other reasons – “their options are running out for bilateral execution” Gavin observes.
Comprehensive coverage and added value
SGPS is one of a smaller group of brokers who can offer clearing on all major asset classes – and is active in all products that are currently cleared (interest rates, equity, credit, and foreign exchange). Clients can decide if they ‘futurize’ ie trade contracts available in futures format, or trade on electronic SEFs (Swap Execution Facilities) such as Bloomberg or Tradeweb. Clearing OTC is popular because “some clients need the perfect cash-flow matching and certainty of an OTC swap rather than just duration hedging” Gavin finds.
Thus clearing OTC swaps is far from a commoditised business and SGPS offers a range of ‘value added’ services, which can include “valuation, reporting, collateral transformation and collateral optimisation” adds Gavin. Taking compression as an example, “we enable clients to have tools to meet their own personal targets on compression and portfolio efficiency” Gavin explains. Aspects of compression include netting, selective netting, and coupon blending. SGPS works with CCPs and analytics providers such as Trioptima, which, having started out servicing executing brokers, is now doing multilateral compression for end clients. Gavin knows at least two large hedge funds that now have dedicated compression desks, devoted to reducing notional exposures.
Choices: clearing house, account structure, venue and counterparty
Across listed derivatives, as well as OTC, SGPS can clear with clearing houses including CME Clearing Europe, Eurex Clearing AG, ICE Clear Europe, Ltd, LCH.Clearnet Limited, and Nasdaq OMX Clearing. As well as “a natural difference between US and European models” there are “distinctions in terms of the choice of documentation and the choice of segregation model” Gavin points out. “There are subtle differences in terms of data; how segregation models work; what happens in default; how porting works; the depth of liquidity; risk processes and default waterfalls” he goes on.
SGPS is agnostic about where clients clear – so long as there is enough liquidity and a robust model – but does educate them about differences between the clearing houses. Marcus underscores how “we are neutral as to choice of clearing house but can highlight pros and cons of different segregation and risk models and how good a match they may be for different portfolios and assets”.
For instance, models include individual segregation, full segregation, net omnibus and gross omnibus. SGPS can work with all of these models and also “ring-fenced omnibus for groups of funds that have to supply ISDAs under EMIR” Gavin adds. Once again Gavin stresses that SGPS is not prescriptive, summing up that “the client decides on the various risk mitigants and if they are worth the costs”.
SGPS can accommodate a range of legal agreements – ISDAs, FOA (Futures and Options Association) agreements, the German Master Agreement on Financial Derivatives Transactions (DRV), and French Banking Federation (FBF) Master Agreements. Most of these are drafted under English or New York law.
Additionally SGPS is open minded about venues, and stays ahead of the curve by getting in at the ground floor with new exchanges and venues. SGPS took stakes in GMEX and ERIS and is a founder member of the LSE’s latest new venue, CurveGlobal, where Gavin envisages “offsetting versus SwapClear positions is a very powerful prospect”.
Gavin stresses that “the clearing side of SGPS is not executing with other parts of Societe Generale, to preserve segregation and keep client information separate from the execution side”. New counterparties are also warmed to by SGPS, which welcomes the entrance of non-bank executing counterparties, such as Citadel, for interest rate swaps.
Regulatory uncertainty and arbitrage
Still, the growth story could be disrupted by adverse regulatory change. Societe Generale and the whole clearing space are anxiously awaiting critical regulatory decisions on how different jurisdictions will treat cleared derivatives, collateral, swaps and futures from a capital perspective in terms of leverage, solvency and liquidity ratios for instance.
“Some outcomes could have a severe impact on businesses’ cost of capital and impact various clients – such as hedge funds, insurance companies, and pension funds – in different ways” Marcus fears. Though various regulators may implement rules differently, Gavin very much hopes that “there will not be regulatory arbitrage as we would rather have a level playing field”.
Yet there are early signs that regulations may be throwing up anomalies. Clearing has already resulted in some discrepancies between pricing on different clearing houses. For instance, CME Group and LCH pricing has diverged due to “structural differences in market participants with LCH having a large dealer community” Gavin explains. Additionally there are gaps between pricing on LCH and JSCC, which is currently Japan’s only clearing house. Domestic Japanese banks are in effect captive to the JSCC, contributing to some basis. Some SGPS clients are exploring the potential to construct arbitrage trades that could profit from persistence, or re-convergence, of these divergences.