New global rules for OTC derivatives have been implemented in the US and are imminent in Europe that will have significant long-term implications for how hedge funds, asset managers and regional banks execute, clear, and report their swap positions.
In particular, 10 June 2013 represents the second phase of the OTC clearing mandate that is required under the Dodd-Frank legislation. This means that those firms defined as part of Category 2 (hedge funds, asset managers and regional banks) that trade swaps must move very quickly to finalize central clearing arrangements.
Firms must act now to finalize their legal agreements and operational set-ups with their clearing members, affirmation platforms, and clearing houses to ensure that they will not be ‘locked out’ of the swaps market and can continue to trade after 10 June 2013.
What is significant about the 10 June swaps deadline and will this apply to all clients in the US and Europe?
In the US, there is a Dodd-Frank requirement to clear certain types of interest rate swaps and credit default swaps. This clearing mandate started in March 2013 for a subset of market participants, with further phases to follow in June and September 2013. Combined with the EU’s European Market Infrastructure Regulation that was enacted in January, both of these initiatives will mean the vast majority of OTC interest rate swap contracts will have to be centrally cleared.
The next key date to pay attention to this year will be 10 June 2013, when interest rate swaps and credit default swaps will have to be centrally cleared by most market participants who fall under Dodd-Frank. Consequently, many of our clients have been finalizing their production account set-ups, and signing up for direct access to their reports and margin analysis tools.
Why does the European buy side need to act now?
Although we don’t have any clear dates yet for the European clearing mandate, it is widely accepted that the mandate will occur some time in mid-2014. Even though there is a quite a bit of time until that date, firms that want to clear in Europe will need to start the lengthy legal and on-boarding process now as they have issues to address that typically can take months to complete. Many other clients are now early movers to centralised clearing because of the Basel III capital requirements that could significantly increase the cost of holding swaps bilaterally.
To put this into context, there are an estimated 4,000 buy-side firms that will have to comply either with US or European legislation, and approximately 20 clearing members offering client clearing (many more banks are clearing members for only their house trading activity). The knock-on effect of clients on-boarding forclearing comes down to bandwidth, as some clearing members will have capacity constraints and be unable to serve as a clearing member for all of these clients.
Is this a big change for hedge funds and asset managers in particular?
Many asset managers do not post initial margin in the bilateral world, so they are preparing their infrastructure to handle this process and calculating both the amount of margin required and the securities that they plan to pledge to meet the margin obligations.
Another significant issue for both asset managers and hedge funds will be that only a portion of their portfolios are currently clearable, so they would have to keep some of their trades bilateral. This bifurcation of their risk would cause their portfolios to be margined as two separate directional portfolios and will result in significantly higher margins.
Many of the largest swap users in the market are also active in interest rate futures. Portfolio margining of interest rate swaps and futures helps alleviate the overall capital strain by delivering significant margin savings for clients of up to 90% for certain portfolios.
This has been available for clearing members since May 2012 and it went live for customer accounts in November 2013. Most buy and sell-side market participants are planning their portfolio margining launch plans for mid to late June, because they want to get through the clearing mandate compliance first, and then focus on the risk reductions and margin savings shortly thereafter.
What will be the key benefits?
Our clients are excited about the reduction in counterparty risk and applying a better risk framework to the interest rate swap market. The levelling of the playing field in the marketplace will be a huge benefit to clients, as they will enjoy a significant increase in transparency on the valuations and margins for their portfolios.
One fund manager sums up the overall advantages clearly. Supurna VedBrat, co-head of electronic trading and market structure at BlackRock, says: “Our priorities are customer protection, margin efficiency and liquidity.”
Other benefits will be economies of scale and liquidity, outlined by Matt Scott, vice president of OTC derivative trading at Alliance Bernstein: “The cleared interest rate swap market feels more balanced over the last six-nine months as clearing volumes have increased.”
What are some of the things buy-side firms are doing to prepare for swap clearing?
Beyond the critical items like legal agreements with clearing members, or connectivity to an affirmation platform, we’re seeing many clients requesting direct access to their reports and advanced margin services.
Advanced margin services enable clients to fully replicate margin calculations into their systems infrastructure so traders, portfolio managers, and risk managers can know exactly how new trades could impact the margin for certain portfolios, and so they can determine the most capital-efficient way to execute their trading strategies.
Will the market evolve as a result of this legislation?
The early signs from our client base are promising and we are confident that this market will grow based on reducing risk in the marketplace, and opening up the market to a greater number of market participants who didn’t previously have access.
Within this market, there will be an increased demand for collateral that can be pledged to a clearing house, and clients are focusing on more centralized management across assets and activities to make more efficient use of collateral.
Market participants should be working towards automation of back-office processes across all elements ofvaluation, accounting, collateral management, and risk management. Many market participants are considering increasing their usage of futures products, because of the operational and collateral efficiencies that come with the usage of standardized products.
Jack Callahan is executive director of OTC products at CME Group. Callahan is responsible for working with buy-side market participants on preparedness for OTC interest rate swap and credit default swap clearing. Before joining CME Group in 2009, Callahan most recently worked for Bank of America as a derivative marketer. He holds a bachelor’s degree in finance from the University of Texas at Austin and an MBA from Harvard Business School.