New Swaps Clearing Rules Trigger Services Shakedown

Brave new ideas, especially when they are mandated by regulators, typically trigger a messy shakedown of systems and services — out with the old, in with the new with a lot of cost and waste lying by the roadside for others to benefit.

Such is the case with the multi-faceted regulatory drive to squeeze potential systemic risk out of the markets. With many over-the-counter (OTC) derivative contracts now joining their exchange-traded brethren in being processed through central clearinghouses, fund managers must deal with a host of new challenges related to multiple clearinghouses, multiple standards for margins and communications, and accountability for margin-related analysis.

In their efforts to reduce counterparty risk in the US$690 trillion swaps market, regulators may have unintentionally given clearing brokers and technology providers a lot to be thankful for. Just don’t count on fund managers to be thankful. They are the ones footing the bills, while struggling with hard decisions.

Fund managers, accustomed to  bilaterally negotiating the collateral requirements — or lack thereof — of their swap transactions with broker-dealers, can no longer enjoy that luxury under the the rules emerging from the US Dodd-Frank Wall Street Reform Act and European counterpart EMIR. The clearinghouses serving as middlemen now have plenty of clout to dictate just how much collateral is required and how quickly.

Buy-side firms will likely rely on clearing brokers — called futures commission merchants (FCMs) in the US — to serve as their intermediaries to the clearinghouses. Those agents typically will add on their own margin requirements — above and beyond what the clearinghouses mandate — as an extra cushion. And they will have extra fees, asset managers must now ante up.

“Relying on a clearing broker to handle all the post-trade requirements isn’t the best alternative to traditional reliance on Excel spreadsheets,” says one operations director at a fund management shop. “It doesn’t generate independent calculations. We’re looking at some tough decisions about additional technology spend for valuations and margin calls at the very least.” Similar comments were offered by five operations specialists at US East Coast fund management firms who spoke on condition of anonymity.

Change is Pricey

Savvy fund managers will have a competitive edge, when it comes to handling an anticipated tsunami of margin calls and ancilliary operational tasks, acknowledges a report just issued by New York-headquartered research firm TABB Group, which interviewed 50 asset managers. But that’s only if they are investing in sophisticated technology to keep watch on their clearing agents and clearinghouses. There is no free lunch.

Still, it may be better than being lunch. For starters, consider an estimated US$2 trillion in initial margin, of which about 40 percent or US$800 billion will be US-related. That translates to about $2.4 billion in fees for swaps clearers based on an estimate of 30 basis points (US$300,000) for each hundred million US dollars in margin posted, according to the TABB Group report entitled “Margin Calls: New Risk Tools for the Buy-Side.”

Fund managers using assets other than cash as collateral could be charged extra delivery fees and given the value of the collateral involved, a service provider could make out like a bandit. Case in point: a prime broker servicing a hedge fund manager client could earn more than US$27,000 in same-day funding just for one delivery of US$1 billion in bonds.

Yet two more costs: fund managers who don’t prefund their swaps portfolio could end up paying clearing brokers extra funding charges to cover intraday margin calls. Some of the larger fund managers with lots of asset allocations who are worried about the US regulatory requirement for clearing brokers and clearinghouses to accept or reject a trade for clearing in close to real-time will need to hire an extra so-called “standby futures commission merchant” to park a large cleared transaction on its balance sheet for a day.

Although fund managers may be quick to gripe about the new fees, it is unlikely they will do anything about it. “There may be a lot of attribution and churning in clearing broker relationships,” explain TABB Group’s analysts and co-authors Will Rhode and Sol Steinberg. “That said, some say the new fees will not have any impact on their clearing relationship, while others may want to pay even more to their clearing brokers to keep them in the game and ensure that enough capacity exists in the overall system.”

Even so, delegating margin negotiations to clearing brokers doesn’t get fund managers entirely off the hook when it comes to their core responsibility of prudent asset management. It is their job to make certain the margin calculations are accurate. If they don’t, they could well end up making unnecessary payments.

Until now, apparently far too many fund managers were willing to just accept the word of clearinghouses and clearing brokers. But some are now demanding accountability, realizing that if they can document evidence of an overcharge in collateral calculations directly with a clearinghouse they stand a good chance of getting it corrected.

The Options

To do so they can rely on either a platform provided by a futures commisions merchant, a full front-to-back office software vendor or a specific risk vendor. Tabb Group’s analysts suggest that depending on an FCM platform isn’t such a good idea, because a fund manager will be unnecessarily beholden to its FCM. Using a full front-to-back office technology can be pretty expensive. The suggested alternative: lower cost-options for specific risk analytics and margin calculations.

“Those [systems] that can replicate, validate and forecast CCP and FCM margin calculations on a real-time basis can help buy-side firms evaluate the impact of new trades and market changes on existing portfolios,” say Rhode and Steinberg. “Valuation tools are also important for reconciliation purposes and investor reporting.”

Taken to the next level, such risk analytics can also allow fund managers to understand the dynamics of the collateral they are using. Collateral is subject to differences in liquidity, valuation and redemption factors. Therefore, keeping an eye on these factors — especially fluctuations in valuation — can help a trader predict a possible margin call, trade out of the collateral and replace it with other higher-quality assets. Bottom line: buy-side traders can dynamically manage their pledged collateral assets just as efficiently as other instruments they are trading.

The two TABB Group analysts didn’t rate the twelve risk analytics and valuation vendors they evaluated and offered high-level praise for each, although they did cite integrating with middle and back-office systems as a common shortfall. Among the providers, Cloud Margin and Imagine were noted for “easy, low-set up costs,” while IBM Algo’s AlgoAsset platform was lauded for “rich risk management functionality.” Likewise, Riskdata, SavvySoft and Quantifi’s applications were called “comprehensive.”

When it comes to deciding just how to optimize the use of their collateral — delivering the lowest cost to the right place and at the right time — fund managers could be better off capitalizing on new tech offerings. Pre-funding their positions, putting up cash, accessing the repo market, or pledging whatever collateral they have on hand can be  costly. Pre-funding, used by about 26 percent of respondents to Tabb Group’s survey is the most expensive option, yet fund managers still rely on it simply because they don’t have the internal bandwidth to do anything else.

“Buy-side firms that want robust, but affordable solutions are turning to software vendors that can optimize their use of collateral,” say Rhode and Steinberg, who cite the use of platforms from 4Sight, Calypso, IntegriData, Lombard Risk and SunGard as viable alternatives.

If fund managers are making some hard technology choices, just where does that leave their clearing brokers? Apparently faced with some tough decisions of their own, say analysts Virginie O Shea and Will Woodward of Aite Group, whose new report entitled “OTC Derivatives Clearing in 2014: Pump Up the Volume” is a bit more sympathetic to the plight of clearing brokers. They must ultimately link to an evergrowing number of clearinghouses, many of which might not even survive.

Although the incumbents — LCH.Clearnet, CME and ICE — will likely remain the industry leaders, according to the analysts, clearing brokers must incorporate multiple message standards and multiple collateral methodologies into their workflows. On the messaging front, the challenge is exacerbated by a split between the adoption of two emerging message protocols: FIXML and FpML. Despite their orientations to different asset classes and functionality, there is enough of a convergence to require clearing brokers to support both. Even worse, there are multiple versions of the FIXML standard. Adding to the fray: another standard developed by over two dozen clearing brokers and US custodians in conjunction with technology provider Sapient.

With regulators not mandating the use of any particular message standard, clearinghouses are free to do as they choose. CME and ICE support both the FIXML and FpML message types while LCH.Clearnet supports only FpML, say O’Shea and Woodward. Some — such as Hong Kong’s HKEx and Japan’s JSCC — don’t support either, instead favoring SWIFT’s message types.

“The longer there is a standards divergence and a multiplicity of CCPs to which firms must connect, the more opportunity there is for third-party providers,” say O’Shea and Woodward. The likely list of hot-selling items includes reconciliation, trade matching, pre-trade credit checks, message transformation and support, and collateral management. It stands to reason that clearing brokers won’t be willing to absorb the entire technology cost so fund managers relying on their services will likely carry much of the freight.

What turns out to be a lot of opportunity for clearing brokers and technology providers is the result of a lot of hard work by fund managers to adjust their post-trade operations. Middle and back-office executives acknowledge they are on a steep learning curve in this new world of swaps clearing and understand the larger noble goal of reduced systemic risk. But getting from here to there is, at least for the moment, clearly a bumpy ride.