Fund managers can no longer afford to view clearinghouses as stodgy infrastructures which just exist for the sake of servicing mega broker-dealers and banks.
With regulators now requiring far more transactions — particularly in the over-the-counter derivatives market — to be processed through clearinghouses, asset managers must realize they have some choices to make and be far more selective in who they are using. They can’t simply leave the decisions to their futures commission merchants (FCMs), or clearing brokers, who may have their own interest in using a particular clearinghouse and little concern whether the fund manager is posting too much collateral or not enough to protect itself.
The US Commodity Futures Trading Commission last year mandated most fund managers to rely on central clearing for interest rate and credit default swaps. Across the Atlantic, the European Securities and Markets Authority is working out which types of European swap contracts should be included in its mandatory clearing requirements, which market players will be affected, and the criteria for whether a swap contract is clearable or not. As a result, clearing in those products has been voluntary so far.
Clearing can be expensive in the best of circumstances. With collateral shortfall forecast to reach an all time high, it doesn’t make sense to use a clearinghouse that asks for far too much collateral. However, when the clearinghouse is too lax in collateral requirements, it can also be problematic if a counterparty goes bust. Then there are all those extra details, like what the FCM will charge, the credit line offered by the FCM, and the clearinghouse’s collateral acceptance policies.
Fund managers who want to exert some control on the clearing of their trades face a complicated juggling act. The decisions cannot be handed off to well-intentioned back-office operations specialists who are mainly interested in a seamless process, or even to trading specialists who will likely only consider how the amount of collateral affects the cost of the trade. Understanding and choosing the best clearing options requires expertise and technology for optimal collateral management, financial control and risk.
When the only choices they had were black-box financial agreements with FCMs or clearing brokers, fund managers didn’t have the tools to make effective decisions. Now with fund managers demanding breakdowns of costs and policies, the potential for informed decisions is opening up. “With choice and greater disclosure of the methodologies for calculating margin requirements, the onus is on the fund manager to be more selective,” says Radi Khasawneh, a fixed-income analyst with research firm TABB Group in London. “They are no longer relying on the FCMs [to make their choices for them] because they have far more information at their fingertips.”
At the easiest level, the choices come down to using the domestic clearinghouses in over twenty markets or four major global providers: CME, LCH.Clearnet, Eurex Clearing, and ICE. Industry watchers expect to see a growing segment of the business going to the giants, because they offer global reach, wide product range, expanded asset classes for collateral eligibility and harmonized margining methodologies. Their competitive weapon is that sooner or later, a fund manager will need to come to them when a local clearinghouse can’t or won’t clear one of their trades because of limited product focus, a narrow range of collateral types and restricted access to foreign players.
The breadth of clearinghouse services may be an important criteria, but it’s certainly not the only one relevent to making clearing decisions. Speaking with collateral management experts at several US and European fund management shops, clearinghouses and consulting firms, FinOps Report has come up with five critical issues in finding the best clearing path.
1. Filter for Eligibility
The obvious question and first filter on potential options: Is the trade “centrally clearable”? Most over-the-counter derivative trades can be processed through a clearinghouse, but others can’t and must rely on a bilateral agreement between counterparties. If the trade is determined to be centrally clearable, the next filter is eliminating the clearinghouse that don’t clear the type of trade. Last but not least, verify that the clearing agent you want to use is a member of the clearinghouses you wish to use.
2. Know Servicers’ Collateral Rates
Clearinghouses have different methodologies for calculating the initial and variation margin required for each transaction. Understanding a clearinghouse’s policies will help ensure the right one is used and a more efficient collateral management process, says Sonia Goklani, chief executive of Cleartrack, a South Brunswick,NJ-based firm specializing in customized technology and consulting for over-the-counter derivatives.
Another factor to consider is how the clearinghouse treats cross-margining. In an effort to build volume through more attractive margining policies, clearinghouses are offsetting requirements in multiple asset classes — a scenario which might seem to help the fund manager by reducing the total collateral required. But cross-margining needs to be evaluated carefully, explains Richard Walker, a director at LCH.Clearnet in London.
The potential cost advantage of cross-margining is highly dependent on the fund manager’s trading strategies, he says. For example, a hedge fund manager that arbitrages differential prices in instruments that are economically equivalent could end up with a lower overall collateral requirements when trading exchange-traded derivatives and OTC products. By contrast, a traditional asset manager with a so-called directional book might not have the necessary offsets in hedging transactions to profit from cross-margining, and may actually be charged more for collateral.
The clearinghouse’s margin requirement is only half of the collateral cost equation. The other half is how much extra cash or collateral the FCM will add on as cushion in the event the fund manager goes bust or does not meet its financial obligations. Some FCMs will openly report this information to a fund-manager client; others will not, so it is important to ask for a breakdown of charges. If the clearing broker is asking for too much collateral, then it may be time to renegotiate the terms of the contract rather than changing clearing brokers or clearinghouses — a far more cumbersome process.
3. Analyze Collateral Treatment
Clearinghouses have started harmonizing their policies about the types of collateral they will accept, but there are still plenty of differences that can affect fund managers. All clearinghouses welcome cash and US Treasuries — the most liquid assets. However, fund managers may not have sufficient cash or liquid assets on hand at clearing. If they have to transform or exchange whatever assets they have into what they need, they could spend a lot more than if they simply used a clearinghouse which accepts the collateral they have on hand. Among the US clearinghouses, CME allows for the broadest use of collateral, but ICE Clear US is far more stringent. ICE doesn’t accept US agency, corporate bonds, equities or letters of credit, says Khasawneh.
Policies on haircuts — the reduction in value clearinghouses attribute to collateral to counteract potential volatility or other market risks if the collateral needs to be used — is also part of the calculations of collateral cost, and also the risk. If haircuts are too lax, the collateral may not be sufficient if a counterparty fails. If the clearinghouse is too stringent, it might cost the fund manager a lot more than if it were to have relied on the higher quality liquid collateral. Case in point: ICE Clear US will haircut US Treasuries at 1 percent to 11.50 percent depending on their maturity. By contrast, LCH.Clearnet will only haircut them between 0.25 percent and 11.25 percent.
4. Know Your Capabilities
Not all the issues are about performance of third parties. Clearing is a time-sensitive, money-sensitive activity. Controlling, managing and,; if necessary, upgrading internal resources are part of optimizing the clearing process and taking full advantages of potential choices.
Credit lines are a make-or-break issue in clearing. The higher the credit line an FCM gives a fund manager the greater the chance its trade will be cleared. There could well be different lines of credit depending on the asset class, the investment strategy, the swap execution facility, and the clearinghouse used, according to Goklani. The CFTC allows FCMs sixty seconds after a trade is sent to a swap execution facility (SEF) to confirm that the fund manager has sufficient credit to do so, and then the clearinghouse will have another sixty seconds to accept or reject the trade for clearing. If the credit line is breached, the trade can’t be cleared and might even have to be unwound.
Yet another factor: how quickly a clearinghouse calculates margin requirements. LCH.Clearnet and ICE calculate variation margin requirements intraday while CME does so at the end of the day. “Asset managers may want to work with clearinghouses that calculate initial and variation margin as close to real time as possible to manage their risk more quickly,” says Goklani. “But such a scenario does require the asset manager to have sufficient infrastructure in place to handle the process.”
5. Use the Right People
Regardless of just how much weight a fund manager puts on each factor, it is important that the right person make the decision, says Goklani. Whether that person is considered a risk or collateral manager, and sits with the front office trading desk or middle office, he or she will need the best tools. Ideally, this would be a collateral management system that can access information such as how much collateral is on hand, the expected collateral requirements of the transactions, and how the cost of collateral might be optimized.
Additional cost-risk calculations associated with various facets of clearing may require development of a computing model with the help of a collateral specialist. Is it worth all the work to dig into the clearing process at this level of detail? If the coming collateral shortfall turns out to be real, that question probably answers itself.
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