What will clearing cost?

Many end-users will have to clear over-the-counter derivatives using services provided by clearing house members – currently, that means the big dealers. But changes in default fund calculations and regulatory capital requirements mean the fees they will be charged for this service are uncertain. If too high, clients might be prevented from clearing, argues Mariam Rafi

With the start date for mandatory clearing quickly approaching, dealers and clients are focusing on preparation. Work is under way to finalise legal documentation and test operational capabilities, but a key question remains unanswered: the cost for clearing members to provide clearing services to clients. Evolving regulatory requirements are causing the economics of the clearing business to change drastically, particularly as a result of increased default fund costs and changes in capital requirements. These have the potential to create an untenable layering of additional costs, which could ultimately affect the ability of clearing members to offer services in this market, and prevent participants from using swaps as an efficient hedging and risk management tool.

Default funds
Clearing houses require their members to contribute to a default fund, in addition to the initial margin held against those positions. This can be drawn upon in the event any clearing member defaults and the initial margin associated with its positions is not enough to cover any loss. These default fund requirements are impossible to replicate, because they are scaled based on activity outside the clearing member’s control, but generally range between 4% and 25% of the initial margin posted by the member.¹ Contributing this amount in support of client positions requires clearing members to incur both funding costs and counterparty risk charges, as default funds are subject to the risk of losses if another clearing member defaults.

Table A illustrates the breakeven costs for a clearing member as a percentage of initial margin contributions. These costs are a function of the clearing member’s funding and/or counterparty risk costs, as well as the eventual ratio of default funds to initial margin.

If the ratio of default funds to initial margin ends up in the 10–15% range, many clearing members will be forced to charge between 20 basis points and 45bp on initial margin just to break even on the funding and counterparty risk costs.

Other clearing houses have not capped the size of their default funds, which makes it challenging for members to plan their liabilities

However, default fund methodologies are changing and may result in clearing members having to make bigger contributions. This is partly in response to a Commodity Futures Trading Commission (CFTC) rule that prohibits derivatives clearing organisations from setting minimum capital requirements for members any higher than $50 million.² That is significantly lower than the membership standards many over-the-counter derivatives clearing houses previously had in place.³

As a result of this rule, LCH.Clearnet changed its methodology for calculating default fund requirements, switching from a fixed default fund size of £125 million for interest rate swaps to a variable structure, which had reached £2.4 billion by July. Speaking to Risk earlier this year, Daniel Maguire, head of SwapClear US and global head of product, attributed the changes to the new membership criteria. “We can use three levers – the membership criteria, the default management process and the default waterfall of financial resources. The minute you pull one of those levers one way or another, you’ve got to rebalance the others. If we go from $1 billion to $50 million in the US, we’d have to tighten the other two levers to equalise,” he said (Risk January 2012, pages 68–69).

As part of this restrike, SwapClear’s default fund is capped at £5 billion. The introduction of a cap on the size of the default fund helps clearing members put an upper limit on their exposure to a central counterparty (CCP), and is a critical element of the risk management process for members. Other clearing houses have not capped the size of their default funds, which makes it challenging for members to plan their liabilities – particularly in light of the uncertainty around default fund calculation methodologies.

Another regulatory driver forcing some clearing houses to consider changing their default fund structure is the implementation of a new customer asset protection model in the US – legally segregated, operationally commingled (Lsoc) – which removes client funds from the default management waterfall. Figure 1 illustrates differences in the default waterfall between the gross omnibus and Lsoc models.

As a consequence, clearing houses must collect increased levels of initial margin from clients or increase the size of their default funds. CME Group has told the CFTC a move to Lsoc could cause the size of its default fund to double, for example.⁴

Citi strongly supports the move to enhanced segregation for clients. However, as clearing houses look to change their financial safeguard packages in response to changes in the default waterfalls, we would recommend the adoption of a ‘defaulter pays’ approach, where the risk of cleared positions is covered through initial margin rather than the default fund. This is economically more efficient for clearing members – and enhances the ability for customers to port positions at a time of market stress, as clearing members are more likely to accept client positions if they do not have to make additional default fund contributions to cover the ported exposures. Keeping default funds small in relation to initial margin requirements is key to having successful portability in times of market stress, hence reducing systemic risk.

Either way, it is extremely difficult for clearing members to accurately calculate the size of their default fund contribution. While it can be estimated as a ratio of initial margin, the actual calculation of the default fund and the allocation to clearing members is a much more complex and iterative process. To calculate default fund requirements, CCPs consider the shortfall in initial margin that would occur in stressed market conditions. While initial margin for cleared derivatives must be calculated at a minimum 99% confidence interval with a five-day holding period, the stressed losses used to compute default fund requirements are calculated at much higher levels – often between 99.75% and 99.9%.

The clearing house will calculate the worst-case uncollateralised loss for each clearing member as the excess of the stressed losses over and above its initial margin requirement. The size of the default fund is normally computed as the sum of the largest two worst-case uncollateralised losses – which assumes the two largest clearing members default simultaneously. The clearing house then allocates this default fund requirement between all clearing members, in proportion to the risk they bring to the CCP. Clearing houses may make this allocation based on each member’s worst-case uncollateralised loss, initial margin requirement, open interest, or a combination of the three.

For clearing members that clear on behalf of clients, the CCP will generally stress each client account separately, and gross-up the worst-case uncollateralised losses for a given number of clients to arrive at the worst-case uncollateralised loss calculation for the clearing member. The number of clients each clearing house will consider for the purposes of this calculation is still under discussion, and could vary from one venue to another. Table B provides an illustrative example of a clearing house default fund calculation.

Under the futures omnibus model, some clearing houses calculated the clearing member’s worst-case uncollateralised loss by netting together all the gains and losses of its clients. Under the Lsoc model, which will be introduced in the US on November 8, it will not be permissible to use a non-defaulting client’s collateral to cover a defaulting customer’s losses. That means clearing houses will no longer be able to net together customer positions to come up with the clearing member’s worst-case uncollateralised loss calculation, and must gross them up instead. Depending on how many clients are included in the gross-up calculation, a clearing member’s default fund calculations could balloon.

As illustrated in table A, a large default fund requirement could lead to significant costs for clients. It is therefore important for clearing houses to adopt a defaulter-pays model and cover the risk through initial margin. Capping the overall size of the default fund would also be a positive step for clearing members to be able to manage risk and control costs. It’s worth noting that clearing houses generally cap their own contributions to the default fund.

Capital costs
In addition to default fund expenses, clearing members must also hold regulatory capital against clients’ cleared positions. The Basel Committee on Banking Supervision originally suggested a conservative methodology for the capitalisation of clearing member default fund exposures. It revised its position in July, allowing clearing members to cap their risk-weighted assets from all their exposures to clearing houses at 20% of trade exposure. This may reduce the expected capital requirements associated with the clearing business.

Clearing members still have to capitalise client positions as if they were uncleared, bilateral positions, but the Basel Committee now permits them to recognise a shorter close-out period for cleared trades in their calculations.⁵

In the US, the CFTC separately subjects futures commission merchants (FCMs) to capital charges for cleared positions. FCMs are required to hold minimum capital of 8% of the total initial margin requirement for positions cleared in customer accounts.⁶ This could translate to a significant capital burden for FCMs, given the high margin levels for cleared OTC products.

Any regulatory capital requirement under Basel III or the CFTC rules will affect the clearing member’s internal return hurdle rates. Looking solely at the CFTC margin requirements, a clearing member targeting a 10% return on capital would have to charge a client fees amounting to 80bp a year on initial margin balances to achieve the target return. That’s because an FCM holding $100 million of client margin balances would need to hold $8 million of capital against it. To achieve a 10% return on capital – or $800,000 – the FCM would need to charge the client 80bp on the $100 million balance.

Citi is hopeful regulators will re-evaluate this capitalisation requirement to encourage cost-efficient client clearing services and global regulatory harmony.

Revenue model for OTC clearing
The revenue model for OTC clearing is also in flux. OTC clearing services to date have been priced across the industry on a costs-plus basis. The pricing model was largely based on legacy derivatives intermediation arrangements – low fixed fees per cleared transaction. These were meant to cover operational processing costs, but were generally not reflective of the risks the dealer assumed by intermediating the transaction. Derivatives intermediation – and by extension, OTC clearing – was viewed as a franchise enhancement service, and often not priced as a stand-alone offering. The business rationale was that by providing derivatives intermediation services to a client, the dealer would be that customer’s first point of call for execution business. Dealers therefore aimed to recoup their costs on enhanced execution.

With the expected increased anonymity of execution in OTC markets as trading shifts to swap execution facilities, the link between the provision of clearing services and enhanced execution may weaken. In addition, the CFTC has finalised conflict-of-interest rules, which state: “No futures commission merchant shall permit any affiliated swap dealer or major swap participant to directly or indirectly interfere with, or attempt to influence, the decision of the clearing unit personnel of the futures commission merchant to provide clearing services and activities to a particular customer, including but not limited to a decision relating to the following: (i) whether to offer clearing services and activities to a particular customer; (ii) whether to accept a particular customer for the purposes of clearing derivatives;... (vi) whether to set a particular customer’s fees for clearing services based upon criteria that are not generally available and applicable to other customers of the futures commission merchant.”⁷

These regulatory changes may preclude execution desks from subsidising clearing services for clients, meaning OTC clearing has to be profitable on a stand-alone basis, rather than being a way of bolstering the execution business. For OTC clearing members to cover their default fund-related costs, many clearing members have started introducing a capital utilisation fee, expressed either as basis points on initial margin balances or as a percentage of cleared notional. To ensure clearing members are able to provide reasonably priced services, it is imperative clearing houses adopt a defaulter-pays model, where the risk of cleared positions is covered predominantly through initial margin. Regulators also need to re-evaluate the capital requirements for clearing members providing client clearing services. Without these changes, providing OTC clearing services could be prohibitively expensive – a trend that would be in no-one’s interests, least of all clients.

Mariam Rafi is Americas head of OTC clearing at Citi in New York

 

1 In accordance with the ‘cover two’ concept established by the Committee on Payment and Settlement Systems and International Organization of Securities Commissions, CCPs generally scale the default fund by looking at maximum stress losses of the two largest exposures in the system

2 17 CFR Parts 1, 21, 39 and 140 Derivatives Clearing Organization General Provisions and Core Principles. Federal Register / Vol. 76, No. 216 / November 8, 2011 / Rules and Regulations

3 LCH.Clearnet and Ice Trust US had minimum Tier I capital requirements for FCM members of $1 billion, and $5 billion for bank members. Under CFTC rules clearing houses are permitted to scale the risk clearing members are allowed to clear, relative to their capital base

4 http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27179&SearchText

5 Basel Committee on Banking Supervision, Capital requirements for bank exposures to central counterparties, July 2012

6 17 CFR 1.17 Minimum financial requirements for futures commission merchants and introducing brokers. Federal Register / Vol. 74, No. 250 / December 31, 2009 / Rules and Regulations

7 17 CFR Section 1.71 Conflicts of interest policies and procedures by futures commission merchants and introducing brokers. (d) Federal Register / Vol. 77, No. 64 / April 3, 2012 / Rules and Regulations