European buy-side firms face clearing crunch

Large buy-side firms will be subject to Europe’s clearing mandate from December 21, but their smaller peers risk being left behind

A clear run: larger buy-side clearers may have an easier ride than their smaller contemporaries

December 21 marks the winter solstice, the shortest day of the year in the northern hemisphere – preceded by the darkest and longest night. Europe's largest fund managers – who will need to begin clearing the bulk of their over-the-counter derivatives trades on the same day – can sleep easy, with few issues predicted in meeting the deadline, but their smaller peers may not be so lucky when they become subject to the mandate in six months' time.

Clearing providers and clients agree that smaller buy-side firms – those with derivatives exposures smaller than €8 billion over three months, that fall into category three under European regulators' designations – face far more significant hurdles when it's their turn. Pending a delay being granted by the European Commission, that could be as soon as June 2017.

A raft of issues – from long lead times in getting documentation completed to the cost of providing clearing services and balance sheet capacity to clients who trade relatively infrequently – have conspired to shrink the already dwindling capacity among clearing providers that is on offer to category three firms. This could leave thousands of counterparties unable to secure clearing agreements by the time they become subject to the rules.

Even where smaller firms have been able to secure clearing agreements, the arrangements are often flimsy, say lawyers: "Category three entities have found clearing member interest in negotiating with them limited, and where they are negotiating, response times are slow. Very few firms have executed client clearing arrangements. [But] a number of those who have, feel they may not have an appropriate arrangement that will enable them to comply with the clearing obligation. [This is because] the clearing member is, at its discretion, able to stop providing clearing services at short notice," says Deepak Sitlani, a derivatives partner at law firm Linklaters.

The notice period within which a clearing member can terminate the services it provides can be extremely short, according to several asset managers who spoke to Risk.net for this article. Early termination clauses in clearing agreements, which many say banks insist on, can be as tight as one or two months' notice, leaving firms with little time to arrange for a replacement clearer.

Category three clearing is a problem because of the way the rules around regulatory capital and the treatment of client margin are constructed at the moment, and you just cannot get around that
Clearing specialist at a European bank

Banks counter that they have had to bake such clauses into client clearing agreements because of the capital pressures that continue to constrain their business. Under the Basel III leverage ratio, client margin held by banks is currently counted in the calculations for capital that they must hold against risk exposure. Clearing members argue its inclusion is unfair, and that, given the margin is risk-reducing in nature, they should not be penalised for holding it.

The impact on clearing capacity has been visible, with FCMs hiking fees to cover the extra cost of holding cash margin on their balance sheets, and many struggling to turn a profit. Some have offloaded unprofitable clients, while others – such as RBS, Nomura and Bank of New York Mellon – have exited the OTC clearing business entirely.

But to date, the industry's limited clearing capacity has been deployed almost exclusively on servicing large clients; what happens when category three firms – which represent 93.5% of the counterparties in the interest rate swap market in Europe but just 1.1% of transaction volumes, according to analysis by the European Securities and Markets Authority (see table A) – want to find a clearing provider?

"There needs to be recognition that this isn't just an issue of timing, legal negotiations or technology," says one clearing specialist at a European bank. "Category three clearing is a problem because of the way the rules around regulatory capital and the treatment of client margin are constructed at the moment, and you just cannot get around that."

In their responses to a June 2016 consultation from the European Securities and Markets Authority (Esma) on delaying the clearing mandate for small financial counterparties, even some of the largest asset managers said the process of securing a clearing provider had been challenging.

Amundi, which has more than €1 trillion in assets under management and manages funds caught by both the category two and three deadlines, described the process of securing client-clearing arrangements as "very frustrating". In its response dated September 5, it said that, at the current stage of negotiations with clearing members, it was "not today in a satisfactory position to use central clearing at a large scale". The firm added it had agreed a temporary contract, but with caveats.

Natixis Asset Management – which manages €349 billion in assets and says most of its portfolios fall under category three – also said in its response that clearing members were looking to charge high costs for their services, adding it had found it "difficult to finalise any agreement". This was particularly the case for credit default swaps clearing, which is due to enter into force for category two firms in Europe on August 9, 2017.

Neither firm responded to requests for further comment from Risk.net.

The high cost of clearing services was something many firms also flagged as a concern in their responses. An analysis by Risk.net of public cost disclosures from major FCMs, which firms operating in Europe are obliged to make under the European Market Infrastructure Regulation, shows where costs can accrue, particularly for smaller buy-side derivatives users.

If they want us to clear for them, then there has to be a recognition that we're not only taking on a big commitment from a risk perspective, but we're also taking an economic hit
Derivatives lawyer

Like-for-like comparisons between FCMs is difficult since there is a wide number of variables between banks' cost structures, but a look at headline fees on an undiscounted basis – without the benefit of cost reductions passed onto the biggest volume clients, for instance – is nonetheless illuminating.

On top of per-ticket fees that range from $750 up to €3,000 ($3,133), clearing members typically levy a charge based on the number of open positions firms hold per quarter. Clients can expect to pay around $5,000 per month in maintenance costs for individually segregated accounts (ISAs), which ensures their margin is not pooled with that from other clients. Others charge more: Credit Suisse, for instance, charges up to €30,000 per ISA, per month.

Firms that fail to meet a minimum revenue threshold – which at UBS and Morgan Stanley is set at $250,000 per annum before clearing services will even be offered – are often hit with monthly fees: Citi, for instance, charges a minimum of $10,000 per month. Clients often bear clearing house fees too, as well as any post-trade services that are offered, such as portfolio compression and trade reporting.

Some FCMs have also taken to levying a flat charge on initial margin balances. Barclays' European FCM, for instance, charges 100 basis points on initial margin deposits.

For firms that are infrequent users of OTC derivatives, all of that might add up to a price not worth paying, say market watchers.

Economic reality

For their part, clearing members argue the costs reflect the economic reality of the business. Discussions with category three firms have to date been long, fraught with legal complications, and inflexibility on the part of clients, they say.

"These firms – and I have to be careful here – often lack for sympathy regarding our own position on this," says one derivatives lawyer, who has worked on contract negotiations with category two members on behalf of clearing members. "If they want us to clear for them, then there has to be a recognition that we're not only taking on a big commitment from a risk perspective, but we're also taking an economic hit, and unfortunately that leaves us limited in how flexible we can be both in fees and in the contractual terms we can offer."

Some dealers also point to the fact that their legal departments are currently swamped with efforts to revise client documentation in the run-up to the March 1, 2017 deadline for variation margin requirements for non-cleared derivatives. For both sets of negotiations, clients outside the bulge bracket are struggling to attract attention at the moment, say lawyers.

"Compared with the margin rules, where we've already had to reassign people from other areas to handle that, you have to start looking at what you can realistically do with the resources at hand and prioritise accordingly," says the clearing banker.

Despite the barrage of problems, however, succour may be on the horizon. Following its June consultation, Esma formally proposed that clearing for category three participants should be delayed by two years, partly to buy time for regulators to hammer out a deal on the treatment of client margin under the leverage ratio.

In its November report on the consultation, the watchdog said: "Esma remains of the opinion that while the framework is still being assessed and finalised, the uncertainties of this situation are impacting the access to clearing and reinforce the need to consider the delay discussed in the consultation paper and in the final report."

On November 23, the European Commission proposed, through amendments to the Capital Requirements Regulation, to allow netting of client margin in its application of the leverage ratio exposure method.

Allowing the initial margin offset would be beneficial, but would not open the floodgates to clearing capacity. It would help, but it's not the panacea most people think
Consultant

As with the amendments to the CRR, any delay to category three clearing would also need to be adopted by the EC, and then put forward to the European Parliament and Council for approval. A November 2016 report from the EC on the implementation of Emir did not mention the proposed delay, saying only that "action to address the obstacles to client clearing should be considered".

When specifically asked by Risk.net whether it would accept the Esma proposal, a Commission official said it was simply too early to say, and that it was "assessing" the report.

Europe's stance on the leverage ratio is also at odds with other key jurisdictions, however – notably the US, which has favoured a more stringent application of the leverage ratio.

Market watchers are also divided on whether the move would significantly bolster clearing capacity, too. One consultant points to the fact that the US-domiciled FCMs currently dominate the client clearing business in Europe; with the leverage ratio applied at the bank holding company level, US banks – already subject to the more punitive supplementary leverage ratio – will not benefit from any offset applied in Europe.

"Allowing the initial margin offset would be beneficial, but would not open the floodgates to clearing capacity. It would help, but it's not the panacea most people think," says the consultant.

While the treatment of client margin under the leverage ratio remains hotly debated at the Basel level, there is broad acceptance that the way in which the metric is calculated is likely to change. The ratio's method of calculating derivatives exposure, which at the moment relies on the outmoded current exposure method (CEM), is being dropped in favour of the standardised approach for counterparty credit risk (SA-CCR), which is more risk-sensitive and allows for greater netting of exposure.

While a switch to SA-CCR should, in general, be less punitive on derivatives exposures than CEM for most vanilla OTC derivatives, dealers are still pushing for client margin to be treated as risk-reducing, an approach dubbed SA-CCR-with-offset. Responding to the Basel Committee's consultation on amending the leverage ratio in July, the Futures Industry Association cited its analysis of 14 futures commission merchants, which suggested the aggregate leverage ratio exposure for those firms would be 88% higher under the SA-CCR than it would under SA-CCR-with-offset.

Absent a fix, clearing will still produce returns on equity "that would be well below even the most conservative ROE targets", the trade body argued.

Limited choice

The figures suggest firms already face a very limited choice among OTC clearing providers. In the US, around $75 billion was held in client-segregated funds for cleared swaps at the end of October 2016, according to data from the US Commodity Futures Trading Commission (see table B). The majority of this, 96.5%, or $72.4 billion, was held by the top 10 firms, with the top five alone holding just under 75% of the total funds.

This in turn puts a strain on the ability of those banks to extend deep credit lines to their clients. One European clearing banker says his bank has had to deploy its clearing capacity tactically as a result, focusing on offering a full service to key clients while being more judicious about the level of new business they accept. Many asset managers in category two alone have panels of clearing banks rather than a single clearer, as a result.

"A couple of years ago, when we started to look at this, banks would come in and say they wanted to be our single, global clearer for all of our over-the-counter business," says Steven Swann, Edinburgh-based global head of trading at Standard Life. "However, once they'd worked out what the capital implications of running an OTC clearing franchise were, they came back and said, 'actually, you probably need more than one clearer'."

Dealers say that in an ideal world, they would be happy to hoover up clearing business where they can: "We, and other banks like us, would love to be the sole clearer for some of these guys," says the European clearing banker. "They do a lot of business, and we think that relationship could be mutually beneficial. But there's this external force that's putting pressure on our ability to do that, and it's not just hurting them but it's hurting us as well."

Compliance allowance

Given the scale of the capacity crunch facing the industry, it seems likely category three firms will get more time to comply with Europe's mandate. Lobbyists argue there would be little systemic risk in delaying or even scrapping the mandate, given the small slice of the market the firms account for, and while potential solutions such as indirect clearing (see box: The curious case of indirect clearing) remain unviable.

"We agree with Esma that postponing the clearing compliance deadlines for small and less systemically important financial counterparties will not compromise the overall objective of the clearing obligation to reduce systemic risk," says Roger Cogan, head of European policy at Isda. "This will give time for regulators and market participants to explore the development of indirect clearing services. However, we think regulators also need to ensure the leverage ratio recognises the risk-reducing effect of client collateral to help facilitate the ability of clearing members to offer client clearing services."

The curious case of indirect clearing

Indirect clearing, in which a smaller firm uses the services of another firm that already has an agreement in place with a clearing member, has been touted as a potential solution to Europe's capacity crunch. But the proposed regulatory framework that will underpin it remains mired in delays.

Esma submitted its final draft standards to the European Commission in May 2016 following an earlier revision of its initial work, but the EC has yet to approve and pass them on to the co-legislators for approval – or send them back to Esma for revision.

While the EC is generally supposed to commit to either route within three months of receiving technical standards from one of its supervisory authorities, it is not legally bound to do so, and can take as much time as it needs to analyse proposals.

Commission officials declined to say whether there was a timeframe in place as of yet to move forward on indirect clearing. An Esma spokesperson did not respond to a request for comment.