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TCS Capital Markets Forum DEFINING TR ANSACTION BANKINGOTC Reform: The New Realityin association with financial-i.
TCS Capital Markets Forum OTC Reform: The New Reality – Introduction The panellists: (from left to right) l Jesus Benito, CEO of Spain’s Iberclear, talks about l Joe Reilly, executive director, LCH SwapClear talks post-trade reporting of OTC trades and why Europe about central clearing of OTC derivatives. needs its own trade-reporting repository. l Michael Mathias, director, Capital Markets l Philip Popple, a derivatives product specialist, BNY Consulting, Tata Consultancy Services, outlines the Mellon Asset Servicing, talks about the impact of potential impact new regulations are likely to have on OTC regulation on the buy side. systems and IT for the buy and the sell side. l Alex McDonald, CEO of the Wholesale Market l Bob McDowall, senior consultant analyst, Aite Brokers’ Association, looks at the impact of OTC Group, provides an outside-in view of what an regulation on trade execution. analyst sees within the OTC derivatives marketplace l Jeff Gooch, CEO of MarkitSERV, talks about the and talks about OTC regulation both in the US impact of regulation on post-trade processing; trade and the EU. confirmation and matching. Introduction The market abhors uncertainty, yet we are in a situation how regulation is likely to impact the different ele- where we face a number of regulations passing through ments within the OTC transaction value chain; from various regulatory bodies in the US and Europe, which trade execution, confirmation and matching, through means that market participants are unclear about how to reporting, clearing, the end user or buy side, and the OTC derivatives markets will be impacted in future. finally the IT systems’ changes that will need to be made in order to meet regulatory demands. For example, the industry is concerned about the Dodd- Frank Act in the US, the Markets in Financial Instruments In the following pages you can read the insights of our Directive or MiFID II, the European Market Infrastructure panel of thought leaders on where the biggest changes Regulation (EMIR), and global regulations like Basel III. are likely to occur, the major differences between the EU and the US with respect to OTC derivatives’ regula- In this first TCS Capital Markets Forum entitled, OTC tion, and the questions that industry insiders are keen Reform: The New Reality, held in association with to have answered. financial-i in London on the 9 March, our objective was to cast some light upon that uncertainty. We invited a number of panellists representing the service provider Michael Mathias, director, Capital Markets part of the OTC derivatives industry, to talk about Consulting, Tata Consultancy Services68 Financial i · Q1 · 2011
Regulatory overview TCS Capital Markets ForumA work in progressThe days of waiting until all questions regardingforthcoming OTC regulation are answered, areover, says Bob McDowall, senior consultantanalyst, Aite Group. Even if institutions are notsure of the destination, they are expected tostart the journey.The OTC initiative started life as one of the G20’sresponses to the 2008 financial crisis. The propositionwas that: “All standardised OTC derivatives contracts should be banks in the OTC derivatives market a regulatory or traded on exchanges or electronic trading platforms financial advantage. where appropriate, and cleared through central count- erparties by the end of 2012 at the latest. OTC deriv- In order to allow regulators to have an overview of the ative contracts should be reported to trade repositories. derivatives market, the Commission is proposing that all Non-centrally cleared contracts should be subject to trades be reported to trade repositories, which can col- higher capital requirements.” lect and collate information on trades. It proposes that legislation will provide a common legal framework toThis statement gave birth, in a relatively short time politi- address authorisation, registration requirements, accesscally, to the proposed draft legislation by the EU and US and participation, disclosure, data quality, timelinessregulatory bodies. From the EU perspective, the European and legal certainty of registered contracts.Commission wants non-standard or bespoke derivativesto be priced to take into account the systemic risk they To ensure transparency and market integrity, theentail and believes collateral levels need to be higher to Commission wants all standardised OTC derivativesreflect the risk bilaterally cleared derivatives pose to the contracts to be traded on exchanges or electronic plat-financial system when they reach a certain critical mass. forms, which are defined by the Markets in FinancialAs a result, it proposes that financial firms entering into Instruments Directive (MiFID) as regulated markets,non-standard contracts must post initial margin in propor- in particular multilateral trading platforms and system-tion to the risk profile of the counterparty and variation atic internalisers. Such moves would make it easier tomargin in relation to the changes in value of the contracts more effectively regulate the OTC derivatives market,over time. This is intended to encourage participants to although there could be negative side effects onuse standardised contracts that are centrally cleared liquidity.wherever possible. Bilateral non-cleared OTC contractswill also be subject to higher capital charges. Two different regimes It was the express intention of the EuropeanThe gap between the relative capital charges for cleared Commission to make regulation consistent with the pro-and non-cleared derivatives provided within the capital visions for OTC derivatives in Dodd-Frank. They haverequirements directive will be widened. The Commission been marginally successful, but there are significant dif-believes that regulation should allow non-financial institu- ferences between the two regimes. For example, globaltions hedging specific exposure to be able to continue banks may find maintaining their compliance difficultto transfer risk without posting additional collateral. if the risk of standardised contracts in the EU and theHowever, there is currently no definition of a non-finan- US do not align. In addition, there is a risk of financialcial corporate counterparty, and it acknowledges that any institutions being able to take advantage of regulatorydefinition should not give institutions that compete with arbitrage if the systems are not kept broadly in line.‘‘ Global banks may find maintaining their compliance difficult if the risk of standardised contracts in the EU and the US do not align. In addition, there is a risk of financial institutions being able to take advantage of regulatory arbitrage. 2011 · Q1 · Financial i 69
TCS Capital Markets Forum Regulatory overview The Dodd-Frank Act imposed a clearing obligation on all parties who trade a clearable contract, save for a very narrow exemption for non-financial enti- ties, which enter transactions to hedge or mitigate commercial risk. The EU regulation appears to be more lenient than Dodd-Frank in that non-standard financial entities only become subject to a clear- ing obligation if their position exceeds a clearing threshold. Another interesting difference between the two regulatory regimes is what is subject to clearing? The EU regulation applies to derivatives contracts that are traded over the counter. The Dodd-Frank Act applies to any agreement, contract or transac- ‘‘ tion that is or in future becomes known to the trade as a swap, a broadly-defined term that encompasses Another question is trading virtually every OTC derivative currently traded in the markets. Spot foreign exchange transactions OTC – how much will move remain outside the scope of regulation, but while to electronic trading on the EU definition also excludes commercial for- eign exchange forward contracts, the US definition exchanges? The other is broader as it merely permits the US Treasury interesting issue is what Secretary to exempt foreign exchange swaps and forwards from the clearing obligations. Finally, the cannot and will not be Dodd-Frank Act mandates that all centrally cleared cleared? Who and how will trades go through an exchange or a swap execution facility (SEF) to increase the pre-trade price trans- that be defined? parency and efficiency of the derivatives market. Destination not yet finalised should achieve the objectives of greater security while Lets turn to the challenges, and obviously they vary reducing the operational risk and cost to clients. One by market participant. The first thing is regulatory of the other areas is the change in business model uncertainty and lack of granularity. Unfortunately, we – will the buy- and sell-side relationship change? cannot wait to commence the planning and implemen- Obviously there will be greater post-trade connectiv- tation until there is a degree of certainty. The days of ity. Will there be a smaller number of relationships? waiting until all questions are answered, I’m afraid, are Will there be a much greater examination of what they over, and institutions are expected to start the journey would see as the independence of the clearing service, even though complete details of the route are yet to and particularly independence and transparency of the be finalised. settlement pricing? Another question is trading OTC – how much will There are also some other interesting issues in terms move to electronic trading on exchanges? The other of national differences and concerns. The UK regulator interesting issue is what cannot and will not be has pointed out that the European authorities cannot cleared? Who and how will that be defined? Will new bear the fiscal responsibilities in the event of the fail- models evolve for this innovative business, and will ure of a CCP (central clearing counterpart), and that those models have the attributes of high margin, high full supervision should therefore reside with the CCP’s risk and high capital with a cap? In other words, will home state. There are also other issues to do with the there be a decline in interest in that business that need for operational and prudential standards for CCPs cannot and will not be cleared? so that we don’t get viral risk being transmitted cross- border because one of the CCPs defaults or cannot One of the investment management associations satisfy its obligations. has urged the European Commission to widen the approach to collateral management so that long-term There is the immediacy for action, the planning has to investors are not disadvantaged by having to convert begin now, there are project risks and costs, and more their portfolios into unproductive assets merely for technology is needed, particularly for the major collateral use. Retaining collateral within the custodian, institutions that conduct this business across all asset subject, of course, to ring-fencing charges or pledges, classes and different jurisdictions.70 Financial i · Q1 · 2011
OTC Reform: The New Reality – Trade execution TCS Capital Markets ForumThe wrong way roundAlex McDonald, CEO, Wholesale Market Brokers’Association, says the regulators have got it thewrong way round and that Basel III and capitalmechanisms should be in place first before tack-ling how OTC trades are executed, cleared andreported.In the latter months of 2008 the G20 came togetherand termed the word ‘exchange’ and said most OTCtrades had to go on exchange. Why years later are westill adhering to what was a viewpoint expressed in themiddle of a panic, which might not have had all the dueconsideration and understanding of the performance and range of hybrid-type products where you trade aroundthe workings of the global marketplace at the time? an MTF or the economic fundamentals are brokered on a screen. Then there is voice for more bespoke trades. ThisWhat we have had to do in terms of the OTC brokers begs the question, when is a deal done? Is it done when itwho put together nearly all the OTC trades in the world is arranged, confirmed, affirmed or when it is cleared, andand, if you like, their regulators and their policy makers, at what point could it be undone?is redefine the term ‘exchange’ to capture what is done inthe real world. And remember, if the OTC market is two Deals are done under two basic models, either nameorders of magnitude bigger than the exchange, it is like give-up where names are passed and the deal is purelyputting a rather large ocean into a pint pot, which makes arranged, or on a matched principle where the brokerit very difficult, and again overtly political. puts his name in between the two. Let’s look at how this might change. Liquidity venue applies to those trades thatThe Basel III process is always going to be key, and until are defined as standardised and clearable. Under MiFIDthat is globally operational, the rest of it is very difficult. there is the idea of an organised trading facility (OTF),If you started off with a new capital mechanism to make which the UK Financial Services Authority opposes sayingthings safe, then you could come back to how trades that it is too broad and that we just need the standardisedwork, how clearing might work, how you can scale it clearable bit, which should come in and sit alongsideor make it all proportionate, and how you can therefore an MTF.define market abuse and methodologies around that,rather than starting at the back and trying to go forward. However, MTFs are designated contracts. The idea is toThis explains why there is delay, deferral, argument and bring the negotiated world of OTC into that scope ofpoliticisation, and why Dodd-Frank, the European Market regulation, but many trades are negotiated around an MTFInfrastructure Regulation and the Market Abuse Directive price under the provisions of the firm. So, if you like, theycannot go anywhere. are hybrid between MTF and off-MTF as well as being hybrid between electronic and voice. It is very difficult toSo what do we do and how will it change? The inter- draw all of that into one regulation.dealer brokers are so broad they are brokering everythingfrom cash and derivatives, secondary hedge funds through There will have to be a level of post-trade transparencyto overnight cash deposits to local authorities and deriva- and a level to which I believe the inter-dealer brokers alltives and cash in between. Some inter-dealer trades are apply to now, which is automating their business so thatdone automatically, either using a multilateral trading facility from the point of trade it is an electronic flow straight(MTF) or a foreign exchange outside the scope of MiFID- down to the point of affirmation and confirmation, whichtype products, which are purely automatic, and where the allows the trade repository function to work into clearingprice and size of a deal is broadcast live. There is a whole or settlement.‘‘ There is a whole range of hybrid-type products where you trade around an MTF or the economic fundamentals are brokered on a screen. Then there is voice for more bespoke trades. This begs the question, when is a deal done? 2011 · Q1 · Financial i 71
TCS Capital Markets Forum OTC Reform: The New Reality – Post-trade processing Getting the message across Although post-trade processing providers like MarkitSERV have already delivered efficiencies to the OTC markets by electronically confirming trades, Jeff Gooch, CEO, MarkitSERV, says in the new world, the ways in which the industry operates and interacts will look radically different. Regulation of OTC derivatives is complicated; no one really knows what is going to happen. That presents a challenge to everybody across the industry. We are all going to spend a lot of money on technology, staffing, the trade means you have to update a trade in a way and for some of us, it will be a very radical change in that didn’t historically have to happen, with the excep- business models. tion of the inter-bank interest rate market. Furthermore, regulators now know what you did, so that information I am going to make two suppositions about the future. is going to have to be posted to a database somewhere. One, it is going to take longer to get there, certainly a There are several requirements in Dodd-Frank for lot longer than most of the politicians think. Two, it is public dissemination of trading information, and it is going to be a much different place from today. The idea pretty clear that MiFID II will have similar requirements that the OTC markets are not going to radically change is in Europe. These reporting requirements are a radical just incorrect. There will be radical change. Whether that change for the industry and they add to the increase is necessary or not we can debate, but the reality is the in operational intensity that we expect to occur. One guys on Main Street in the US, and pretty much every- of the priorities for us at MarkitSERV is developing the body in France and Germany, believe the OTC markets solutions required to enable efficient reporting and get- are at fault and they want to see change. ting messages where they need to go. The new world is probably going to be safer, certainly The second factor in the new world is that everything more transparent but it is also going to be a lot more has to happen a lot faster. If Dodd-Frank is implemented operationally intense than anything we do currently. unchanged, you are pumping trade data out as soon as Today’s bilateral world for derivatives is very straightfor- technologically possible, and in no case later than 15 ward, believe it or not. Quant traders sit there with com- minutes. From an IT perspective, we have technology plicated models, but for the back-office guys it is very and the networks that do that quite easily, but a lot of simple. Two people speak on the phone, they kick some the business models that underlie that information will brokerage to an inter-dealer broker and you have a trade, have to change radically, particularly for fund managers. and, traditionally, you get a nice piece of paper that rep- Many traditional fund managers are suddenly waking resents that trade. Over the last several years, MarkitSERV up to the operational implications of the need to post has helped the industry automate some of that process allocations electronically and the need to deal with col- and electronically confirm transactions. lateral messaging at the fund level from lots of CCPs on daily rather than weekly cycles. Today, you agree the document, electronically sign it, match it, affirm it. In the new world, those processes start Everything we do has to get automated and faster, and to look radically different. To start, a lot more people will when we’ve finished, we will work out whether we want to know about trading activity and trade details. have a market left to service. I believe we’ll still have a Approximately 70% of OTC trades will be centrally dynamic market. It’s just going to be different and it’s cleared. Those trades are going to have to go to a clear- going to require new levels of electronic messaging to inghouse and be accepted or rejected. The act of clearing make it all work. ‘‘ Many traditional fund managers are waking up to the operational implications of the need to post allocations electronically and the need to deal with collateral messaging at the fund level from lots of CCPs on daily rather than weekly cycles.72 Financial i · Q1 · 2011
OTC Reform: The New Reality – Trade reporting TCS Capital Markets ForumImproving market practiceMany firms may be opposed to more regulationof the OTC markets, however, Jesus Benito,CEO, Iberclear, says the best approach is toaccept there is going to be change and thenlook for ways to improve the way the businessis conducted.There are going to be big changes in future in thederivatives markets. Regulation is the main focusof the current discussions in Europe and Americaand also in other countries, and the current situa-tion, whether we like it or not, is that the US regu- to improve current market practices. This is the mostlation is more advanced than European regulation. intelligent way of doing things.However, it is of the utmost importance to haveboth these regulations in line, and that other mar- Our vision is that this market is global, and if youkets around the globe look at what the American mean global it’s not only global in geographicaland European regulations are going to be if we terms, it’s global in the way that it is not only Europeare to avoid regulatory arbitrage as much as pos- and the USA, it is also the financial institutions thatsible. Some of the technical consequences of the are dealing with this market and the corporatesCommodity Futures Trading Commission (CFTC) who are also part of this market. And we have toregulations will mark the path to be followed by take into account a lot of the necessities that theEuropean and other global regulators. corporates need from this market, and therefore we believe we have to give a solution for not only theThe consequences of more regulation imply more 14 biggest dealers in this market, which are obvi-cumbersome tasks, and therefore this means more ously very important, but they are not the only par-cost. If you ask anyone whether they want to be ticipants. Also, even if the regulators want to pushmore regulated, they would probably say, ‘No ahead for more standardisation, more contracts to bethank you. I’m okay, I do not need more regu- tradable, more contracts to be passed through clear-lation’. The point is that if the regulation is not ing, there are very good economic reasons to haveproperly designed there could be undesired effects bespoke contracts, especially between the banks andor collateral damage, which could be very dramatic corporates.for the markets. You can have different attitudestowards the regulation. Of course, you can be We believe in competition, definitely. We believe intotally opposed to regulation and try to avoid it, competition also in the trade repository field, andbut I don’t believe at this point in time that is the we believe in a one-stop shop for participants rathercorrect way to do things. The second approach is than participants having to connect with five dif-to accept that there is going to be some form of ferent trade repositories. We also think that we canregulation and to try in the best possible way to offer to the market, whether they are financial insti-have the best possible regulation concerning trans- tutions or non-financial institutions, good services inparency. The third option is that you can accept order to improve the current ways the administrativeregulation and try to take advantage of it in order tasks are conducted in this business.‘‘ You can be totally opposed to regulation and try and avoid it, but I don’t believe at this point in time that is the correct way to do things. The second approach is to accept that there is going to be some form of regulation and to try to have the best possible regulation concerning transparency. 2011 · Q1 · Financial i 73
TCS Capital Markets Forum OTC Reform: The New Reality – Central clearing Clearing matters up When you introduce the buy side into the equation, clearing starts to get complicated, says Joe Reilly, executive director, SwapClear, particularly in terms of how margining, segregation and omnibus arrangements may work. There is a lot of uncertainty as to where the future lies, but we can tell you for certain that there is currently USD 266 trillion-worth of interest rate business already being cleared in today’s marketplace. It is also fair to say that the things we worry about most, and what the buy side are certainly worried about most, are cost, segregation, direct clearing members of the clearinghouses, and the portability, what levels of protection are they getting, and clearinghouse itself. So what type of legal arrangement what are the risks they are being exposed to? is in place? Typically in Europe, the arrangements are normally on a credit intermediation basis, which means If we address the cost issue first of all, in terms of the that the client has a principal relationship with its clear- USD 266 trillion number, cost was a no-brainer because ing member and not the clearinghouse. There are also if you look at the zero capital charge weightings to be agency models, which are more akin to the futures mar- able to support your portfolio versus the cost of clearing, ket where clients have relationships with the clearing the benefits were mind-bogglingly superior to the actual member but acting through an undisclosed principal. cost associated. When we introduce the buy side into the That is a complex legal arrangement and it is clear in equation things change, because they don’t necessarily these early days of buy-side clearing, that it is not fully get the full capital and balance sheet benefits. understood by a wide section of commentators. What type of costs do the buy side need to worry about? There are different types of segregation being offered They need to worry about initial margin, which is the by clearinghouses, but it is very important that the buy core protection that the clearinghouse gains in the event side understand all the implications of segregation. It is of a default, coupled with the variation margin, which in clear that the segregation that is in place for the futures summary is the P&L, which the buy side would normally market in the US is very different to the segregation experience on movement of their mark-to-market expo- rules that are in place in Europe. In particular, there is sures under their credit support annex agreements. It’s a very strong debate going on around what clients are the transactional cost and the cost of collateral. Those are exposed to in omnibus arrangements. So you have the the sorts of things, which are very concerning to the buy concept of clients having co-mingled positions with side, and we have to be open and honest and say that other clients, and that is a situation which clients trad- costs are going up from that perspective. ing OTC instruments are not used to, but in the futures market that is a very common arrangement. One of the key benefits of clearing for the buy side is protection against default, and you have to be concerned One of the key areas that needs consideration is about what levels of protection are we offering to clients, when we talk about ‘portability’, what happens in the and that’s a complex question. You have to determine event of a default of a clearing member? One of the whom are you trying to protect yourself from? In terms of pitfalls of today’s clearing models is that there is no protection there are two key models out there, which are guarantee of portability, although we think that por- different depending on the jurisdiction and the clearing- tability will start to become guaranteed and emerge house. One is called the principal-to-principal model, and as and when we move closer to full clearing that is really talking about the relationship between the initiatives. ‘‘ What type of costs do the buy side need to worry about? They need to worry about initial margin, which is the core protection that the clearinghouse gains in the event of a default, coupled with the variation margin.74 Financial i · Q1 · 2011
OTC Reform: The New Reality – The buy side TCS Capital Markets ForumCollateral damageGreater regulation of the OTC markets poses alot of unanswered questions for the buy sidewho face increased margin and collateral costs,says Philip Popple, Derivatives Operations, BNYMellon Asset Servicing.It is difficult to justify why central clearing is being forcedupon the buy side, because it is resolving a problem thatis a sell-side issue rather than a buy-side issue. Havingsaid that, the buy side are engaged and are looking tomove forward, and there are a number of issues thatcome to light. bonds. If, for example, an equity long fund may have some OTC derivatives but they don’t have spare cashIn the operating models that are going to emerge in the or bonds sitting around as eligible collateral; they havefuture, it appears that we are going to have three differ- equities, and that is probably not going to be eligibleent models. We are going to have an exchange-traded for use in a CCP model.derivatives-shaped model, a traditional OTC deriva-tives model, and a hybrid model, which is centrally- I don’t think the buy side yet understands what willcleared OTC trades, because upfront they are going to happen in a default scenario because if they are able tobe traded bilaterally, but once they have gone through put up any bonds as collateral, they will expect thosethe trade and the confirmation cycle, they will fall into instruments to be theirs. Yet, I understand that in sucha centrally-cleared and margined solution that is more a scenario, it is difficult to move the collateral withakin to exchange-traded derivatives. So the buy side are trades. They may be different shapes and very often itnow seeing a different level of complexity and systemic means that portfolios that are lodged as collateral needrequirements that weren’t there before. to be liquidated.I anticipate increased lobbying from those entities and What we will end up with is the existing book of OTCorganisations that may wish to claim exemptions, but trades remaining as they are and being collateralisedfrom my perspective I can’t see how that will ever work. bilaterally, and then future trades going through a CCPWhilst there may be possibilities for exemption, trades being margined. There is going to be a reduction inwith the sell side will be subject to a capital charge if the opportunities to net off the collateral at a singlethey don’t centrally clear. So from a commercial perspec- counterparty, so the cost of collateral is also going totive, I don’t see how the sell side will trade outside clear- increase because we are going to have two models.ing because they will incur the capital charge on their My final point is that from the buy side, often we areside. There will need to be some changes and clarity as looking at liability-driven investment and trying tothe Basel III regulations come through. match liabilities with the assets. In order to do that they have to both be valued on the same basis, otherwiseWe foresee an increase in margin costs. One of the there will be a mismatch. So in future we may see oneproblems is eligible margin. In the bilateral model there pricing model for investment purposes, and for the col-has been evolution over the last few years and the collat- lateralisation or margining it is going to be a differenteral in a bilateral OTC model is generally bonds or cash; model. There is a conflict there that will need to bethe majority is cash. On the buy side there isn’t a great resolved on the buy side, and they may have to try anddeal of cash floating around; they would rather put up find other ways of valuing or reporting.‘‘ I don’t think the buy side yet understands what will happen in a default scenario because if they are able to put up any bonds as collateral, they will expect those instruments to be theirs. Yet, it is difficult to move the collateral with trades. 2011 · Q1 · Financial i 75
TCS Capital Markets Forum OTC Reform: The New Reality – Technology Making sense of it all For both the buy and the sell side, regulation means a number of process and IT system changes particularly with respect to new execu- tion, clearing and reporting requirements, says Michael Mathias, director, Capital Markets Consulting, Tata Consultancy Services. Changes to the derivatives’ architecture in response to regu- lation are manifold. Starting with connectivity, the panel was unanimous that there is much uncertainty and ambiguity. One thing, however, is clear, and that is that the sell side will require connectivity to the multiple OTC clearinghouses systems that may not set out their contracts and trading that are likely to emerge. Additionally, Dodd-Frank in the portfolio in the prescribed format for standardised con- US also discourages the use of single dealer portals, which tracts. How this can be resolved depends on each firms’ could result in a proliferation of exchanges. We envisage an architecture. In the case of vendor systems, these may environment with multiple swap execution facilities (SEFs) need to be upgraded so that standardised contracts can and multiple clearinghouses, possibly divided along asset be reflected, traded and passed straight through to the class lines. Connectivity becomes a real challenge in this clearinghouse. If they are in-house systems, then poten- landscape. tially there is quite a lot of rework required. Margin: Assets eligible for initial margin are cash and gov- Complex trades: Often banks use workarounds to reflect ernment bonds, while cash is only eligible for variation mar- complex trades in their systems. For example, a callable gin. The buy side prefers not to pay cash as margin since swap might be booked as a set of cash flows and a this impacts investment returns. There is an opportunity for ‘swaption’, with individual cash flow legs loosely linked the sell side to provide collateral substitution services but thistogether. This approach may, for internal systems pur- adds a further layer of complexity in terms of technology poses, correctly reflect the risk and cash flows, but the and systems. workaround will not be effective for confirmation pur- poses. Additionally, it is unlikely that the clearinghouse Risk management: Much of the risk management performed will reflect a trade constructed in this way. Therefore, by brokers will now be performed by CCPs. However, clear- remediation is required with respect to the way trades ing brokers will need to take on new clients and will have are held in terms of the workaround. to process additional volume. From a technology perspec- tive, brokers will need to upgrade their client credit risk sys- Buy side: From the buy-side’s perspective, key areas tems (risk, margin management and collateral management) for change concern the new execution, clearing and to keep pace with the CCPs. Additionally, there is a need to reporting requirements. Some trades will go straight look at the risk before a client is on-boarded, and to man- through in terms of being standardised and executed age risk through the transaction life cycle. Furthermore, sell- on-exchange. Others will go directly to clearing but side derivative clearing members will probably have other won’t be executed on-exchange, and yet others will businesses; for example, they could be prime brokers with a need to be traded bilaterally. This means that there are high level of bilateral derivatives trading. It will be necessary three or more different types of trades that are being to factor the new client/clearing risk into the enterprise-wide cleared through multiple clearinghouses, with the rout- risk profile of the clearing broker. This adds even more ing based on complex criteria. It is necessary to auto- complexity to the technology requirements. mate the clearing of derivative contracts with systems that are able to make sense of all that. Finally, reporting Systems re-mediation: The Dodd-Frank Act refers to stan- is a complex area, however, it mainly impacts the sell dardised contracts that should be traded on exchanges side because the buy side can delegate its reporting to and cleared through CCPs. Companies will have legacy the sell side.76 ‘‘ We envisage an environment with multiple swap execution facilities and multiple clearinghouses, possibly divided along asset class lines. Connectivity becomes a real challenge in this landscape. Financial i · Q1 · 2011
OTC Reform: The New Reality – Q&A TCS Capital Markets ForumMore questions than answersPanellists fielded a range of questions on the politicisation of OTC derivatives reform, buy-sidechallenges and how central clearing and trade repositories will work in the new reality?Given the ‘tsunami’ of regulation that the OTC industry faces, good, as long as it doesn’t become a race to the bottomaudience members were unsure as to who the regulations on margin.”were really designed to protect? Alex McDonald, CEO ofthe Wholesale Market Brokers’ Association says the raft of Jeff Gooch, CEO of MarkitSERV, says the choice of clear-new regulations: Dodd-Frank, MiFID II and the European ing depends a lot on the buy-side firm you’re talking to. HeMarket Infrastructure Regulation; would add more silos, says hedge funds led the push for access to clearing. Mostcosts and compliance for the end user (asset managers, of them got to choose their own clearing brokers, their ownliability managers, corporates). “It is likely to make all prime brokers and, presumably, their own CCPs. Goochfinancial instruments more expensive,” he says. “By redi- says hedge funds will concentrate their positions over a fewrecting the working capital of the financial system into institutions. Yet, traditional money managers come from aclearinghouses as margin in the form of high quality liquid world where the underlying plan sponsors often choose theassets, the regulations will impede bank lending and yet custodian for cash settlement, and in many cases, expect tothey remain a political selling point to the electorate.” choose the clearing broker and may even be the underlying CCP their trades go through. “A lot of these guys are start-On the clearing side, the buy side face a number of chal- ing to worry,” says Gooch, “particularly those with a widelenges around margining, collateral and segregation. Joe variety of underlying clients. They may have to more or less ‘‘Reilly, executive director, SwapClear, says there are fun- connect almost everybody because they pitch for business.damentally two different types of segregation: one whereyour assets are completely segregated from the assets of theclearing broker’s house account, and also segregated from You havethe other clients within that clearing broker’s arrangements,which provides the maximum amount of protection for the pros and consclient and the greatest probability for the clearinghouse. for everything,However, he says this may prove to be a more expensivesolution for clients as it limits the ability of the clearing bro- but we believekers to take advantage of offsetting positions for differing in competitionclients, commonly known as omnibus arrangements, whichis the second option. for the trade repositoriesIn terms of whether clients are likely to get the same col-lateral back, or the collateral that was pledged or offered field also.to the clearing broker in the event of a liquidation, Reilly Jesus Benito, CEO,says that’s not necessarily a problem if a backup clear- Iberclearing member can be found to take on those positions.However, he says there are all sorts of issues around valu- They can’t say, ‘I’m not going to take that business because theations of collateral and haircuts. “The traditional arrange- clearing broker is such and such or the underlying CCPment which has been offered to European clearinghouses preference is LCH’”.for the exchange-traded businesses is what’s called anomnibus arrangement,” Reilly explains. “The typical omni- On the trade repository side, participants are also faced withbus arrangement is a net omnibus arrangement where choice. Jesus Benito, CEO of Iberclear, which set upoffsetting positions are calculated so that the amount of REGIS-TR a trade repository in Europe, says there is dis-collateral or margin posted to the clearinghouse is differ- cussion about whether there should be one single tradeent to what will be collected from the clients.” repository per asset class or competition. “You have pros and cons for everything, but we believe in competition forOne audience member asked how much choice there would the trade repositories field also,” he says. But how do yoube in terms of where, for example, a Canadian entity trad- ensure a high level of co-operation between global regula-ing dollar swaps out of London, could direct those trades tors and market participants? “It is going to be complicated,”for clearing? “My view is there will be choice,” says Reilly. says Benito. “At the level of the regulators, there is a specific“There are many debates as to whether one CCP is the right follow-on from the central banks and the regulators in theanswer or whether there should be many CCPs, and of G20 countries to co-operate and to co-ordinate the legislation.course there are commercial dynamics which push the argu- The US is marking the path and Europe is following. We reallyment towards a single CCP, but the reality is competition is hope that both regulations are in line.” 2011 · Q1 · Financial i 77
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