Large buyside institutions and trading desks that utilize over-the-counter derivatives, most notably interest rate swaps, are waking up to an uncomfortable new reality in the post-Dodd Frank world-the coming cost of mandatory clearing of OTC derivative products.
As a result, conversations over clearing costs are migrating to the forefront of the ongoing debate over OTC derivative clearing, even changing how the buyside looks at these instruments. More importantly, the buyside also is searching for ways to alleviate these costs, and may have hit upon one: pressure the smaller banks and brokerages they do business with to offer clearing services, thereby increasing competition in the marketplace and lowering costs overall.
Buysiders have been reaching out to smaller firms, urging them to get involved in clearing, said Steve Grob, director of group strategy for Fidessa, a U.K.-based software and trading systems service provider. Because now that the buyside is being forced to clear, they want more choices.
By all appearances, the buyside is working diligently to shape the newly emerging trading regime in OTC derivatives into a model that works for them. In addition to pressuring smaller banks and brokerages into entering into the clearing fray, the buyside is urging the disparate groups of swaps clearinghouses and large financial institutions that facilitate most of the trading-the so-called Futures Commission Merchants (FCMs)-to provide more commoditized service and uniform post-trade data so that traders can more easily move their swap transactions among a group of financial agents or clearing servicers. Also, the buyside wants clearinghouses and other clearing servicers to allow for more off-setting of common derivative contracts-essentially zeroing-out some risk and decreasing margin requirements. Because of all these efforts, several market analysts and observers said, the buyside is paying far more attention to post-trade execution and costs in the OTC derivative market than ever before.
Grob said hes observed when dealing with buyside clients that its clear they are looking closely at clearing and its associated costs, sometimes even more than they are looking at this or that particular swap or other product. From a tech perspective, its really interesting, he explained. Were adding the clearing conversation to the transaction, and the buysider is having to develop a sort of multi-directional mindset with derivative trades.
Its little surprise, because if left unmonitored, these clearing costs can quickly become a real pull on an institutional fund managers bottom line, according to some estimates. Sapient Global Markets analyzed the cost of hedging with OTC derivative swaps in the post-Dodd-Frank environment in a June 2013 study and found that costs could drag down a portfolios alpha between 20 and 62 basis points for cleared trades and up to 91 basis points for the traditional, uncleared bilateral trades. Once all the proposed post-Dodd-Frank regulations are in place, hedging using centrally cleared instruments… will be cheaper than uncleared OTC instruments, the study stated. Therefore, we expect market participants to choose this option and move to central clearing, regardless of trading costs.
No doubt, this new reality has seeped into the buysiders usual tunnel vision that most often had been focused on product price and annual return. Theyre not just automatically trading the best price on the screen any more, but are now looking for the most beneficial trade margin-wise, Grob said, adding that Fidessa, which counts the largest buy- and sellside firms among its clients, is seeing first-hand the changes the new derivative regulation is bringing, especially to the buyside mindset. It is very interesting to see the conversation the buyside is having on clearing efficiency, he added. Simply because they didnt have to think about this before.
And he is not alone in noticing this change. According to a recent white paper published by Sapient Global Markets, financial institutions-especially smaller banks and brokerages-are facing increasing pressure from buyside clients to offer clearing services. This leaves these banks and brokerages in a tight squeeze with limited choices-either begin offering a risky, cost-heavy and low-margin service like clearing to clients, or face losing those clients to bigger banks that already offer those services.
Ironically, the paper pointed out that the bigger banks may not want the business either-several of the largest banks are winding down their clearing operations on OTC derivatives and other products because of the increased cost and up-front capital required by new banking industry regulations.
Phil Matricardi, a manager at Sapient Global Markets and co-author of the paper, said the changes in OTC derivative clearing since the financial crisis have really up-ended the landscape for firms that offer clearing services. Big banks already been offering clearing, but now they are under pressure to really cut costs, and offering clearing services can be very costly, Matricardi said. On the other hand, smaller banks would have to start up clearing operations from scratch, and that investment in personnel and technology might be too much for them to take on.
In the past-at least before the financial crisis-clearing of OTC derivatives was a completely different world. Much of it was done by the largest banks as secretive, bi-lateral transactions between two parties, a method that was very profitable for the Wall Street banks that facilitated much of the trading in that asset class. Then-after the financial crisis and the ensuing regulations-everything changed. Gone was allowing bi-lateral deals and voluntary clearing; now, clearing was mandatory, and was to be done through a third-party system of central counterparties (CCPs) throughout the world. Almost immediately, regulatory bodies from the U.S. and Europe began squabbling over which regions clearing standards and regulatory model would become the global template. (Note: link to article in last quarters Clearing Quarterly.)
While there is evidence the ice may be thawing among global swaps regulators on both sides of the Atlantic, it is uncertain if the buyside desks that trade these products are as comfortable as they want to be and are seeking more reassurance from their financial agents. And often, that reassurance comes in a form that could cost those agents plenty in terms of capital outlay. The buyside sees a limited number of clearing facilities, and because of that, they see the execution costs as too high, said Virginie O’Shea, senior analyst at Aite Group. So the buyside wants to see more of their banks and brokerages offering clearing services so there is more competition and that will drive down costs.
But in a way, OShea explained, the buyside may be trying to wring water from a stone-or at least, trying to wring full service from already cash-strapped smaller regional banks and brokerages. The costs to enter into clearing services is very high, and was made more so by the post-crisis regulations, she said. In addition, the clearing party would have to hold a lot of capital as a buffer against default.
The buyside is also letting their financial agents know that in addition to offering clearing, they want them to offer a certain type of commoditized service and post-trade data trail. In the pre-crisis days, banks trading and clearing of swaps was a highly bespoke and secretive system, said Sapients Matricardi. Each financial institution developed different standards and methods for doing business. Now, however, these customers want uniformity in their trades and a template for post-trade reporting that will be the same wherever they go.
Join Or Else
Worse yet for the under-pressure banks or brokerages, those that decide not to get into the clearing game could be shut out of the OTC derivative market altogether, especially if part of their corporate financing strategy has been to bundle an interest rate swap into a client companys planned offering of floating-rate debt, as explained in the Sapient white paper. [B]anks that have traditionally done a good business in corporate finance are very concerned that a key component of their structured finance offering is missing now that they have lost access to the swaps market, the paper stated.
Those financial institutions may be left with little choice but to go to FCMs-the massive global banks like JP Morgan, Barclays and Citigroup that are the intermediary members of swaps clearinghouses-to get the interest rate swap component of their customers deal done. The smaller banks end result of passing through its best customers like that, of course, is that the larger, deeper-pocketed FCM could simply poach those customers, since the FCM, unlike the smaller bank, offers swaps clearing services.
Its a predicament that leaves the smaller banks and brokerages tying themselves into knots to please their buyside clients. Some of these banks will bend over backwards for clients, and begin offering too much proprietary service just to keep them happy, said Adam Kott, a Sapient senior associate and co-author of the white paper. Eventually that level of service gets too costly for the smaller bank to sustain. And that ultimately could leave the buyside with fewer options if too many of these smaller players simply decide to throw in the towel on clearing and derivatives altogether.
Strength In Numbers
One possibility for the smaller banks and brokerages to stay in the clearing game would be to band together to form a sort of industry utility that would share the costs of technology, personnel and capital required to run a clearing operation, Kott said. In fact, Sapient executives are in talks with a number of smaller and regional banks and other financial institutions to establish such a utility, he added, declining to name the specific banks or set a timeframe for when this could become a reality.
For the buyside, however, whether its dealing with large FCMs, clearinghouses or smaller banks banded together into a clearing utility, it still comes down to cost and whether that cost is getting too high to maintain.
In the past, one large, risk-adverse buysider could simply trade derivative products with another large, risk-adverse buysider, managing their risk at little cost, Fidessas Grob explained. Now, they have to have everything centrally cleared, the costs go up, and you have to ask whether there are going to be unintended consequences of increasing the costs of managing risk, he said.
Its like having fire insurance on your house, Grob said. You have it to manage the risk of a fire, but if the monthly premiums keep going up and up and up, after a while, you might just take your chances with the risk of the fire.
