New rules like the Dodd-Frank Act in the U.S. and EMIR and Basel III in Europe are presenting buyside professionals with a unique challenge: How do they clear their executed trades in a post-regulatory financial landscape and mitigate their own risk? Like all new regulations, questions abound. Traders spoke with the head of American business of LCH.Clearnet for his take on what the buyside needs to do now.
Change is here. With the rollout of the Dodd-Frank Act’s mandatory clearing requirements for parts of the derivatives market-which force traders to post collateral known as margin-broker-dealers, futures commission merchants (FCMs) and clearinghouses have had to adapt to profound changes to the way they do business in a very short period of time.
Mandatory clearing of interest rate swaps and index-based credit default swaps, both regulated by the Commodity Futures Trading Commission (CFTC), was gradually rolled out last year. The Securities and Exchange Commission, which regulates single-name credit default swaps, has not yet set a timetable for mandatory clearing for those instruments.
As Traders’ Clearing Quarterly was going to press, the next big regulatory hurdle was due to begin rolling out on February 18. Under CFTC rules adopted last year, any swap that is required to be cleared must be executed on a designated contract market (DCM) or swap execution facility (SEF), unless no DCM or SEF makes the swap “available to trade.”
The agency defines an SEF as a “trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system and is not a designated contract market.”
Meanwhile, industry observers including Virginie O’Shea, senior analyst at Aite Group, expect to see a shakeout among central counterparties (CCPs) vying for the new clearing business. “You’ll get some regional players in specific markets, but I believe there will still be a relatively limited number of CCPs because it’s a volume game. It’s quite hard to make money out of it if you don’t get that volume,” she said.
One firm that does have that kind of volume is LCH.Clearnet’s SwapClear, an interest rate swap (IRS) clearing service with a 76 percent market share of IRS buy-side activity. LCH also offers CDSClear, a credit default swap clearing service, for the much smaller CDS market. Clearing Quarterly contributor Mary Schroeder recently spoke with David Weisbrod, the CEO of LCH Clearnet’s U.S. business, to discuss the impact of the regulatory changes on the dealer and FCM market.
Traders: What has been the impact of the regulations to date?
David Weisbrod, LCH.Clearnet: The impact has been tremendous. The market has transformed from being a largely over-the-counter bilateral type of market to one that’s now going to trading venues and clearinghouses. It is really significant. From the dealer side, they have had to introduce new operational processes and technology changes to comply with the new rules. The next milestone will be Feb. 18, when the “made available for trade” rule that requires swap trade execution via SEFs takes effect. We are deeply engaged to ensure this runs smoothly from the clearinghouse side.
Traders: What operational processes have been affected and will be affected when the SEF execution rule goes into effect?
Weisbrod: Currently, when a dealer executes a trade, it gets sent directly to the clearinghouse. Starting Feb. 18, the trade will need to be executed through a SEF. This changes the operational flow; trade instructions will have to be first routed through the SEF before it can be registered at the clearinghouse. That’s a major change.
By way of illustration, LCH.Clearnet is currently connected to 13 SEF platforms. On Feb. 18, as mandated trading goes live with some of these venues, we will be watching very carefully to make sure the flows work and monitoring for any operational issues that might arise. We are talking about a profound change in how the whole process works.
Traders: What about the challenges facing FCMs, the intermediaries between buyside clients and the clearinghouse?
Weisbrod: For FCMs, there is a lot of change going on right now and everybody has to get used to the new regime. In addition, banks are adjusting to the new Basel III capital rules. In January, for example, there was a clarification of how Basel III leverage ratios must be calculated. In the original guidance, the calculation would have resulted in increased capital pressures on the banks that could have challenged the whole FCM business model.
Traders: What was the original plan?
Weisbrod: The original plan was that margin provided by clients through the FCM was deemed to be on the balance sheet of the bank, and therefore, was included in their leverage ratio. That would have meant banks would need to hold additional capital to offset the margin they were holding. Changes were made to the Basel rules that mitigate how much of the margin is attributed to the bank’s balance sheet, so there was some recognition that the original ruling did not provide the best outcome. The big issue for FCMs is how to run a viable business with all the uncertainties that still exist and the potential costs that could arise.
Traders: What are some other changes that banks must deal with?
Weisbrod: Collateral segregation is a big issue. FCMs must ensure that their clients’ collateral is segregated-not commingled-from its own collateral and the collateral of their other customers. This requirement was introduced by the CFTC and is known as “Legally Segregated Operationally Commingled” or LSOC. It’s a new mechanism to ensure each client has its own collateral separate from that of the FCM or the FCM’s customers. In the event an FCM were to go out of business, its clients have a lower chance of their portfolios being frozen as part of the FCM’s estate and a higher chance of porting to a new FCM. It’s a significant improvement over the way things have been done before, but it’s still a major adjustment across the board.
Traders: What about the impact of changes in European regulation?
Weisbrod: There is a different set of requirements coming out of Europe under EMIR (European Market Infrastructure Regulations), and those regulations are not fully harmonized with what has emanated out of Dodd-Frank. This is causing cross-border regulatory uncertainty that is weighing on both dealers and clients.
Traders: Would you agree that while traditionally firms looked just at the cost of trading swaps, because of the new regulations and the costs associated with them, now they need to focus on everything from trade execution to settlement costs?
Weisbrod: Yes, I think that’s right. But we should keep in mind the huge benefits associated with clearing. The notion of having a central counterparty margining in a standardized way, with a default fund in place to act as an additional buffer and with certain outcomes in the event of a default, is tremendously beneficial. Also, the trade netting opportunities that arise from having multiple counterparties on a single platform offers significant operational and capital efficiencies. This is the reason SwapClear existed 10 years before the financial crisis. It was not put in place because of a regulatory requirement, but because the dealers wanted it there. They obtained netting and safety benefits by virtue of a knowable counterparty that they knew would be margining the assets correctly.
Traders: What was SwapClear’s experience during the financial crisis?
Weisbrod: During the crisis, our risk management actions helped protect the integrity of the cleared markets because we had, and continue to have, policies in place that protect our users in the event of a default. For example, if there is a default, there is no knock-on impact to any of the non-defaulting members and clients. Their positions are unaffected. This is one of the many benefits of clearing. So, while the change since the financial crisis has been great and there are costs associated, my view is that the market has adjusted remarkably well. There are still a lot of uncertainties, a lot more change that’s going to occur, a lot more innovation on segregation and margining is going to come, but my view is that we are creating a safer and sounder trading environment. And that has to be beneficial for everyone.
NOMURA TAPS FIDESSA FOR EXCHANGE CONNECTIONS
As firms deal with the pressures for FCMs under the new clearing requirements, including the need to connect to central counterparties, manage collateral across the firm and meet the needs of their clients, at least one buyside firm has decided to offload part of its technology.
Nomura has tapped Fidessa to handle connectivity to global futures exchanges and order management, which the firm previously handled in-house, said a representative for investment firm Nomura who requested anonymity.
“There is a lot of regulatory pressure coming down the line to FCMs and end clients,” the rep told Traders. “To keep this business efficient in the sense of execution and clearing, we want to lean on infrastructure providers such as Fidessa so we can focus on the client-facing pieces and innovations.”
Under the deal, Fidessa provides connectivity to about a dozen exchanges globally, including ICE, the CME and Liffe. Nomura tapped the vendor because of its exchange reach. “They provided us with a global reach which meant our stringent requirements,” said the Nomura rep.
Nomura uses the Fidessa order management system and exchange gateways, which was rolled out last year, to support its own proprietary trading as well as its clients.
“We connect our clients to the markets via the Fidessa piece,” said the Nomura rep. “Firms like Nomura want to spend their time focusing on clients’ needs rather than looking after the plumbing.”
Nomura provides its clients with clearing for both over-the-counter and listed derivatives, enabling it to handle all of its clients’ clearing requirements in one place, according to the company. On the OTC side, the firm uses an in-house- developed platform to access the major central counterparties.
As Dodd-Frank moves the world of OTC derivatives onto at least a centrally cleared and, if possible, electronically traded business model, it’s converging the worlds of OTC and exchange traded derivatives. Before this, they existed in parallel but separate universes. The largest challenge the change presents involves clearing, Steve Grob, director of group strategy at Fidessa, told Traders.
“Different flavors of swap contracts are cleared through different clearing houses. First problem is: How do you get them offset,” said Grob. “One may be cleared on Eurex, one LCH, so they are technically non-fungible. Any concept of interoperability between clearing houses looks to be a long way off.”
Virginie O’Shea, senior analyst at Aite Group, agreed, but added that this issue is a reason for a firm to consolidate its clearing. “If you concentrate all your flow including credit default swaps and interest rate swaps into one clearer, then you have netting opportunities,” she said. “If you spread out across different CCPs, your risk goes up and your costs go up. There is an incentive for firms to go with one clearer.”
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