Putting clearinghouses together with buyside firms may not strike many as a “you got your chocolate in my peanut butter” moment, but the relationship between the two is certainly changing.
Ever since the inception of clearinghouses, membership in central counterparty (CCP) clearing organizations has always been a sellside affair, with buyside membership frowned upon by the largest dealers.
The owner and operators of the CCP firms once thought that it would level the clearing playing field too much by providing buyside members easier access to other clearing firms, explained Murray Pozmanter, managing director and general manager at the Depository Trust & Clearing Corp.
Once Citadel Securities joined LCH.Clearnet’s SwapClear interest-rate swap clearing service as the first non-bank member in October 2015, the industry conversation began percolating once again.
“It’s something we and the industry are looking at, but we have not had many clients asking to become direct members,” said John Horkan, COO of SwapClear. “However, there is potential demand emerging in Europe.”
(It is important to note that while Citadel Securities is not a bank, neither is it a buyside firm. It is, in fact, the broker-dealer arm of Citadel and separate from Citadel Asset Management.)
Much of the buyside’s historical disinterest in joining clearinghouses can be traced to the membership fees that they would have to pay for a risk-mediation service. The theory goes that they would not fully appreciate these fees since they trade with a very select group of counterparties, Pozmanter said.
Even if buyside firms clear these hurdles, those companies regulated by the Investment Company Act of 1940 cannot participate in potential loss mutualization. This means that these entities can contribute to a clearinghouse’s general default fund that covers third-party defaults. According to Pozmanter, “They’re allowed to take losses associated with the trade they do, but they just can’t take a loss associated with the failure of [a party] with which they didn’t trade.”
Many CCPs discount the idea of creating a junior membership that would not require a member to contribute to the CCP’s general default fund. “Our membership rules require all members to meet certain criteria, including contributing to the default fund, which exposes members to mutualization risk,” LCH’s Horkan explained. “Every member is subject to the same criteria, no exceptions. Some market participants are prohibited from participating in loss mutualization, making CCP membership challenging under current rules.”
Basel III and the CCPs
As the largest dealers continue to face Basel III’s capital requirement and de-leverage their balance sheets, it has had a significant knock-on effect on the buyside-CCP conversation.
Dealers that did not want their buyside clients to join CCPs due to a possible growth in clearing-service competition are now more worried about using what capital they have as efficiently as possible. “If the buyside does not clear tri-party trades, their dealer counterparties will not be able to net those trades on their balance sheets, which will constrain the number of trades the dealers can do,” Pozmanter explained.
If the 40 Act-regulated firms cannot trade as much as they wish with their select group of dealers, they either have to expand the number of dealers with which they trade, even if they have a worse credit profile, or they can invest funds in the Federal Reserve’s temporary reverse repo program.
“What we are seeing now is the buyside engaging us regarding a way to bring them into the CCP, because they’re concerned that the dealers that they prefer to trade with don’t have the capacity now, or won’t have the capacity in the future to continue to do the same level of business with them,” Pozmanter said. “Basel III also treats exposure to CCPs much lighter than it does bilateral exposures.”
Central clearing and settlement of tri-party repo transactions through the FICC could also help prevent another squeeze in tri-party liquidity such as the one the industry witnessed in 2008, he added. “The buyside can trade away from firms quickly if the buyside has concerns over them. We saw this happen with Lehman Brothers. Buyside firms lost all of their tri-party funding in a matter of hours, which caused a severe luquidity crunch for them.”
A second benefit of bringing buyside counterparties into the CCP arena: CCPs could better analyze the sellside’s balance sheets and calculate margin requirements more accurately.
“Right now, we have a very one-sided view of our customers’ books,” Pozmanter said. “So, if a dealer were sitting between our dealers and the institutional market, we would see a very inflated version of their positions because we only would see the sides of their trades that are in the CCP. Clearly this is going to impact the way margin that position to the extent that the dealer has a much more flat book than what we see.”
To eliminate future incidents such as what happened to Lehman, the FICC has been working over the past year on its Centrally Cleared Institutional Tri-Party offering for the $1.6 trillion institutional tri-party repo market, and plans to take it live later this year.
The CCP chose to start with tri-party repo clearing since the asset had the most apparent need for central clearing as well as the largest concentration of a single type of customers, Pozmanter said.
“There’s not much work that the CCP needs to do to move this initiative forward,”he said. “It’s really getting the right regulatory construct to allow registered investment companies to participate while staying within the bounds of 40 Act requirements.”
The Tri-Party Repo Initiative
This isn’t the DTCC’s first rodeo when it comes to clearing repo counterparties between two sellside parties, in the deliverable and tri-party markets.
The clearinghouse even has experience in on-boarding buyside firms, such as when it decided to turn its mortgage-backed securities division into a CCP. It developed a loss waterfall that would not conflict with 40 Act restrictions, according to Pozmanter.
The FICC doesn’t have that much more to do to move forward on the project, since the DTCC’s existing General Collateral Finance (GCF) repo service is essential a cleared repo that has been available since its launch in 1998, Pozmanter added.
If approved by regulators, the new service would allow the submission of institutional tri-party repo transactions between the members of the FICC’s Government Securities Division and 40 Act-regulated investment companies. This would occur when the investment companies are lending the cash in the tri-party repo transaction, according to DTCC officials.
The DTCC plans to create a limited GSD membership for tri-party money lenders, but it would be separate from the full GSD membership and would relieve money lenders from meeting all of the requirements of a full GSD membership.
This is, by all accounts, a lengthy and complicated process. What is taking the most time for the DTCC is getting regulatory approval from various divisions with the Securities and Exchange Commission.
When the DTCC began working with the SEC’s Division of Investment Management last year, it did not anticipate how long it would take for the division to become comfortable with the DTCC’s proposed process.
The DTCC needs to demonstrate that its proposal does not present any conflict between the CCP’s rules and the 40 Act, so that firms that want to participate will not have to ask the SEC for relief from portions of the 40 Act, Pozmanter explained.
Once the Division of Investment Management thoroughly vets and approves the DTCC’s proposal, the Division of Trading and Markets needs to approve rule changes for the FICC that would allow the creation of the limited GSD membership. At presstime, DTCC’s Pozmanter estimated that the Division of Investment Management was close to signing off on the clearinghouse’s initiative, which may go live by the end of the year.
The DTCC plans to expand its buyside membership further by admitting cash lenders other than the 40 Act funds into the CCP.
“The second phase is for securities lenders who access the market via agent lenders,” Pozmanter pointed out. “The last phase will be a two-way model for firms that are not clearinghouse members but that are borrowers and lenders of cash.”
After the DTCC completes its three planned services for Treasuries, agency debt and agency mortgage-backed securities, it might examine offering similar services for products cleared by the FICC’s sibling clearinghouse, the National Securities Clearing Corp., he added.
Although it might be a while before buyside firms become members of the DTCC on a regular basis, the long-term benefits for them, and the market as a whole, will be a strong driver for adoption. The conversation and the second look are far from over.
