Change is here. With the rollout of the Dodd-Frank Acts 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 OShea, senior analyst at Aite Group, expect to see a shakeout among central counterparties (CCPs) vying for the new clearing business. Youll get some regional players in specific markets, but I believe there will still be a relatively limited number of CCPs because its a volume game. Its quite hard to make money out of it if you dont get that volume, she said.
One firm that does have that kind of volume is LCH.Clearnets 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 recently spoke with David Weisbrod, the CEO of LCH Clearnets 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 thats 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. Thats 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 banks 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. Its a new mechanism to ensure each client has its own collateral separate from that of the FCM or the FCMs 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 FCMs estate and a higher chance of porting to a new FCM. Its 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 thats 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 SwapClears 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 thats 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.
