New global rules for OTC derivatives have been implemented in the US and are imminent in Europe that will have significant long-term implications for how hedge funds, asset managers and regional banks execute, clear, and report their swap positions.
In particular, June 10, 2013, represents the second phase of the OTC clearing mandate that is required under the Dodd-Frank legislation. This means that those firms defined as part of Category 2 (hedge funds, asset managers and regional banks) that trade swaps must move very quickly to finalize central clearing arrangements.
Firms must act now to finalize their legal agreements and operational set-ups with their clearing members, affirmation platforms, and clearinghouses to ensure that they will not be ‘locked out’ of the swaps market and can continue to trade after June 10, 2013.
To understand the greater significance for those institutions, we asked Jack Callahan, Executive Director, OTC Products at CME Group, to explain.
What is significant about the June 10 swaps deadlineand will this apply to all clients in the US and Europe?
In the US, there is a Dodd-Frank requirement to clear certain types of interest rate swaps and credit default swaps. This clearing mandate started in March 2013 for a subset of market participants, with further phases to follow in June and September 2013. Combined with the EU’s European Market Infrastructure Regulation that was enacted in January, both of these initiatives will mean the vast majority of OTC interest rate swap contracts will have to be centrally cleared.
The next key date to pay attention to this year will be June 10, 2013, when interest rate swaps and credit default swaps will have to be centrally cleared by most market participants who fall under Dodd-Frank. Consequently, many clients have been finalizing their production account set-ups at CME Clearing, and signing up for direct access to their reports and margin analysis tools.
Why does the European buy side need to act now?
Although we don’t have any clear dates yet for the European clearing mandate, it is widely accepted that the mandate will occur sometime in mid-2014. Even though there is a quite a bit of time until that date, firms that want to clear in Europe will need to start the lengthy legal and onboarding process now as they have issues to address that typically can take months to complete. Many other clients are now early movers to centralized clearing because of the Basel III capital requirements that could significantly increase the cost of holding swaps bilaterally.
To put this into context, there are an estimated 4,000 buy-side firms that will have to comply either with US or European legislation, and approximately 20 clearing members offering client clearing (many more banks are clearing members for only their house trading activity). The knock-on effect of clients onboarding for clearing comes down to bandwidth, as some clearing members will have capacity constraints and be unable to serve as a clearing member for all of these clients.
Is this a big change for hedge funds and asset managers in particular?
Many asset managers do not post initial margin in the bilateral world, so they are preparing their infrastructure to handle this process and calculating both the amount of margin required and the securities that they plan to pledge to meet the margin obligations.
Another significant issue for both asset managers and hedge funds will be that only a portion of their portfolios are currently clearable, so they would have to keep a some of their trades bilateral. This bifurcation of their risk would cause their portfolios to be margined as two separate directional portfolios and will result in significantly higher margins.
Many of the largest swap users in the market are also active in interest rate futures at CME Group exchanges. Portfolio margining of interest rate swaps and futures helps alleviate the overall capital strain by delivering significant margin savings for clients of up to 90% for certain portfolios.
What will be the key benefits?
Clients are excited about the reduction in counterparty risk and applying a better risk framework to the interest rate swap market. The levelling of the playing field in the marketplace will be a huge benefit to clients, as they will enjoy a significant increase in transparency on the valuations and margins for their portfolios.
One fund manager sums up the overall advantages clearly, Supurna VedBrat Co-head Electronic Trading & Market Structure, at BlackRock, says: “Our priorities are customer protection, margin efficiency and liquidity. CME Group delivers on buy-side needs, and its model is aligned with our priorities.”
Other benefits will be economies of scale and liquidity, outlined by Matt Scott, Vice President, OTC Derivative Trading, Alliance Bernstein:
“We appreciate the operational and capital efficiencies we gain from clearing at CME Clearing, while enjoying exactly the same liquidity from dealers on all of our swap trading. The cleared interest rate swap market feels more balanced over the last 6-9 months as clearing volumes have increased.”
Do you see the market evolving as a result of this legislation?
The early signs from our client base are promising and we are confident that this market will grow based on reducing risk in the marketplace, and opening up the market to a greater number of market participants who didn’t previously have access.
Within this market, there will be an increased demand for collateral that can be pledged to a clearinghouse, and clients are focusing on more centralized management across assets and activities to make more efficient use of collateral.
Clients are working towards automation of back office processes across all elements of valuation, accounting, collateral management, and risk management. Many market participants are considering increasing their usage of futures products, because of the operational and collateral efficiencies that come with the usage of standardized products.