OTC Derivatives Prime Brokerage Survey 2011 Introduction: Into the Unknown
Throughout the last 12 months, the OTC derivatives prime brokerage business was dominated by exactly the same topic as it was in the previous year: the coming of centralized clearing. Unlike 2009, however, there was more substance to the discussions between prime brokers and their hedge fund clients on how exactly they will work with each other once centralized clearing becomes mandatory. This is because both now have some concrete experience of centralized clearing in practice. Market participants can already clear interest rate and credit default swaps at CME in the United States. ICE can clear credit default swaps in Europe as well as the United States. In Europe, Eurex Clearing can clear credit default swaps as well as equity derivatives. LCH.Clearnet has added credit default swaps to its already dominant position in interest rate swaps. SwapClear, the centralized clearing service for interest rate swaps introduced by LCH.Clearnet for sell-side firms way back in 1999, was opened to the buy side in December 2009. With more than 1.7 million transactions outstanding, totaling $248.3 trillion in notional value, SwapClear now claims to clear just over 50% of the global interest rate swap market.
True, this does not suggest there is yet massive involvement in clearing by hedge funds. An International Monetary Fund (IMF) report estimated that in 2009, before SwapClear was even opened to the buy side, 46% of the outstanding notional value of interest rate swaps was centrally cleared, chiefly because the bulk of the business was conducted between dealers. However, Swap- Clear has now absorbed successfully the first interest rate swap portfolio to be shifted from bilateral arrangements to centralized clearing. In early September 2010 Barclays Capital announced that the investment banking arm of Banca Monte dei Paschi di Siena had appointed the firm as its agent for clearing interest rate swaps through Swap- Clear, and that it had already back-loaded a large proportion (more than $200 billion in notional value, to be exact) of the historical OTC derivative transaction portfolio into a centralized clearing arrangement. This was also the first instance of a counterparty appointing a centralized clearing agent for a portfolio of transactions with multiple counterparties in the new age of centralized clearing of OTC derivatives.
As it happens, regulators on neither side of the Atlantic are even asking for existing portfolios to be back-loaded into centralized clearing, so the transaction went beyond regulatory requirements. But then market practice in OTC derivatives has tended to keep ahead of official requirements since the industry first found its infrastructure being questioned by the regulators back in 2005. Clearing of interest rate swaps, by the sell side at least, dates back to 1999. The reporting of OTC derivative trade details to trade repositories, now being made mandatory by legislation on both sides of the Atlantic, was pioneered on a voluntary basis by the Depository Trust and Clearing Corporation (DTCC) as long ago as 2006.
But none of this history means there is not a high level of anxiety about the deadlines for mandatory clearing now being set by the regulators. The Dodd-Frank Act, which obliges OTC derivative dealers and their major clients to clear trades through a central counterparty clearing house (CCP), was signed into law on July 11, 2010. Because the legislation stipulates that central clearing must start by the later of 360 days after July 11, 2010, or 60 days after the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have published the rulebook, mandatory clearing is likely to be live in the United States in the second half of this year. The European Market Infrastructure Regulation (EMIR), the European equivalent of Dodd- Frank, is operating to a more leisurely timetable, but is still expected to make centralized clearing of OTC derivatives mandatory in Europe by the end of 2012.
Despite the imminence of this deadline, there remains considerable uncertainty over exactly how centralized clearing of OTC derivatives will evolve in 2011-12. With the CFTC in charge of regulating swaps (rates, FX and index CDS) and the SEC in charge of regulating security-based swaps (single-name CDS and equity derivatives), American market participants still await rules specifying exactly which OTC derivatives must be centrally cleared and which OTC derivative users must centrally clear. The rules may yet encompass trades with at least one leg in another part of the world. The uncertainty in the US market is so great that in late December ICE Trust, the main provider of clearing services to the credit default swap market, withdrew its application to the CFTC to register as a derivatives clearing house. In Europe, the counterparty definitions (essentially, all but the largest corporate end-users) and geographical scope (any trade with at least one leg in Europe) are set by EMIR, but decisions on which OTC derivative products are covered will be made by a pan-European regulatory body that has yet even to be set up: the European Securities Market Authority (ESMA).
Despite the obvious similarities between Dodd-Frank and EMIR, there are also significant differences between the American and European approaches. The anxiety of the US regulators to avoid bailing out banks solely on account of losses on OTC derivatives trading means that Dodd-Frank obliges users to put their OTC derivatives activities into a separately capitalized entity. The dominant role of the CFTC in derivatives regulation has also obliged market participants to clear through the Futures Commission Merchants (FCMs) familiar from exchange-traded derivatives. That means clearing agents in the United States must perform a pure agency role and cannot - as a number of prime brokers had planned - act as principals on behalf of clients clearing through a CCP. It has already forced ICE to abandon its principal model and apply for a derivatives clearing license. LCH.Clearnet, which does not use FCMs either, is having to adapt its approach in the US market to accommodate this requirement too.
For hedge funds, the Dodd-Frank insistence on using FCMs adds a layer of complexity. For a start, it exposes them to CCP risk directly. While that might sound reassuring by comparison with the alternative of exposure to an investment bank as their clearing agent, it obliges them to undertake more due diligence. They obviously have to understand the status of their collateral at the CCP, and ensure it is held in a segregated account, and understand the exact sequence in which capital is put at risk in an event of default by a user of that CCP. Then they have to assess their exposure to default not only by their clearing agent at each CCP but to other clients of their clearing agent at each CCP, and their rights and obligations under the law of the jurisdiction in which each CCP operates. The good news is that this need to check how and when liability kicks in will offset the risk of a "race to the bottom" in CCP margin requirements. In assessing their exposure to defaults, market participants will now have to look beyond the value of the initial and variation margin requirements set by a CCP. If they have to do it in the United States, they will probably do it in Europe too.
That said, CCPs are of course competing furiously with each other to try and corner business, and margin requirements are an obvious competitive weapon to use. The fear among regulators of a "race to the bottom" is one factor that has helped to stall progress toward interoperability between equity CCPs in Europe (though French plotting to regain control of Clearnet from LCH.Clearnet is also at work). Certainly, the costs to clearing agents of providing their hedge fund clients with a full choice of CCPs are far from insubstantial. One investment bank says it had to subscribe $50 million up front to the guarantee fund for the CME Group centralized clearing service for interest rate swaps before it went live. With the current list of OTC derivative CCP contenders numbering 14 long - including operations on both sides of the Atlantic - $50 million a time adds up to $700 million in committed capital for guarantee funds alone. Initial margin is likely to demand 100 times that amount. Then there is the cost of separate interfaces, and comprehending and operating different operational processes as well. Those costs will be prohibitive for all but the largest hedge fund managers, but they will to some extent have to meet them by paying their clearing agents to manage on their behalf the capital and complexity costs of using multiple CCPs.
It is hard to see how any clearing agent with real ambitions in the business can escape the obligation to support multiple CCPs. No one CCP currently covers all possible OTC derivatives - rates, credit, foreign exchange, equity, energy and commodities - and only CME and LCH.Clearnet either cover or even plan to cover a majority of them. No CCP at all is ready yet to clear foreign exchange derivatives, though CME Group and CME Clearing Europe, LCH.Clearnet and the Singapore Exchange are working on services, and ICE is talking to a group of banks about following their example. That means loading a portfolio of foreign exchange OTC derivatives into a CCP is not an option for any clearing agent or its buy-side clients for the time being. Even in interest rate swaps, where LCH.Clearnet has a service that dates back more than a decade, and is always extending the range of currencies it encompasses, the clearing house still covers only 14 currencies. It follows that any hedge fund manager conducting more than a narrow range of business will be forced to use multiple CCPs, at least until such time as every CCP is either fully competitive in all products or fully consolidated into a single global entity. That may never happen, not least because of the massive concentration of risk consolidation would entail. Even now, no hedge fund of any size would want to concentrate all of its business at a single CCP (or a single clearing agent for that matter) anyway.
But to achieve that kind of diversification of risk will take more work than simply putting trades into whatever CCP or group of CCPs will clear that type of trade. Hedge funds will have to work out exactly what resources stand behind a CCP, how it segregates margin posted by members, the sequence in which it would call on the successive lines of defense when making members whole in an event of default, and what protection the laws of the jurisdiction that govern the CCP affords to its users. That research is essential, because at some point in a major event of default a CCP is going to have to call on non-defaulting clients. That point is usually reached after the variation and initial margin posted by the defaulting client, the default guarantee funds posted by the clearing broker to the defaulting client and the resources of the CCP itself are all exhausted. The prudent hedge fund will naturally seek to use the CCPs that place the maximum distance between a default and the crystallization of their own liability to help make the losers whole.
Nor is the likely persistence of multiple CCPs the only infrastructural challenge facing hedge funds. Though regulators on both sides of the Atlantic are adamant that all clearable OTC derivatives must also be traded on regulated exchanges or electronic trading platforms, there is still considerable uncertainty over whether and when this will actually happen. Dodd-Frank says that any OTC derivative that can be cleared must be traded on a regulated exchange, or what it calls a "swap execution facility" (SEF). Exactly how the SEC and the CFTC would like this to be done awaits the new rulebook. EMIR, on the other hand, says nothing about mandatory on-exchange trading of OTC derivatives. That requirement appears instead as part of the review of the Markets in Financial Instrument Directive (MiFID), which the European Commission launched via a consultation paper it published on Dec. 8, 2010. It proposed that all clearable and sufficiently liquid OTC derivative contracts be traded on regulated exchanges, electronic trading platforms such as MTFs or what the consultation paper calls - in a less succinct turn of phrase than SEF - a "specific sub-regime of organized trading facilities, to be precisely defined in MiFID." The consultation paper stipulates that qualifying trading platforms must provide open access, full pre- and post-trade price transparency, report all transactions to trade repositories, and "have dedicated systems or facilities in place for the execution of trades.
While it is clear that SEFs are not the same as regulated exchanges - the Dodd- Frank legislation defines them openly as any kind of trading platform that enables multiple participants to accept bids and offers from each other - it is not clear until the rules are finalized by the SEC and the CFTC whether they will be order-driven or quote-driven platforms, or closed to the buy-side or open to all-comers. It remains to be seen if the request for quote (RFQ) system operated by Tradeweb or the BARX electronic trading platform run by Barclays Capital or the i-Swap platform run by ICAP or the CDS trading platform run by MarketAxess or the CreditEx platform acquired by ICE or Bloomberg Tradebook or indeed voice-brokered deals passed on to platforms will meet the Dodd-Frank definition of an SEF as "a facility, trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by other participants that are open to multiple participants in the facility or system."
But such platforms already dominate dealer-to-dealer business and naturally expect to be classified as SEFs. They will also be obliged by regulators to clear through CCPs. Indeed, in September 2010 Tradeweb claimed to have executed the first electronically traded interest rate swap in Europe to be processed by a CCP. That tri-party arrangement again involved Banca Monte dei Paschi di Siena as customer and Barclays Capital as the clearing agent that faced off against LCH.Clearnet as CCP, though Credit Suisse was executing broker. Tradeweb then repeated the feat in the US market in November, when an unidentified fund manager completed a US dollar-denominated interest rate swap with Deutsche Bank acting as both the executing broker and clearing agent, and CME Group as CCP. Deutsche Bank had already become one of the first clearing members to clear a swap with CME Clearing, when an interest rate swap was cleared on behalf of Citadel through the Deutsche Bank dbClear platform. Tradeweb is now sufficiently optimistic about becoming an SEF under Dodd-Frank later this year that it is openly planning to register as one with the CFTC.
What remains completely unclear is the impact on liquidity and price formation of a switch to public trading of OTC derivatives. "Trading" of OTC derivatives is at present primarily a professional activity conducted between banks, intermediated by inter-dealer brokers through a combination of voice broking and proprietary electronic platforms. Efforts to create dealer-to-client trading platforms have not met with success. CMDX, the credit default swap trading platform set up by CME Group and Citadel in 2009, was shunned by the major investment banks until CME Group ditched Citadel. It is notable that the landmark Tradeweb transactions were purely interbank exercises. The investment banks that dominate OTC derivative trading would greatly prefer it if OTC derivatives did not gravitate to regulated exchanges and SEFs remained dealer-to-dealer platforms, offering no more than negotiable prices to insiders such as themselves rather than executable prices to the buy side. The OTC derivative prime brokers as a class have no incentive to encourage either price transparency or direct trading between buyers and sellers of swaps on the basis of prices, trading fees and technology alone. Indeed, the pricing of credit derivatives is already under investigation by the US Justice Department, which is looking for evidence of anti-competitive practices, including collusion between the major investment banks. OTC derivative trades tend to be large and infrequent anyway, and increased price transparency could see trading volumes fall further as market-making investment banks retrench. Evidence from the reform of the NASDAQ equity market in the 1990s and the introduction to the US corporate bond market by the Financial Industry Regulatory Authority (FINRA) of its Trade Reporting and Compliance Engine (TRACE) in 2002 suggests that trading costs will plummet but trading volumes might shrink as market-makers withdraw.
Since OTC derivative trading is dominated by the major investment banks, the pattern could be similar if transparency trims profits, and they are not allowed to start or run their own SEFs. Prime brokers are already concerned that CCPs, by eliminating the counterparty credit risk of trading electronically, will give competitors a leg-up. The surge in electronic trading of repo in the early years of this century, which was fiercely opposed by the major investment banks, was driven by the fact that the major trading platforms were underpinned by CCPs. This explains why smaller banks, investment banks and broker-dealers, including BNY Mellon, MF Global, Newedge and State Street, reckon the "group of 14" major investment banks that have cooperated since the 2005 trade confirmations backlog became a regulatory issue are discouraging CCPs from admitting them to their inner counsels, in order to retain tighter control of clearing prices, margin requirements and relationships with trading platforms.
There is obvious scope for SEFs that are vertically aligned or even co-owned by CCPs or their shareholders to price execution and clearing in ways that are anti-competitive. The Lynch Amendment to the Dodd-Frank legislation, which was ultimately defeated, endeavored to restrict ownership of SEFs and CCPs by the investment banks for this very reason. The final draft did give regulators power to limit both the shareholdings and the voting rights of particular groups of CCPs and SEFs, suggesting legislators are alive to the fact that their reforms face anticompetitive threats. If this reluctance on the part of the leading investment banks to trade spread for volume persists, expectations that CCPs and SEFs will bring in a much wider range of market participants - notably the traditional fund managers who trade OTC derivatives, but never had to use a prime broker - will be disappointed.
In any event, there will be limits to the range of OTC derivatives that can be traded electronically. The earliest candidates are obviously straightforward interest rate swaps, index credit default swaps and some FX swaps (pending CCP support). It can be argued that electronic trading of interest rate swaps by large broker-dealers will scarcely mark any change at all, since most of the business is already intermediated by interdealer brokers such as BGC, ICAP and GFI, whose electronic platforms will simply be relabeled as SEFs. It is the dealer to hedge fund business that the major investment banks are really seeking to protect. Whether that ambition can survive the principal motive behind the regulatory insistence that cleared trades be traded openly - greater transparency - must be doubtful. Dodd-Frank wants prices and volume reported to the marketplace instantly. Though there is room for discussion on exactly when a swap transaction is completed - an agreement to buy a swap is often followed by further haggling over the details - the public reporting of prices will for the first time give hedge funds and other clients of the investment banks a strong sense of where market prices actually are. That must mean tighter bid-offer spreads, driven initially by a group of innovative electronic trading platforms that will perform much the same role as the multilateral trading facilities (MTFs) in the European equity markets after the MiFID directive became effective in November 2007. Predictions by investment banks that they will either abandon their market-making role as spreads narrow, or clean up because they have inside knowledge of market-clearing prices, are a measure of their nervousness at the prospect.
Change is always disruptive and, if the investment banks are uncertain what OTC derivative trading platforms supported by CCPs will do to their revenues or margins, hedge funds are equally uncertain what the same combination will do to their costs and risks. Inserting CCPs into markets that have hitherto operated bilaterally poses some less-than-obvious operational challenges for buy-side firms. If a centrally cleared swaption is in the money on the exercise date, will the CCP or the hedge fund be responsible for actually exercising the option? Likewise, centrally cleared cross-currency swaps will still entail the counterparties swapping currencies at the outset of the contract. It is not yet clear if that will be facilitated by the CCPs or not. But at the start of 2011 hedge funds do at least have a better understanding of the potential benefits of centralized clearing than they did a year ago. Those benefits do of course vary by the size and sophistication of a fund. For a minority of smaller hedge funds the change in prospect is a relatively straightforward one. They will exchange multiple bilateral relationships intermediated by a single prime broker for multilateral relationships intermediated by a single central counterparty (CCP), but managed by a single clearing broker. It cuts their counterparty risk to a single counterparty, concentrates margin in a single, segregated account at the CCP, and makes it relatively easy to shift positions to a new clearing broker should the existing provider default or perform unsatisfactorily.
For major fund managers with complex OTC derivative portfolios, the benefits of the new operating model will not be quite so straightforward. Large long-only managers, for example, have never posted initial margin up-front on their positions, only variation margin on the net present value of those positions. Unlike hedge fund managers, they found their size and quality persuaded counterparties to deal with them directly rather than via prime broker. This enabled them to skip the obligation to post initial margin in their Credit Support Annexes (CSAs), where they were required to post variation margin only. In a centrally cleared marketplace, by contrast, long-only managers will have to post initial margin. They will also have to get used to the idea that they need to find cash rather than securities to post.
For less creditworthy hedge funds, on the other hand, posting initial margin is not an alien concept. Indeed, the value of the collateral they have to post could actually fall in a centrally cleared environment by comparison with a prime broker-intermediated marketplace, though by exactly how much will depend on the diversity of their OTC derivative portfolio. A hedge fund trading OTC derivatives today has to post considerably more collateral than it did in 2007 - by 2009 the margin requirements set by the CME Group for hedge funds were twice as heavy as 2 years earlier - and in a bilateral market each position is collateralized separately. This collateral cost can be reduced only where a prime broker is willing to cross-margin the various positions and charge a single net amount. In a CCP, by contrast, all positions in that CCP can be netted. That allows a single margin calculation to be performed on the entire OTC derivative portfolio at that CCP.
In reality, however, hedge funds will still be dealing with multiple CCPs and clearing brokers. But they will be fewer in number. Hedge funds will exchange multiple bilateral relationships for a smaller set of multilateral relationships intermediated by no more than two or three CCPs. In terms of clearing brokers, risk management grounds alone argue for appointing more than one. That way, if a clearing agent fails, an OTC derivative portfolio can then simply be ported across to an alternative provider. But enticing banks to become second-string clearing brokers, and especially to ensure they are willing to take on business in extremis, entails giving them business in the good times. In an event of default, a CCP may give a back-up clearing broker as little as 2 hours to decide whether or not to take on the risk of a client portfolio from a failed broker, and they are unlikely to do that without being densely involved with the same client for a lengthy period.
But hedge funds will still be able to operate successfully in centrally cleared OTC derivatives markets with fewer clearing brokers than they have prime brokers in the current regime. Most will need no more than two or three. This will create scope for more consolidated reporting of positions and less variation in pricing of the same instruments. Centralized clearing of even the most active and diversified portfolios will also give hedge funds the opportunity to manage their collateral on an integrated basis across both listed and OTC derivatives, leading to greater efficiency in collateral usage. Instead of managing dozens of bilateral CSAs, and meeting or making multiple margin calls, they will be able to run a single margin management process with each CCP, and perhaps even appoint one clearing broker to optimize the management of their collateral across all of the CCPs they and their counterparties use.
The question for prime brokers is whether collateral management services of this kind are a worthwhile business opportunity or not. On the face of it, the answer is in the affirmative. Hedge fund managers have long judged prime brokers by their ability to economize on their use of collateral across all of the business they conduct with the firm. The difficulty is to decide whether centralized clearing makes cross-margining harder or easier. On one view, it will get harder. In the old world of prime broker-intermediated OTC derivative trading, the prime broker could cross-margin across all types of OTC derivative business a client transacted with the firm. Because not all CCPs will support all types of OTC derivatives, margin posted to CCPs will not cross many product lines. There is no possibility that CCPs will cross-margin clients between themselves.
Even if there was, not all OTC derivative instruments are clearable, forcing hedge funds to post collateral at both a CCP and with a clearing broker, sometimes for different parts of the same instrument. For example, a callable swap - that is to say, a plain vanilla interest rate swap with an option on top - might consist of a clearable interest rate swap plus a non-clearable option. The obvious solution to this conundrum is for the clearing broker to act as principal, becoming counterparty to both parts of the instrument, and netting margin across both parts internally. But even a service of that kind would not obviate the need to collateralize the clearable part of the product at the CCP. The only way to cut the cost would be to waive or reduce the obligation to collateralize the non-clearable part. That is a reasonable course of action, in the sense that the option is after all hedging the swap, but would lead to an increase in the risk-weighted capital cost. Which is why the pessimists argue that appointing a clearing broker as third-party collateral manager will not be cheap, even if it is possible.
Optimists counter that buy-side firms with a diversified portfolio of OTC derivative positions will not want to manage the interfaces to separate CCPs, let alone the separate margin requirements of multiple CCPs themselves, especially in combination with managing the collateralization of non-clearable bilateral transactions. In one sense, CCPs also make cross-margining easier to perform. They are already in place in the futures markets. Once the bulk of OTC derivatives are also centrally cleared - and it is important to remember that, even if not all OTC derivatives can be cleared, three-quarters to four-fifths probably can be - a large number of bilateral margin relationships, each with their own collateral eligibility criteria, is reduced to a much smaller number of margin calls with a limited number of CCPs, whose collateral requirements are more standardized and predictable.
The scope for a prime broker to optimize the management of the collateral of its hedge fund clients across cleared listed derivatives, cleared OTC derivatives, non-cleared OTC derivatives, equity finance, securities borrowing, payments in central or commercial bank money and credit for settlement purposes is increased commensurately. Over time, the CCPs will gradually aggrandize more of what is currently non-clearable, making the collateral management task cheaper and easier still. In short, by forcing collateralized derivatives trading of both the OTC and the exchange-traded kind down a narrower range of relationships, centralized clearing enlarges the scope to take collateral management services on to a higher plane. That higher plane is one in which the initial and variation margin posted to CCPs is just one duty performed by the clearing broker across all types of collateralized activity undertaken by a hedge fund client.
All of that said, if a new era of collateral optimization is now possible, it is not one that many clearing brokers have identified as a money-spinner. The exception is J.P. Morgan, where the merger of the OTC derivative operations groups of the investment banking and custodian businesses several years ago has created an opportunity to manage the collateral of buy-side clients across cleared and non-cleared OTC derivatives out of a single custody account for all long assets. However, the J.P. Morgan model does entail the bank acting as a further layer of intermediation behind the clearing brokers that actually interface with the CCPs, making it a costly option - albeit one necessitated by the regulatory preference for CCPs. For the investment banks that dominate the OTC derivatives industry, and plan to become clearing brokers only, the calculations of value are somewhat different. The pricing of OTC derivative prime brokerage, like cash prime brokerage, hinges not on being paid to manage collateral on behalf of the client but on the client surrendering control of collateral to the prime brokers for the prime brokers to use as they judge best for their own business.
Yet that may, paradoxically, be precisely the reason why clearing brokers could be interested in becoming third-party collateral managers. If hedge fund managers deprive their prime brokers of the right to re-hypothecate their collateral, they will have to pay for it in some other way, and paying fees for collateral management is one option, as J.P. Morgan has recognized. They should be willing to consider it. Hedge funds know that centralized clearing will cut their counterparty risk. What they do not know is what it will cost. A rough cost-benefit analysis would net the costs (legal fees, a variety of CCP interfaces, clearing broker fees, CCP fees, CCP margin calls and additional capital costs for non-cleared trades) off against the benefits (the reduction in counterparty credit risk on the value and duration of positions, measured by CDS spreads, plus some gains in operational efficiency). Hedge fund managers understand the potential gains in operational efficiency. After all, they opted under the ancient regime to appoint a single prime broker to intermediate their trades as much for the operational benefits as the counterparty quality. But they will be hard to quantify. Adding tangible gains from optimizing collateral usage could make all the difference to the outcome of the cost-benefit analysis.
Centralized clearing through a single clearing broker not only preserves the gains in operational efficiency, and adds the reduced counterparty credit risk of dealing through CCPs, but also creates an opportunity to pay the clearing broker an agency fee to optimize the use of collateral. Trades can still be executed with multiple counterparties, confirmed electronically by both parties and "given up" to a prime broker as clearing agent. Margin requirements are determined not by the multiple methodologies of several prime brokers and the appetites of their clients but by the methodology of each CCP. Any margin posted to that CCP is kept in a separate account that eliminates the risk of its being lost if another participant fails, and of it getting caught up in a prolonged, Lehman-style liquidation process. Prime brokers will handle the variation margin process on behalf of hedge funds, making it operationally efficient.
Most importantly, prime brokers have a clear opportunity to cut margin requirements against an OTC derivative portfolio because they have oversight of all uncleared as well as cleared business conducted by a client. They could, for example, handle the CCP initial and variation margin calls on a cleared interest rate swap, but charge no collateral requirement at all on an uncleared but associated option. If a hedge fund appoints a prime broker as its sole clearing agent across multiple CCPs, all of this can be reported to the hedge fund manager on a consolidated basis in a single daily report, instead of being cobbled together by themselves from different reports from different prime brokers. Appointing a prime broker as a third-party collateral manager is a means of overcoming the potential loss of collateral efficiency occasioned by the existence of multiple CCPs.
The prospect of prime brokers acting as fee-earning agents rather than spread-collecting principals is not as revolutionary as it sounds. In reality, prime brokers have played both roles for years in different aspects of the business, and sometimes fulfilled both roles simultaneously. Even in centralized clearing of OTC derivatives, prime brokers are now offering to act as both agent (in which the CCP is the counterparty) and principal (in which the prime broker is the counterparty). But what is really making prime brokers more open-minded is the fact that the world has changed. As the introduction to this survey observed a year ago, the regulatory appetite for centralized clearing of OTC derivatives predates the collapse of Lehman Brothers by at least 12 months, and arguably dates back to their forced automation of trade confirmations in 2005. But until the successful unwinding of the cleared portion of the OTC derivatives portfolio of Lehman Brothers took place in 2008, regulators were discussing theoretical rather than demonstrable benefits. The SwapClear service provided by LCH.Clearnet famously resolved the 66,000-trade, $9 trillion interest rate swap portfolio of Lehman Brothers in just 3 weeks, and within the margin held, so no loss fell on any other market participant. That event confirmed regulatory confidence in CCPs.
It also changed the attitude of the buy-side clients of the prime brokers. Until Lehman Brothers failed, hedge fund managers that used prime brokers to intermediate their OTC derivative transactions did not regard the bankruptcy of a major investment bank as a serious possibility. The annual margin surveys by the International Swaps and Derivatives Association (ISDA) show that, as the industry went into the crisis in 2007, two-fifths of OTC derivative transactions by both number and mark-to-market exposure were uncollateralized. Such a sanguine approach to risk is now history, to both sell and buy side. The 2010 ISDA margin survey found that 97% of credit derivatives trades by the 15 largest reporting firms, and 78% of all OTC derivative transactions executed by the largest dealers, were collateralized. It also found that hedge fund exposures were on average 141% collateralized - far more than any other group of market participants.
That is precisely why hedge funds welcome the intermediation of CCPs, which segregate collateral and eliminate investment bank risk. In the financial crisis, the buy side learned to its cost not only that a major investment bank could fail, but that they could lose control of collateral, and for a prolonged period. Fund managers also learned that these twin risks were eliminated in those trades that were intermediated by a CCP. If a CCP could protect market participants from bilateral counterparty risk, even when a major investment banking counterparty defaulted, it is little wonder hedge funds have come to share the regulatory conclusion that centralized clearing is a low-cost, tried and tested method of cutting counterparty risk. It is not often that regulators find their proposals have the support of a significant segment of the industry, but this is a case where they do.
However, there is one reason to believe that centralized clearing of OTC derivatives is not as obvious a win for hedge funds as it appears. The clearing brokers they use to access the CCPs will be subject to the capital adequacy rules now being reset by the Basel III framework that will be implemented over a 6-year period starting in January 2013. Inter alia, Basel III aims specifically to ensure that counterparty credit risk on OTC derivative positions has a greater risk weighting than it had under Basel II, precisely because the Lehman collapse persuaded regulators that the low capital charge on OTC derivatives failed to take account of their inherent riskiness so completely that it actually increased systemic risk as well. The capital requirements for counterparty credit risk in OTC derivatives will now be driven not only by defaults and deterioration in counterparty credit risk but by so-called "stressed inputs" and mark-to-market losses occasioned by deteriorations in counterparty credit risk. Under Basel II, the mark-to-market losses that accounted for two-thirds of the losses from counterparty credit risk were not directly capitalized at all. In addition, net OTC derivative positions will now find their way into the Basel II leverage ratio calculations, whether they are on or off the balance sheet. Most important, however, is the fact that under Basel III OTC derivative counterparty credit risks intermediated by CCPs will enjoy preferential capital treatment. The risk-weighted capital requirement of just 1-3% is higher than the current weighting of zero, but is nevertheless a strong incentive for banks to stick to clearable OTC derivative risks.
Barclays Capital has calculated that Basel II will require the top 20 US banks to add $326 billion of risk-weighted capital for clearing OTC derivatives on behalf of clients, but that this sum will be outweighed by an estimated $400 billion saving for the same banks from the switch of the bulk of OTC derivatives to centralized clearing. Capital savings of this magnitude will also encourage banks to backload their OTC derivative portfolios into centralized clearing, even though they are not obliged to do so. They may even be the factor that tips European regional banks - which EMIR may yet allow to self-clear OTC derivatives - into using CCPs.
The savings will of course be offset by the need for clearing brokers to post additional collateral at CCPs as initial margin - Barclays Capital put that at $100 billion for the US banks alone - but the real capital cost for clearing brokers lies in servicing non-clearable OTC derivatives. These will attract a much higher risk weighting for capital requirement purposes, which will be reflected in a higher price for trading non-clearable OTC derivatives. That will almost certainly reduce liquidity in non-clearable products, and make valuations harder to agree on, because not every clearing broker will assess their liquidity and riskiness in the same way. Some will not want to service such business at all. Indeed, it is now abundantly clear exactly which prime brokers are serious about becoming clearing brokers.
Three firms are attacking the centralized clearing opportunity with vigor: Barclays Capital, Credit Suisse and J.P. Morgan. They see it primarily as an opportunity to cement existing franchises and relationships, and protect them from competitive assault, rather than a major source of new business. None is showcasing third-party collateral management as a profitable strategy. In fact, they reckon the only real source of fresh revenue from central clearing of OTC derivative trades probably lies in helping hedge funds secure CCP-eligible collateral when they need it, either by reverse repo-ing the securities they do not have or repo-ing the securities they do have. Firms such as Bank of America Merrill Lynch, Goldman Sachs, Deutsche Bank and Morgan Stanley, which largely exited OTC credit derivative prime brokerage as too unremunerative for the risks involved during the crisis of 2008-09, have mostly focused more narrowly on rates and foreign exchange, but have clearing services spanning multiple asset classes at various stages of development. Citi and UBS, after understandable periods of quiescence, are also now moving cautiously from a wait-and- see stance to a more active role, as the way in which the market will work has become clearer. But no other firms have yet thrown as many people and as much money at the challenge as the three market leaders.
Yet even an effective choice of somewhere between three and nine does not make it easy for hedge funds to choose between the contenders. Where Barclays Capital, Credit Suisse and J.P. Morgan will register with users is in terms of creditworthiness, where there is little to choose among them, but much to choose between them and standalone investment banks. As the 2011 Global Custodian OTC Derivative Prime Brokerage survey suggests, all three firms also offer an excellent service. Though the Monte dei Paschi back-loading gives Barclays Capital an edge, which it has maintained by becoming the first to clear client trades on both CME and LCH.Clearnet, its rivals are operationally and infrastructurally ready to clear trades on behalf of clients too.
All three banks can also clear through any of the CCPs offering a service, which is essential for hedge funds trading the full range of OTC derivative products with a wide range of counterparties. The key differentiators hedge funds will look for in a clearing broker are therefore few in number. They probably reduce to the ability to report positions promptly and on a customized as well as a consolidated basis, plus the ability to net positions and margin requirements. But there is a risk that some hedge funds will find they do not have a choice at all in the end. With only three serious contenders for the role of clearing broker, and the timetable looking exceptionally tight, there is a risk that there will be insufficient capacity to meet demand when centralized clearing starts in earnest in the second half of 2011.