OTC Clearing: Prepare To Pay

Virtually none of the established practices for trading and clearing derivatives will remain unaffected as a result of the implementation of European Market Infrastructure Regulation (EMIR) over the next two years. For some firms these changes are so daunting they will exit the business. For others the cost may inhibit their involvement. But every sell-side firm planning to engage in OTC central clearing is having to re-evaluate and often redesign aspects of their traditional business.

The disruption is partly mitigated by the long transition process, from early preparations in 2009 to pension fund compliance in 2017 and possibly longer. This is giving firms time to adjust many facets of their clearing business, including client pricing models.

“It is very clear that EMIR is directly increasing costs, in terms of new trade reporting, margining and collateral processing requirements,” says Barry Polak, global head of products, ABN Amro Clearing. “But clients are broadly sympathetic to the new fee levels which are required as a result of EMIR.”

Some banks may consider the return does not justify the investment. Bank of New York’s decision to exit exchange-trade derivatives (ETD) clearing in the U.S. in 2013 was followed in 2014 by a similar move in Europe where the decision to exit OTC clearing was attributed to delays in implementation to 2015-16 leading to a lack of prompt return on the investment. Other banks have rushed to cherry pick big OTC clients, leading to concern that smaller clients might not be serviced as that business would be unprofitable against the cost.

But the largest changes required by the industry are undoubtedly in client margining and collateral management for OTC central clearing.

The credit crisis has been moving this trend towards a more collateralized trading regime anyway but now specific aspects of CCP practices need addressing, says Eugene Stanfield, head of derivatives execution and clearing services at Commerzbank Corporates & Markets. OTC clients, he notes, “will need to set up accounts for same-day margining, systems of handling margining in different currencies, and even adjust to quite basic issues as bank holidays.” CCPs in international markets ignore some national holidays which domestic clients observe. Clients will need to be able to accommodate margin transfers on such dates.

Some of these adjustments will be easier for some clients than others. Initial margin is usually in the form of assets but variation margin is almost invariably cash. However,

“Some clients, such as a fully invested or geared corporate bond fund, may have neither the underlying asset [acceptable to a CCP] nor the cash for both the initial and variation margin. In that instance we work with them to resolve that, for example, by developing their repo and financing capability.” says Jamie Gavin, Newedge’s head of
institutional OTC clearing sales for the U.K.

The main operational choice facing clients adopting a clearing regime for the first time concerns account segregation. The somewhat opaque ESMA CCP authorization programme required CCPs to detail their client account segregation models and asset protection schemes before authorization was granted.

Broadly, however, it comes down to clearing brokers offering individual segregated accounts (ISAs) where individual client assets are isolated, or omnibus segregated accounts (OSAs), where client assets can be commingled with other clients but not the broker’s. Initial responses from clients seemed to indicate a preference for the security of ISAs. But as mandatory clearing approaches OSAs are gathering support.

“New services will incur new costs,” Commerzbank’s Stanfield adds. “Certain choices, for example between ISAs and OSAs, are not simple binary either/or decisions but part of a broad-based adoption of the new regulatory requirements. Early expectations that clients would routinely adopt ISAs are now evolving into a broader recognition of the virtues of OSAs.”