Build it well and the buy-side will come
When is the right time to comply with a regulation which entails substantial operational, risk and cost changes? Is the advantage with the first mover or the last?
This continues to be a delicate and contentious issue for European asset managers and owners ahead of the central clearing mandate imposed by the European Market Infrastructure Regulation (EMIR), as reflected at a panel session on OTC derivatives reforms at the Euroclear Collateral Conference in Brussels in late May.
In 2009, G-20 leaders set a 2012 deadline for the imposition of a new framework for trading, clearing and reporting OTC derivatives, as a key plank of global efforts to reduce systemic risk in the financial markets. At present, no market participants - buy-side or sell-side - are legally obliged to clear OTC derivatives in Europe. And, even though it’s still not entirely clear when mandatory central clearing of the most liquid interest rate swaps will begin, banks with high volumes of OTC derivatives transactions, representing 75% of the total swaps market, already centrally clear a high proportion of these instruments for operational and counterparty risk reasons. But, despite the fact that interbank OTC derivatives transactions will need to be collateralised by September 2016, with client business following later in 2017, the arguments for change for buy-side firms don’t stack up so well.
As noted by several panellists in Brussels, that moveable regulatory deadline has not helped. At a time of low yields, limited resources and high levels of regulatory change, competition for budget is fierce at all financial institutions. EMIR’s regular timetable shifts have caused many buy-side firms to temporarily mothball their central clearing projects, shifting focus and resource to other projects. A related point - voiced by providers and users alike on the OTC derivatives panel - is that regulatory uncertainty has slowed the development of the commercial solutions needed to enable buy-side firms to clear swaps. Delays to the start of central clearing in Europe have led to several brokers quitting the business, causing capacity concerns among clients, while clearing houses are still building out solutions that offer different levels of asset protection, as demanded by EMIR.
The risks of moving too early can be seen in the evolution of the debate over which account structures asset managers and owners should chose when posting collateral at clearing houses to support cleared OTC derivatives positions. Initially, many buy-side firms plumped for maximum protection via full segregation, in expectation of the need to regularly leverage and mobilise assets held in client portfolios. But so far the feared collateral crunch has not been as painful as expected, cash and government bonds are still the primary eligible collateral at clearing houses, and the choices facing many first-time clearers are more evenly balanced. Omnibus accounts may still be an option for many. Finally, volumes matter. Firms that are heavy users of the OTC derivatives markets - notably those offering liability-driven investment products - are more likely to need early preparations than less frequent users.
Towards central clearing
Caution, uncertainty and reluctance to incur unnecessary costs were apparent in the results of digital polling conducted during the panel session. In short, it seems the buy-side have the ability to clear before required by law, but not necessarily the will. In a mixed buy- and sell-side audience, 35% of poll respondents said they were still mulling over which account structures to use when posting initial margin, 32% said they didn’t know whether the cost of central clearing of OTC derivatives would prompt them to switch to exchange-traded derivatives. And while 48% of poll respondents said they were already clearing, 23% said they expected to have the capacity to be ready, while 29% had no firm plans. In addition, 42% said they had seen ‘no change’ in the migration to central clearing in the past 12-18 months.
Buy-side representatives on the panel said that the cost implications for the underlying investor made it hard to justify an early move to central clearing. The contribution of central clearing to the broader G-20 goals of reduced risk and greater transparency and protection for end-users was also questioned. But ultimately it comes down to cost: the buy-side will move early, if the sell-side and market infrastructure providers make it cost-effective for them to do so.
In the meantime, many buy-side firms are using this interregnum effectively. As well as working closely with clearing brokers and clearing houses, they are also getting to grips with collateral management implications of central clearing. One custodian on the panel observed that collateral optimisation is an evolving practice across the buy-side, with varying interpretations at this stage. Brokers noted that the slower roll out of regulation had eased the anticipated squeeze on collateral, but not postponed it on a permanent basis. Whether moving early or late, it is far too soon to consider the job done.