Hobson: How did you approach the introduction of OTC derivative clearing and reporting in the United States?
Callahan: We were fortunate that many of the largest swap users were already active in our futures markets, so as OTC regulation rose up the agenda, we had the ability to go to some of our largest clients and discuss with them what they were looking for so that we could build it. In particular, they wanted access to reports about their open positions, their valuation and margin requirements, and netting opportunities. So we built a secure FTP site and CORE margin tool that together offer clients end-of-day valuations of all open positions, the inputs and outputs of our valuation yield curve, margin projections on both an actual and a `What if?’ basis, and trades eligible for netting.
Hobson: Are your clients not getting the reports they need from their clearing brokers?
Callahan: What clients find, as they adapt to the change in the structure of the market, is that they need to validate what they are receiving from other parties. So they have found value in the transparency that CME Group provides by coming to us directly for reports, as a secondary source of information to what they receive from their clearing brokers. Clients can take our data on a daily basis, replicate the valuations, and integrate it into their own books and records. They also use the reports to reconcile trades and positions with custodians and administrators, so the data is also used to populate their compliance reports.
Hobson: Europe chose a Big Bang approach, while the United States adopted a phased approach. Which is better?
Callahan: Clearing in the United States began with the active hedge fund community in March 2013, followed by the bulk of the asset managers, the remaining hedge funds, plus insurance companies and regional banks, in June 2013. The final group, consisting mainly of pension funds, started clearing in September 2013. So from September 2013 all of the buyside in the United States was in a cleared environment. The phasing meant we were able to work closely with clients on a consultative basis to ensure that we were doing everything we could to help them prepare for these changes in the structure of the market. We helped clients with things that were not even directly tied to CME Group, because what is required of a client to begin clearing OTC derivatives involves a lot more than building a link to a clearing house. Clients want the ability to confirm and submit trades to the clearinghouse via a middleware provider, execute swaps via a swap execution facility (SEF), and set up the back-end reporting from an administrator. Even though we fit into only one part of the value chain, we tried to help clients on both the front and the back end, to create a more seamless process.
Hobson: Are you now doing the same in Europe?
Callahan: The fund managers we work with are truly global in nature, and they have some accounts that fall under EMIR and others that fall under Dodd Frank. It is important for us to have a vibrant solution in Europe as well as the United States. The two jurisdictions are at different points of the clearing mandate cycle, while the clearing mandate in the United States has passed already, and clearing of swaps is now business as usual, whereas in Europe we do not know for certain when clearing is going to begin. We are working with clients in Europe on the same consultative basis as we did in the United States, and we are doing everything we can to make the transition to clearing as easy as possible.
Hobson: What were the principal lessons of your American experience?
Callahan: The workload for clients to fully prepare for these changes is significant. It is realistic to assume, when clients go live with a major new protocol, that it is not going to be perfect from day one. That created opportunities for us, not only to help our clients get through the hiccoughs, but also to improve the process for them. Many of the enhancements and innovations that we delivered were based on direct client feedback.
Hobson: Give me some examples.
Callahan: As clients went live with SEFs, they realised that the traditional way of doing block trades and allocating across multiple funds did not work anymore, because they have to clear the block trade in real-time. So we set up a “bunched order” solution, by which clients can clear the block trade first, and allocate seamlessly after clearing.
Hobson: Anything else?
Callahan: When a trade goes into clearing, the attributes of the trade have to match exactly if you want to terminate your side of a trade to net down your book. But clients have found trades often fail to match exactly, especially in terms of small items such as day count conventions and accrual periods. So we created a unique netting identifier for each trade, based on its attributes. If you have two trades you expect to net down, you can see via the netting identifier whether those trades are eligible for netting. Clients wanted certainty over which trades can be netted, and the netting identifier gives it to them.
Hobson: Have you found any ways in which to help clients save on capital allocations?
Callahan: From a capital treatment perspective, there are efficiencies to be gained from having fewer line items and lower gross notional amounts in a clearing account, so we have enhanced our compression services. This summer we are launching a coupon blending solution, which will enable clients to reduce hundreds of line items to just two trades, without changing the cash flows or exposure of the portfolio. This will benefit clients that have a portfolio of swaps, each of which has the same attributes but trades at a different coupon.
Hobson: There was a lot of talk about savings in margin payments through portfolio margining of swaps and futures. Have you achieved any for clients?
Callahan: One of the key concerns for clients is the capital constraints they face, so we invested heavily in the tools and processes to make portfolio margining work, including building a margin optimiser tool that calculates the ideal futures to margin with the swaps. We worked with all participants and launched portfolio margining for house accounts in May 2012, and then expanded this for customers in early 2013.Eight clearing members are now live with the solution, and as a result of our collective efforts, we now have over 30 accounts benefiting from portfolio margining of swaps and futures. The aggregate savings in margin reductions are in the neighbourhood of $1.8 billion, and the average margin saving for a client is around 40 per cent.
Hobson: End-investors and regulators are also demanding greater protection of collateral. What have you been able to do?
Callahan: Clients certainly say this is a major priority. In the United States we work under a Legally Separate but Operationally Commingled (LSOC) regime, but we have sought to enhance that to protect excess collateral held by clients at clearing brokers. In Europe, we offer a choice of segregation and protection options, and in due course we will offer full segregation of individual client collateral. Even though the collateral segregation regime in each jurisdiction is governed by local laws and regulations, the underlying principle of delivering on increased customer protections is the same.
Hobson: Has investing in compliance left any room to invest in innovation?
Callahan: When we launched clearing of rates swaps in October 2010, the US dollar was our only currency. We now clear 18 currencies, including Mexican peso, and this is the broadest currency scope available globally. CME Clearing Europe is live already in ten currencies, and is in process of providing the same range of currencies as we do in the US.Clients like the option to clear in additional currencies, because they can reduce risk by adding offsetting trades to a portfolio, and increase levels of automation by processing a larger percentage of a portfolio via a single workflow.
Hobson: We have talked a lot about the buy-side. How do you keep the sell-side onboard?
Callahan: The innovations we develop must have clearing member support, so that clients can enjoy the full benefit of what we have to offer. We spend a great deal of time working hand in hand with clearing brokers to ensure that we deliver things that work for them, economically as well as operationally. In fact, the sell-side is the biggest beneficiary of some of the efficiencies we are delivering, such as compression via coupon blending, because it is the sell-side that pays the direct capital charges.
For further information, please contact:
Executive Director, OTC Products at CME Group.
+ 1 312 454 8312