CCPs and their implications for the buy-side: Interview with Jon Hitchon, head of Deutsche Bank Market Clearing
Central counterparty (CCP) clearing houses, without doubt, look set to become one of – if not the – most systemically important financial institutions (SIFIs) in the marketplace once clearing reforms are implemented next year under the US Dodd Frank Act and the European Markets Infrastructure Reform (EMIR). COO Connect Editorial speaks to Jon Hitchon, head of Deutsche Bank Market Clearing about the implications mandatory clearing will have on the buy-side.
“There are a lot of challenges which the buy-side needs to confront,” acknowledges Hitchon. Under the reforms, experts anticipate between 60% and 70% of vanilla OTC derivatives will be forced onto clearing. The Markets in Financial Instruments Directive II (MiFID II) consultation even suggested banning CCP-eligible trades, which CCPs refused to clear – such a proposal would certainly pose a dilemma for CCPs although most market commentators expect this suggestion will be quietly dropped. “Nevertheless, the existing bilateral trading relationships hedge funds have are certainly moving towards clearing and electronic CLOB and RFQ environments,” he stresses.
The proposed regulation is a major overhaul and questions still remain as to whether buy-side market participants are adequately prepared. “The level of preparedness depends on the client. There are a lot of big institutional money managers out there who have taken a very proactive approach ahead of the deadlines because they have got the resources, operational infrastructure, staff and technology to cope with these changes. Hedge funds are well prepared too on the whole although there is a lot of documentation that they need to review and provide to investors. There is a lot of legal documentation which will identify what is eligible for clearing, which hedge funds need to get in place. Furthermore, hedge funds will need to make changes to their systems and integrate their systems to be line with clearing members and futures commissions merchants (FCMs),” says Hitchon.
There have been concerns that some hedge funds could face a last minute scramble to find a clearing member – such a scenario would be unwelcome although Hitchon believes most managers are ahead of the game. Some have urged regulators to exempt smaller managers from clearing – earlier, this year, the EU exempted pension funds from clearing for three years. However, this could lead to regulatory arbitrage and general confusion. “It will be a challenge for smaller hedge funds, especially with the registration and reporting requirements associated with Dodd Frank. However, regulators need to adopt a consistent approach with clearing,” he says. Optimists have acknowledged some hedge funds might make long-term operational savings by using CCPs as they will reduce the number of prime brokerage and counterparty relationships they have. But hedge funds will undoubtedly face major operational challenges getting their infrastructure in place to meet these new requirements. Yet these are not the only challenges.
CCPs’ raison d’être is to bolster risk management. CCPs’ security against failure is guaranteed by six lines of defence against a counterparty default – these are netting arrangements, membership requirements, initial and variation margin requirements and guarantee requirements for members – all of which are continually appraised. It is these collateral requirements, which could pose a challenge to the buy-side with TABB Group estimating CCPs’ initial margin requirements could cost OTC derivatives participants up to $1.4 trillion over the next three to five years. Eligible collateral must be high-quality – either government bonds or cash. Corporate bonds are considered too risky. However, there have been reports that some CCPs are competing on margin requirements. “There have been mumblings about this but firms like Deutsche Bank sit on the risk committees of CCPs so there are checks and balances. Regulators like the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) will also be keeping a close eye on CCP practices. Despite this, the need to make a profit will always be an issue,” say Hitchon.
Providing CCPs maintain their strict risk management criteria, many buy-side firms will struggle to obtain eligible collateral – most buy-side institutions do not have cash or government bonds at hand. A recent survey by technology provider Algorithmics, now part of IBM, revealed 55% of buy-side respondents would like to use equities as eligible collateral while 32% wanted to use shares of funds. The challenge doesn’t end there. CCPs, during periods of intense market volatility, can demand margin calls up to six or even seven times per day. Some 54% of buy-side firms said they only made weekly margin calls. “The margin requirements are going to be incredibly costly for the end users. Not only that but clearing fees and prime brokerage charges will also add on,” he acknowledges. However, firms like Deutsche Bank, will be able to offer collateral transformation upgrade services whereby ineligible collateral is made eligible for clearing in exchange for a fee. “It is important for us that clients have the wherewithal to produce collateral for initial and variation margin. It is inevitable that some products like equities will not be eligible for clearing but we will lend clients money on a case by case basis to help them meet their collateral requirements. This lending will of course depend on the creditworthiness of the client. Deutsche Bank is a market leading bank with a sophisticated and carefully risk-managed collateral transformation upgrade service. There are going to be six or seven banks which will dominate this space going forward,” adds Hitchon.
It is these collateral requirements and other lines of security that help guarantee a CCPs solvency in the event of severe market volatility. Speak to most CCPs and they will state these risk management procedures will prevent a clearing house default. LCH Clearnet, for example, successfully wound down the Lehman Brothers default using up a 1/3 of its initial margin. The $750 billion Lehman default was the biggest bankruptcy in US history although this should not lead to hubris or complacency. “CCPs have failed in the past and it would be wrong to suggest CCPs could survive a truly, black-swan, Armageddon event. If there is a massive counterparty default and a host of clearing members are unable to meet collateral calls, that could be a problem,” rues Hitchon. Hitchon’s comments are certainly not reactionary. History has shown us several times that CCPs can and have defaulted. The Paris-based Caisse de Liquidation des Affaires en Marchandises (CLAM), the sugar market’s clearing house, collapsed in 1974 following a period of “rampant speculation on world sugar markets” whereby white sugar prices quadrupled in the first 11 months of the year. Many traders were unable to meet their margin calls forcing CLAM to close. In 1983, the then newly established Kuala Lumpur Commodity Clearing House (KLCCH) in Malaysia failed following a $70 million default by six brokers trading palm oil contracts on the Kuala Lumpur Stock Exchange. “CCPs nevertheless are a risk mitigator providing they can meet their collateral requirements. They ultimately do reduce systemic risk,” highlights Hitchon.
It is clearly evident the shift towards clearing will require time, money, effort and resolve for a broad array of asset managers, real money accounts and hedge funds. But what are firms like Deutsche Bank doing to make the transition for their clients that much easier? “The most important thing we have done in the run-up to mandatory clearing is to consult our clients about what the whole process means for them. We have been adopting a collaborative approach and educating them about the operational challenges they may face. It is important to take a proactive approach,” says Hitchon.