Clearing for the buy-side
As the market in Europe prepares for the commencement of mandatory clearing, new clearing structures are being devised by CCPs (central counterparty clearinghouses) to make the process smoother, more cost efficient and, perhaps most pertinently, more collateral efficient for clients.
With increased demands being placed upon collateral, collateral management and optimisation has never been more important. Being able to source the right collateral at the right time is vital.
With CCPs increasingly becoming the central guardians to the future safety and smooth running of financial markets acting as buyers to ever seller and sellers to every buyer, they are treading a fine line between competitive necessities and regulatory imperatives.
On the one hand this is a competitive landscape, therefore, attracting business to your clearinghouse is essential. On the other, ensuring that the right amount of acceptable collateral is gathered to margin against the trading risks of the clients is equally as important in fulfilling the regulatory mandate laid out before them.
The buy-side has come sharply into focus in the recent clearing debate. How will funds access central clearing and how can they do this most efficiently? Two of Europe’s largest clearinghouses are undertaking initiatives to address this. LCH is planning to launch a new client account structure, CustodialSeg, and Eurex has recently announced a new clearing model aimed directly at the buy-side, ISA Direct.
“We’ve developed CustodialSeg as a result of our collaboration with the buy-side across Europe, and with our clearing members and custodians,” says Richard Pearce, director, SwapClear Product, LCH. “EMIR (the European Market Infrastructure Regulation) sets certain standards for account types, but the buy-side and our clearing members have additional constraints. We are, therefore, trying to incorporate a broader set of requirements than those just defined from a regulatory perspective.”
The CCPs are having to think outside the box.
One of the regulatory hurdles that these new models have in common is the easing of one key regulatory goal in the central clearing framework, that of porting. This is the notion that, if a client’s clearing member goes into default, the client can simply port its book of business to another, backup, clearing member and continue accessing clearing functionality in the same way. It’s a nice idea in theory.
“What if porting doesn’t happen?” asked Mathias Graulich, chief client officer at Eurex, at a launch event for ISA Direct. “If a large pension fund cannot port to another clearing member, then all of its positions and collateral would have to be liquidated, adding further stress to what would already be a stressed market. This is a scenario that needs to be avoided.”
Both the LCH and Eurex models would ease porting in the event that it is needed, since the clients will be able to post their collateral directly with the CCP. This removes any transit risk for the client, since they are not exposed to the possibility of the clearing member going into default during the processing and delivery of collateral.
“The ability to deliver collateral directly to the CCP means that the client can maintain their level of collateral at LCH, even if their clearing member goes into default,” explains Pearce. “That offers the client a significant advantage in trying to secure a port to a backup clearing member. It provides an extra layer of control if their account at the CCP remains fully collateralised.”
Graulich is equally optimistic about the porting opportunities under a direct collateral arrangement. “Without huge collateral constraints, it significantly increases the likelihood of porting,” he says. “It also creates new business opportunities, since the relaxed collateral consumption means that clients can appropriate their securities for use elsewhere.”
LCH’s model operates on a tri-party arrangement between the client, the CCP and the custodian bank, Euroclear. As securities are posted at LCH directly by the client, within full view of Euroclear, it means that collateral substitutions can be performed rapidly, also opening up new business opportunities whereby the client can swap collateral around for optimum use elsewhere.
“If the client wants to substitute specific collateral out for use elsewhere, Euroclear can simply replace it with other eligible collateral,” says Gerard Smith director, Collateral Services at LCH. “This process can now be done in a matter of minutes. This is a clear operational benefit of working in a tri-party collateral arrangement. This streamlining also carries benefits for the clearing member, as they are no longer handling all of the requests to move collateral backwards and forwards.”
Tri-party collateral arrangement
“The current models that we have involve a transit of securities from the client delivered by their custodian, to the clearing member, then on to LCH,” explains Gerard Smith. “There are a few differences in the CustodialSeg model that are beneficial to both the client and the clearing member. The movement of assets will be from the client’s custodian to us directly with Euroclear bank acting as a tri-party agent.
“Tri-party collateral management is one of the potential benefits here. Euroclear sits between a giver and a taker of collateral, LCH being a taker to cover margining requirements. There are three parties; LCH, the client and the tri-party agent, in this case Euroclear. Effectively, what we are doing is outsourcing the collateral management and optimisation functionality to Euroclear. Each party enters a transaction into Euroclear for an amount of the securities.
“We could say, for example, that a client is going to deliver £300 million of eligible collateral. The tri-party model means that they do not have to select which individual securities they want to deliver and then deliver them line-by-line. We tell the tri-party agent what LCH accepts as eligible collateral. They can then set up that schedule between LCH and the client.
“Euroclear will then look into the client’s account to select the available collateral that can be delivered. All we have to do is match on the amount that needs to be delivered. Clients can also order the collateral with Euroclear, in terms of what they would prefer to provide i.e., optimise from their available inventory.”
The operational role of the clearing member is a little further removed from the traditional clearing models, whereby clients access a CCP through a clearing member or clearing broker. The clearing member or broker, however, still has risk management functions to fulfil and remains responsible for default fund contributions and margin calls on its clients. The CCPs will still be conducting operations in this way under their new models.
“The operational transit of the collateral bypasses the clearing broker,” says Pearce. “The clearing broker’s role, however, remains the same; they are managing the risk of the client. This means that they need to retain control over how much and what collateral is being delivered.
“What we have enabled is that the transit of the collateral can be direct, but the clearing member retains all of the controls that they need to manage the risk of the client. All margin calls, for example, would be done through the clearing member, as would contributions to the default fund. All that CustodialSeg changes is the operational flow of collateral from client to CCP.”
Another change to the flow of collateral from client to CCP, under both the LCH and Eurex models, is that securities will not be subject to a full title transfer, as they are under more traditional models. This means that the client will not lose beneficial ownership of the securities – a far more comfortable arrangement for buy-side clients.
It is clear that CCPs are improvising in response to client demand as the central clearing mandate approaches. Flexibility in account models and structures will be more attractive to buy-side clients and will, therefore, result in more business for the CCP.
“We are trying to make things more cost efficient for the buy-side,” asserts Graulich. “We are trying to make this business attractive again.”