Moving onto clearing: Hedge funds entering into unchartered territory
Assessing the potential impact central counterparty clearing (CCP) will have on hedge fund operations is a bit like stepping into the unknown. As things stand, the regulatory authorities in both the US and European Union (EU) are formulating the policies which look set to govern how over-the-counter (OTC) derivatives are cleared. However, both sides have yet to set the requirements in stone.
The US Securities and Exchange Commission (SEC) has until summer 2011 to come up with the rules as mandated by the Dodd Frank Wall Street Reform and Consumer Protection Act earlier this year. The European Commission is also still in the process of drafting the European Markets Infrastructure Regulation (EMIR) – this is something that looks likely to take time to come into place. One thing is certain, central counterparty clearing houses are going to have an elevated importance in trading processes.
Participating in a CCP does have fundamental advantages especially for major hedge funds. Firstly, it is highly unlikely a CCP will fail providing that they are operated well and monitored effectively by the regulators. The risk of a CCP going bust is minimal as long as it maintains a sound legal framework ensuring certainty that its netting arrangements cannot be challenged, its right to collateral is undoubted and it has an absolute ability to realise all security held. Furthermore it must ensure it has sound risk management practices and that the level of collateral it calls is sufficient.
Providing all these criteria are met, a CCPs security against failing should be guaranteed by its six lines of defence against a counterparty default – these six lines are netting arrangements, membership requirements, margin requirements (initial and variation) and guarantee requirements for members – all of which are continuously appraised and acted upon to ensure the CCP is always in a safe position to deal with any anticipated or unexpected risk. This is best illustrated with LCH Clearnet’s excellent handling of the Lehman Brothers default in autumn 2008 whereby it managed down the risk in several weeks using up approximately 35% of its margins.
So in these uncertain times, how should hedge funds approach these imminent but unknown regulatory changes? First and foremost, hedge funds are unlikely to become full clearing members - their prime broker (or agent bank) will though. Therefore, hedge funds are likely to be indirect members of clearing houses through their relationship with the prime broker or agent bank.
“When I see our clients, I tell them that clearing will be up and running by 2012,” says Martin Higgs, senior vice president of derivatives and collateral product management for Europe, the Middle East and Africa at State Street Bank & Trust. “However, I also say that it is not necessary for them to choose a clearing member just yet because the regulations have not been finalised,” he adds.
Experts predict that more than 70% of OTC derivatives will be put onto clearing in the foreseeable future. Assets that are not cleared via a CCP will be subject to added capital requirements although the details or timing of any regulations in this area is unknown.
Clearing such a large proportion of OTC derivatives could prove problematic for smaller hedge funds as prime brokers offset the costs to these entities. These costs are likely to be exacerbated by the significant declines in assets under management many hedge funds have experienced since 2008. More hedge funds now fall into a smaller size bracket following a sharp drop in assets under management, from a peak of $1.9 trillion in January 2008 to $1.65 trillion in the second quarter of 2010, according to data from Hedge Fund Research. It could be argued that larger hedge funds too could be impacted as the assets they hold are unlikely to be acceptable as collateral by the clearing houses and therefore they would need to arrange collateral swaps with their clearing broker. In addition, they may have issues with their administrators who are liable for losses of assets under the new regulations.
Simon Grensted, managing director of business development at LCH Clearnet, believes the fees hedge funds will pay for these services are difficult to quantify because the costs consist of many components and are different for each one. Nevertheless, he emphasises there has been a lot of interest among fund managers about clearing recently. “We are speaking to a variety of buy-side market participants wishing to use OTC clearing. Many hedge funds are interested in clearing services and need to consider the benefits that are associated with clearing,” says Grensted.
Hedge funds of all sizes will be required to sign multiple legal agreements and pay initial and variation margins to their clearing member. This, acknowledges Higgs who is an ardent supporter of CCPs, is somewhat misguided. “Is it worthwhile forcing small funds, either hedge funds or investment or pension funds with one interest rate swap for hedging purposes into central clearing? What harm is that fund going to cause the industry? That fund will need to sign multiple legal agreements and pay initial and variation margins. Most funds are too small for this.”
Grensted agrees that there may be little point in small hedge funds being part of CCPs as members because there are many obligations and requirements that are different at each CCP. The process would be more efficient if they used a third party clearing member.
From a regulatory perspective there is little systemic risk from the default of small funds. However, some legislators have made exceptions already for corporate entities hedging business risks but it appears regulators are wary of extending this to hedge funds just because they may be small in size.
But at what size is it appropriate for a fund to indirectly use a CCP? This is the difficult question facing the regulators which they need to confront. Higgs believes only the larger players or market movers need to be indirect clearing members and that a threshold should be applied for the financial players similar to the non-financial players. He adds the benefits of a large hedge fund with a high number of transactions participating in a CCP would be significant, particularly as it will reduce operational risk. “It will, however, leave the smaller funds with difficult choices on how they can efficiently participate in the derivatives market," he adds.
One unintended consequence of these rules could be a sharp reduction in hedging – something that could lead to increased risks in other areas of the market.
It isn’t only the smaller funds that will be impacted but also those firms which have portfolios containing a large number of structured derivatives – these are products that are generally not meant to be cleared. However, it is becoming abundantly clear that the majority of vanilla products will end up in clearing houses – in time, perhaps some of the more exotic products may join them.
“There are some products that cannot be cleared. Funds with highly structured portfolios with a lot of hedging with vanilla products or those where they have an end user strategy whereby they have put together a single structure for their clients will suffer. Hedge funds might have many trades going through clearing and a rump still being done bilaterally because those trades won’t ever be able to go through clearing. These might include some single name CDSs, exotic options and more complex interest rate swaps, for example,” comments Higgs.
Funds will undoubtedly be hit by the cost of having to trade through clearing and bilaterally simultaneously. Again, this is something that will disproportionately hit the smaller alternative asset managers. “Most funds will have somewhere between five and ten counterparties. Vanilla trades with those counterparties will be sent to clearing but they will still have ten collateral agreements for the bilateral trades. The common perception is that CCPs are fantastic and this is true – I do support the concept of CCPs but only for the right products and participants. There are some things that cannot be cleared and it will cause problems for parts of the industry,” says Higgs.
Not only will funds be confronted by higher trading costs but many are going to have to re-jig their operational due diligence practices to cope with the new requirements. “If the prime broker is a clearing member, then hedge funds will need to undertake a lot more operational due diligence,” he comments. “The hedge funds will need to do this to fully understand the relationship their prime broker or clearing member has with the clearing house and how their initial and variation margin is being treated for example,” adds Higgs.
However, Grensted believes not only hedge funds but clearing houses will also be hit with the additional workload. “Clearing houses, clearing members and non-clearing members all have to implement new aspects to their services driven by the new and still emerging OTC clearing rules. It is a lot of work.” says Grensted.
While US and EU legislation detailing the precise rules determining what needs to be cleared and how is still up in the air, hedge funds need to be aware of what is going on. They need to prepare for the legislation although they need not rush into choosing a clearing member until the rules are finalised. Despite the uncertainty, hedge funds are going to be affected by the incoming regulation -that is definite. Over time, some funds may need to completely rethink their trading strategies and move away from using derivatives if the cost of moving into central clearing becomes prohibitively expensive. Perhaps this is what regulators and politicians are looking for after all?