Mandatory Centralised Clearing - Creating a liquidity crisis?

Mandatory centralised clearing Creating a liquidity crisis? Nicole Grootveld, Cardano John Wilson 25 March 2011

Dealers who are market makers tend to run well matched or ‘two-way’ books from an market risk exposure perspective and therefore have minimal net exposure subject to margining
Dealers largely impacted to the extent collateral agreements are ‘one-way’ i.e. client exempted from obligation to post collateral i.e Sovereign, supranational, agency –> liquidity risk for dealers
Pension funds, Mortgage banks and Car financing companies are examples of Buy-Side participants who use derivatives to hedge commercial financial risks. Hedging reduces overall economic risk albeit the ‘one-sided’ derivative position results in large derivative exposure subject to margining
Financial exposure is ‘matched’ and therefore systemic/economic risk is reduced however variation and initial margin based on a ‘one-sided’ derivative exposure -> liquidity risk for buy side
Liquidity Impact of Margining Buy-Side users of derivatives with “one way” positions impacted the most OTC Derivatives Market / CCP Scope Buy-Side Mortgage Bank Sell-Side Dealer fixed floating fixed floating fixed Pension Holders Buy-Side Pension Fund fixed Mortgage Holders

Liquidity Impact Central Clearing For example EUR 1 billion 30 year interest rate derivative & 1% rate increase Largest Impact Pension Fund will need to Post EUR 270 million in total margin Liquidity issue to the extent existing Asset not eligible for margining (cash vs bonds) Buy-Side Mortgage Bank CCP fixed floating fixed floating fixed Pension Holders Buy-Side Pension Fund fixed Mortgage Holders Variation Margin EUR 150 mln Variation Margin EUR 150 mln Initial Margin EUR 120 mln Initial Margin EUR 120 mln Day 1 Both counterparties must finance and post Initial Margin at moment of new trade execution

fixed floating fixed floating fixed Pension Holders fixed Mortgage Holders Liquidity Impact Central Clearing For example EUR 1 billion 30 year interest rate derivative & 1% rate decrease Largest Impact Mortgage Bank will need to finance an additional EUR 120 million in margin versus bilateral CSA margining Cost of financing this extra margin to be passed on to mortgage holders in form of higher mortgage rates Buy-Side Mortgage Bank CCP Buy-Side Pension Fund Initial Margin EUR 120 mln Initial Margin EUR 120 mln Variation Margin EUR 150 mln Variation Margin EUR 150 mln

Key concerns: Initial Margin Total Buy-Side impact analysis on Initial Margin has not been performed
Many buy side participants use derivatives as a hedging instrument and have a one sided derivative exposure (Pensions & Insurance Funds, Mortgage & Car Financing entities, etc)
Initial Margin requirements can represent a substantial portion of a fund’s value (10-15%)
Initial margin requirements can only be satisfied with a narrow range of eligible assets
The magnitude of initial margin would have multiple effects:
Removes substantial high grade collateral from markets impacting money/repo markets
Forces end-users to switch from high yield to high grade collateral, depressing investment returns which will negatively impact consumer savings and pension savings
Financial entities such as Mortgage & Car Financing entities that do not have eligible financial assets to post as collateral will have to finance Initial Margin requirements via borrowings and will pass the financing costs on to end consumers, effecting real economy

Primary concern: Variation Margin Cash Only Buy-Side participants do not have readily access to cash
Cash only Variation Margin is a significant issue for Buy-Side participants who tend to be fully invested. Cash is neither an effective liability matching or return-seeking asset.
Article 43 paragraph 1 of the draft EMIR Regulation states that margin is posted by means of highly liquid collateral with minimum credit and market risk; both cash and high quality government bonds meet this definition
Notwithstanding this, CCPs are restricting eligible collateral for Variation Margin to cash
Unless legislation explicitly stipulates that liquid non-cash collateral is also acceptable, Buy-Side participants will be forced to adopt one or more of the following strategies
hold higher amount of cash in asset portfolio
enter into expensive guaranteed liquidity arrangements
be exposed to having to quickly raise cash through asset sales in falling markets

Impact of a failure to access sufficient liquidity is immense. Failure to meet margin on intra-day movements may result in a illiquid 50 year interest rate swap hedge being closed out
The long duration and substantial size of pension liability hedges results in a very high interest rate sensitivity and therefore large and unpredictable margin calls
The margin contingency reserve will need to be significant, representing perhaps 20% to 25% of total assets which will be funded by a reduction in the allocation to return-seeking assets
The cost of maintaining a 25% allocation to cash:
25% * (4.0% p.a. - 0.5% p.a.) = 0.8% p.a.
Expressed in terms of immediate impact on funding level: expected return loss of 0.8% p.a. would is equivalent to a reduction in funding level of c. 16% (20 yrs duration x 0.8% p.a.)
Whilst liquidity is available in “normal” times, pension funds must plan for liquidity tail events given the enormity of the consequences and the inadequacy of current liquidity solutions
Primary concern: Variation Margin Cash Only Pension Fund example: Liquidity has a high cost to be borne by pensioners Assumes cash return of c. 0.5% and yield on longer-dated governments bonds of c. 4.0%

Forced to liquidate long term asset positions to meet margin calls related to short term volatility in markets or borrow cash under already stressed market conditions
In August 2010 long term interest rates fell 80 bps. Pension funds with robust liability hedging received collateral in the magnitude of approx. 10% of notional in one month
Assuming the combined UK/NL pension industry has EUR 500 billion in derivative notional this translates to EUR 50 billion one month movement
The systemic risk aspects of liquidity management are not to be underestimated. Many Buy-side participants have insufficient skills and infrastructure to manage it effectively. Open interest in OTC derivative markets not comparable to future markets in terms of magnitude of margining. Primary concern: Variation Margin Cash Only Raising cash in volatile/stressed markets

Primary concern: Variation Margin Cash Only The counter argument…Clearing Members will provide access to liquidity
Clearing members, custodians are all keen to provide liquidity / repo services to assist the buy-side in meeting their (intraday) margin obligations... for a fee...
Such services are not in itself an adequate solution for liquidity management:
Counterparty Risk : The OTC counterparty exposure will be replaced with repo counterparty exposure to the same banks. Intra-day margin liquidity lines require over-collateralisation of CCP margins with clearing members. Both conflict with the whole objective of the EMIR to reduce counterparty exposure and systemic risk.
Refinancing Risk : Liability hedging swaps have terms up to 50 years whilst liquidity in the repo market is concentrated in terms 3 months or less. The refinancing risk inherent in repos combined with the finite size of the repo market implies that the entire buy-sdie industry cannot rely on the repo market as its primary source of liquidity, especially in distressed markets
Operational Risk: Repo is not a natural activity for most buy-side participants and especially smaller funds do not have the required knowledge and infrastructure
Most solutions offer liquidity under normal market conditions and not guaranteed liquidity under stressed market conditions – buyer beware!

Non-cash VM options
Current “Market” Model:
Pension Fund custodian
Pension Fund clearing member
Market [repo market for short-term liquidity or longer-term liquidity via sale of non-cash investments]
One-way CSA This option assumes that counterparties that are out-of-the-money collateralise their losses with the CCP, which does not re-distribute the collateral to “in-the-money” counterparties. Similar to Sovereign CSAs, this model permits the use of non-cash, but dramatically changes swap pricing.
Central Bank Discount Window This is the most straight forward yet political challenging option, which envisages wider access to a Central Bank Discount Window to ensure guaranteed liquidity to the wider market, rather than simply banks. This model is operating on a restricted basis in certain countries including the USA for money market funds and Eurex in Germany is able to access Central Bank liquidity. This option may be required for the Asymmetric model too but restricted to the CCP.
Continued…..

Non-cash VM options
Continued…..
Asymmetric CSA model: Clients/Clearing Members determine a default method of providing cash or non-cash to settle their VM for each CCP account, with the latter being restricted to sovereign debt in the currency of the underlying transactions. Recipients of VM are paid in cash, with the CCP arranging for the conversion of non-cash to cash collateral
Symmetric CSA model: Clients and Clearing Members determine a default of providing cash or non-cash to settle their VM, with the latter being restricted to sovereign debt in the currency of the underlying transactions. Recipients of VM may be settled in cash or non-cash at the CCP election i.e. CSA terms are symmetrical to payers and receivers.

A [Stock] B [Stock] C [Cash] CM1 CCP CM2 X Y Z “ Out of the Money” Counterparties “ In the Money” Counterparties CM3
[End-user accounts] are set to be either cash or stock payers at the CCP
CCP generates calls knowing what form of collateral will be received based on the account default, but does not know exact ISIN
CM1 generates calls knowing what form of collateral will be received based on the account default, but does not know exact ISIN
CM1 is required to satisfy the calls within 1 hour on the basis of the account defaults, notwithstanding that the end-users may not have settled their calls and hence furnished requisite assets
CCP enters into repo transactions to convert the non-cash collateral to cash via a) repo market b) discount window in emergency
End-users meet their calls to CM1
CCP satisfies cash calls to CM2 and CM3 in cash
CM2 and CM3 pay their end-users
(1) (1) (1) (2) (2) (2) (3) (3) (3) (4) (4) (4) (5b) (5a) (6) (6) (6) (7) (7) (8) (8) (8) Repo Market Central Bank Asymmetric CSA Model

Pros
In the Money counterparties continue to receive cash as today, hence avoiding disruption to swap market and swap pricing
Costs of providing non-cash VM can be directly passed back to end-users availing of the facility
CCP knows in advance what collateral inflows are to be expected that can be pre-positioned to generate requisite liquidity
End-users have ability to provide non-cash collateral at all times
Participants are impeded from “arbitraging” by having to nominate the account as paying stock or cash upfront
Cons/Issues
CCP is a point of concentration for accessing the repo market liquidity, whereas the current model is distributed
CCP needs a substantial repo function to be able to support the gross OTM amounts at the CCP
Model is wholly dependent upon central bank support in a time of stress
CMs need to have available non-cash assets to meet end-user calls ahead of end-user deliveries, which may force them to use the repo market
As an OTM position reduces, the CCP needs the ability to return original stock, which adds a complication to the process
When coupons are due, end-users are likely to wish to substitute assets to avoid tax issues but retrieving these along the chain will be complex
Asymmetric CSA Model

A [Stock] B [Stock] C [Cash] CM1 CCP CM2 X Y Z “ Out of the Money” Counterparties “ In the Money” Counterparties CM3
[End-user accounts] are set to be either cash or stock payers at the CCP
CCP generates calls knowing what form of collateral will be received based on the account default, but does not know exact ISIN
CM1 generates calls knowing what form of collateral will be received based on the account default, but does not know exact ISIN
CM1 is required to satisfy the calls within 1 hour on the basis of the account defaults, notwithstanding that the end-users may not have settled their calls and hence furnished requisite assets
End-users meet their calls to CM1
CCP satisfies calls to CM2 and CM3 with cash and/or stock at its’ discretion
CM2 and CM3 pay their end-users
(1) (1) (1) (2) (2) (2) (3) (3) (3) (4) (4) (4) (5) (5) (5) (6) (6) (7) (7) (7) (6) Symmetric CSA Model

Pros
CCP continues to act as a pass-through of collateral
CCP knows in advance what collateral inflows are to be expected for the purposes of allocating assets for collateral outflows
End-users have ability to provide non-cash collateral at all times
Participants are impeded from “arbitraging” by having to nominate the account as paying stock or cash
Cons/Issues
Requires an overhaul of the cleared swap market to move to a consistent CSA featuring cash and non-cash collateral, which will impact swap pricing
CMs need to have available non-cash assets to meet end-user calls, which may force them to use the repo market
As an OTM position reduces, the CCP needs the ability to return original stock, which adds a complication. Likewise, as an ITM position reduces, so will the party be required to return the same assets?
When coupons are due, end-users are likely to wish to substitute assets to avoid tax issues but retrieving these along the chain will be complex
Merely shifts the liquidity problem as recipients of non-cash collateral may need to generate cash
Symmetric CSA Model

Big Bang Implementation of EMIR? Not prudent given that the impact on liquidity is not known
Whilst opposed by MEPs, EU Commission and Council of Ministers is still contemplating backloading of a subset of existing positions. This would have immediate liquidity consequences via initial and variation margin requirements
Staggered implementation for both products and participants will ensure that market impact, operational impact and liquidity constraints are better understood
Market fragmentation needs to be avoided through natural groupings of products (e.g. interest and inflation swaps) to be fully introduced
Provides more time for margin rules to be adapted to more fairly reflect contribution to systemic risk
Regulatory reporting and transparency should remain a priority
Reduction in credit, liquidity and operational risks need to be considered holistically

Liquidity Management What can Buy-Side participants do to prepare themselves?
Establish liquidity management process parallel to derivative execution process to ensure Initial Margin is available on Day 1 and impact on variation margin in known in advance
Understand the margin requirements on your derivatives portfolio but performing scenario analysis assuming both stable and stressed market conditions
Understand the risk of a failed margin call on derivatives portfolio and understand when positions will be closed out and the market risk impact on the economic position
Create an internal liquidity management plan that spreads liquidity financing across alternative sources and understand the stability of that source under stressed market conditions
Ensure cash holdings or access to cash is sufficient to meet liquidity under stressed market conditions -> think in terms of guaranteed liquidity
Create clear internal processes/escalation plans (i.e. Pre agreed asset sale categories) for when clearing member calls stating “your margin account is short of funds……”

Liquidity Management What can Buy-Side participants do to limit the impact of liquidity?
More lobbying of governments to understand the needs of the buy-side and more education on the impact of the new legislation on liquidity and onward costs to economy
More education on buy-side use of derivatives to the benefits on small consumers and how these stakeholders will be impacted by the new legislation
More lobbying to CCPs and CM to design more flexible solutions for meeting the needs of the buy-side instead of forcing a bank focused futures model on buy side participants

Questions & Answers

Contact Information
John Wilson
[email_address]
+44 78 5054 3065
http://www.linkedin.com/in/johndwilson
Twitter: @cdsclearing @irsclearing @otcclearing @fxclearing @clientclearing @otcderivatives
Nicole Grootveld Cardano [email_address] +31 10 243 4324 http://www.cardano.com

This presentation is meant for instistutional investors only
The information contained herein reflects, as of the date hereof, the views of Cardano Risk Management BV (“Cardano”) and sources believed by Cardano te be reliable. No representation or warrantly is made concerning the accuracy of any data compiled herein. In addition, there can be no guarantee that any projection, forecast or opinion in these materials will be realised.
The views expressed herein may change at any time subsequent to the date of issue hereof.
No information contained herein may be construed as any sales or marketing materials in respect of any financial instrument, product or service sponsored or provided by Cardano or any affiliate or agent thereof.
References to specific securities are presented solely in the context of industry analysis and are not te be considered recommendations by Cardano
Cardano and its affiliates may have positiens in, and may effect transactions in the marktes, industry sectors and companies described herein.
This presentation is not an advertisment and is not intended for public use or addional distribution
Cardano Disclaimer © 2011 Cardano Risk Management B.V.

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Mandatory Centralised Clearing - Creating a liquidity crisis?

by johndwilson on May 10, 2011

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Mandatory Centralised Clearing - Creating a liquidity crisis? Presentation Transcript