The operational & liquidity implications of CCPs


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The operational & liquidity implications of CCPs

  1. 1. Investigating the Operational & Liquidity Impact of CCPs<br />John Wilson<br />Former Global Head of OTC Clearing <br />at RBS Global Banking & Markets<br />
  2. 2. Agenda<br />The context of change<br />Trade processing<br />Collateral management<br />The liquidity challenge<br />2<br />
  3. 3. Regulatory Pipeline Overview<br />Not exhaustive, just exhausting!<br />Equity Market Infrastructure<br />Securities Directive<br />OTC Derivatives – Trading Platforms<br />Interest Rate Risk – Banking Book<br />OTC – Infrastructure<br />Non Equities Price Transparency<br />Short Selling<br />Fundamental review of trading book<br />Securitisations<br />Market Abuse<br />OTC – Capital<br />Market Risk<br />US Banking Reform<br />External Credit Ratings<br />LargeExposures<br />FSA liquidity framework<br />Leverage<br />Structural Separation <br />Capital<br />Remuneration<br />UK Bank levy<br />Resolution<br />Systemic Banks<br />Cross-border funding restrictions<br />IGL restrictions<br />Recovery<br />EU Bank Levy<br />Supervisory Architecture<br />Basel Liquidity<br />EU Crisis Management<br />Procyclicality<br />Regulations in final stage of policy setting – Actual impact and mitigation numbers, appropriate external engagement<br />Regulations in early stages of policy setting – Impact and mitigation, Initial steps in external engagement<br />Regulations in early stages of discussion or not yet identified – Regulatory Intelligence<br />
  4. 4. 4<br />CCPs – The Financial “Nuclear Power” Station<br />
  5. 5. The “Elephant in the Room”<br />5<br />
  6. 6. Assessing the impact of EMIR<br />Huge uncertainty exists at present<br />Product & Participant scope<br />Segregation requirement [CCP and method]<br />Capital requirements [for cleared v bilateral trades; for providing clearing services]<br />Costs for banks and end users<br />Time to implement [“phase-in”]<br />Historic trades [“front loading”]<br />Bilateral risk impact<br />Impact on pricing and liquidity fragmentation<br />Role of ESMA<br />Liquidity impact [CCP will hold between $1.5tn - $2tn collateral]<br />Buy-side impact<br />Costs<br />Liquidity & Collateral Management<br />Operational and infrastructure changes<br />
  7. 7. Different US and EU legislation on derivatives<br />US and EU are heading in broadly similar direction with inconsistencies<br />US process is faster and currently broader<br />Clearing<br />Bilateral activity<br />Trading<br />Transparency<br />Push-out<br />Liquidity impact of US reforms eg Repo restrictions<br />Strong indications of extra-territorial intent<br />SEC trade reporting<br />Non-US firms ensnared under Dodd-Frank as Dealers and Major Swap Participants<br />Only US regulated firms may offering clearing in US CCPs, regardless of MOUs with overseas regulators<br />Non-US CCPs require US regulatory approval if US firms are to use them<br />EU MEPs are citing “smart protectionism”<br />US Clients may only access CCPs anywhere in the world via US domiciled Futures CommissionsMerchants<br /><ul><li>Potential for regulatory arbitrage and fragmentation given timing differences between US and EU</li></li></ul><li>The business case for clearing<br />Benefits<br />Costs<br /> Capital charge reductions<br /> [Probable] execution price improvements<br /> [Likely] Reduction in credit and replacement exposures<br /> [Probably] Frees up credit limits<br /> [Likely] Administrative ease<br />Netting<br />Collateral management<br />Trading relationships relatively unaffected<br /> Clearing fees<br />Clearing House<br />Clearing Broker<br /> Collateral drag<br />Weak returns on collateral<br />Magnitude of initial margin<br />Asset immobilisation<br />Funding costs<br />Infrastructure<br />Technology<br />Collateral management<br />The regulations demand significant change <br />throughout the organisation and the transaction lifecycle<br />
  8. 8. Evolve or wither – The execution challenge<br />Execution liquidity will fragment across venues and multiple CCPs will exacerbate this<br />Differential pricing will quickly emerge between cleared v non-cleared trades AND between different CCPs to reflect the economics<br />Collateral implications needed to be embedded in trading but considered across the firms/desks<br />Eligible collateral requirements and magnitude<br />Availability of required collateral within inventory or costs of sourcing<br />Trade-off with solvency & liquidity regulatory demands<br />Essential to also evaluate capital impact of achieving economic exposures via deal structure options eg standardised [“cleared”] v bespoke [“non-cleared”] trade<br />Such considerations demand <br />the requisite data to enable measurement of alternatives [“what if”] and actual outcomes, considering all relevant costs including liquidity<br />an organisation structure to pro-actively manage such issues<br />9<br />
  9. 9. Trade processing issues<br />Restriction on dealing counterparties / possible need to trade on “Exchange / SEF” if product and firm is part of clearing obligation<br />Identifying the Clearing Broker at time of execution [SwapClear]<br />Single Clearing Broker per block trade [ICE, SwapClear]<br />Partially cleared trades<br />Trades failing to clear – fallback procedure<br />CCP opening hours<br />Risk bookings<br />Offsetting trades v unwinds<br />Upfront fees<br />Best execution consideration<br />Trade and transaction reporting requirements<br />
  10. 10. Collateral management for cleared trades<br />Clearing Houses<br />Clearing Members<br />Clearing House calls need to be settled by clearing members usually within one hour, with some Clearing Houses operating regular intra-day calls<br />All Clearing Houses have the ability to make ad-hoc intra-day calls on members<br />Variation Margin needs to be settled in cash<br />Restricted list of eligible collateral<br />Returns on collateral set by the Clearing House<br />Client collateral segregated from that of clearing members<br />Timing of call settlement agreed bilaterally between clearing member and client<br />In advance<br />Intra-day<br />Next day<br />Clearing member may retain ability to make ad-hoc calls synchronised with Clearing House<br />Variation margin may be settled on a basis agreed with the clearing broker<br />List of eligible collateral agreed bilaterally with the clearing broker, unless restricted by regulation<br />Returns on collateral agreed bilaterally<br />Clearing member may operate margin add-ons and higher collateral haircuts that the Clearing House<br />Collateral not held at the Clearing House is not necessarily covered by protections<br />
  11. 11. Bilateral Collateral Management<br />New Regulations around Clearing will <br />break-up existing netting sets, thus increasing exposures and hence collateral required across cleared and non-cleared positions<br />demand collateralisation of all non-cleared trades for some counterparties on terms that may be specified by regulators<br />be likely to impose initial margin on bilateral trades<br />There will be material pressures to re-construct netting sets under “cross-entity”, “cross-margin” and intermediation arrangements with Clearing/Prime Brokers for capital efficiency<br />Impact on counterparty exposure management<br />Legal certainty<br />Funding costs<br />Existing bilateral collateral infrastructure will persist but may be obliged to be more effective per regulatory demands<br />
  12. 12. Effective collateral management<br />Key factors<br />Upgrading the collateral function from being a clerical to an optimisation and trading function<br />Active measurement and management of collateral returns, including electronic codification of CSA terms<br />Eliminating latency in collateral movements eg later cut-offs, automated instruction, real-time movement reconciliation<br />Seamless integration between settlement and collateral activities<br />It may be necessary to evaluate whether you have the skills/mass to perform collateral in-house or outsource<br />
  13. 13. Current liquidity position…Liquidity impact is highest for Buy Side with one sided derivative exposure <br />Broker-dealers benefit significantly from multi-lateral netting and tend to run well matched books from a exposure perspective – resulting in relatively low initial and variation margin<br />Pension funds use derivatives to hedge; the liabilities on the ‘other side of the transaction’ are not cleared<br />Financial exposure is ‘matched’ but variation and initial margin based on a ‘one-sided’ cleared exposure<br />fixed<br />fixed<br />fixed<br />End User Pension Fund<br />Pension Holders<br />End User Hedge Fund<br />Bank<br />floating<br />floating<br />scope central clearing<br />
  14. 14. Key concerns: Initial Margin Total Buy-Side impact analysis on Initial Margin has not been performed<br />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)<br />Initial Margin requirements can represent a substantial portion of a fund’s value (10-15%)<br />Initial margin requirements can only be satisfied with a narrow range of eligible assets<br />The magnitude of initial margin would have multiple effects:<br />Removes substantial high grade collateral from markets impacting money/repo markets<br />Forces end-users to switch from high yield to high grade collateral, depressing investment returns which will negatively impact consumer savings and pension savings<br />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 borrowing cash or eligible assets and will pass these costs on to end consumers<br />
  15. 15. Primary concern: Variation Margin Cash OnlyBuy-Side participants do not have readily access to cash<br />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.<br />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<br />Notwithstanding this, CCPs are restricting eligible collateral for Variation Margin to cash<br />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<br />hold higher amount of cash<br />enter into expensive guaranteed liquidity arrangements<br />be exposed to having to quickly raise cash through asset sales in falling markets<br />
  16. 16. Assumes cash return of c. 0.5% and yield on longer-dated governments bonds of c. 4.0%<br />Primary concern: Variation Margin Cash Only Pension Fund example: Liquidity has a high cost to be borne by pensioners<br />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<br />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<br />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<br />The cost of maintaining a 25% allocation to cash:<br />25% * (4.0% p.a. - 0.5% p.a.) = 0.8% p.a.<br />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.)<br />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<br />
  17. 17. Primary concern: Variation Margin Cash OnlyPension Funds may be forced to raise cash in volatile/stressed markets<br />Pension funds may be forced to liquidate long term asset positions to meet margin calls related to short term volatility in markets<br />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 <br />Assuming the combined UK/NL pension industry has EUR 500 billion in derivative notional this translates to EUR 50 billion one month movement<br />The systemic risk aspects of liquidity management are not to be underestimated. <br />
  18. 18. Primary concern: Variation Margin Cash Only The counter argument…Clearing Members will provide access to liquidity<br />Clearing members, custodians and the repo market are all keen to provide liquidity lines and repo services to assist the buy-side in meeting their (intraday) margin obligations....for a fee...<br />Such bank funding products are not in itself an adequate solution for liquidity management:<br />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. <br />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-side industry cannot rely on the repo market as its primary source of liquidity, especially in distressed markets<br />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<br />
  19. 19. Liquidity ManagementWhat can Buy-Side participants do to prepare themselves?<br />Understand the margin requirements on your derivatives portfolio but performing scenario analysis assuming stable and stressed market conditions<br />Understand the risk/sources of a failed margin call on derivatives portfolio and understand when positions will be closed out and what the market risk impact would be<br />Create an internal liquidity management plan that spreads liquidity financing across alternative sources and understand the stability of that source under stressed market conditions<br />Ensure cash holdings or access to cash is sufficient to meet liquidity under stressed market conditions<br />
  20. 20. John Wilson<br /><br />+447850543065<br /><br />Twitter: @cdsclearing @irsclearing @otcclearing @fxclearing @clientclearing @otcderivatives<br />