A new dawn: client clearing

Next year the market is set to see the introduction ofmandatory client clearing in Europe, after several false starts, but whateffect will this have on relationships, and what does the future hold,post-mandate. Alice Attwood reports.

Client clearing is coming, that much is indeed clear; themandatory clearing of standardised over-the-counter (OTC) derivatives, alongwith margin for non-cleared trades, were key goals of the European Union’spost-financial crisis regulation, the European Markets InfrastructureRegulation (Emir).

While the rules came into effect back in 2012, the clearingobligations have been dogged by delays; the European Securities and Markets Authority(Esma) last summer delayed the provisions from early 2015 to early 2016.

The outcome, it seemed, was set out, and firms began to gettheir technological, trading and infrastructure-ducks in a row, with theEuropean Commission back in June confirming that mandatory clearing rules forinterest rate products were set to come into force as early as April 2016,marking a key component of Europe’s post financial crisis reforms.

Jonathan Hill, EU Commissioner for the financial servicesand stability, told a public hearing on the Emir review that "the firstclearing rules for certain interest rate products might be in place as soon asApril of next year."

At the time, the commissioner also said he expected that Europe’ssupervisory authorities would deliver draft rules on margin requirements fornon-cleared trades in the “coming months” with a view to implement rules inlate 2016, in line with internationally agreed timetables.

Delay?

However, at the time of writing (mid-September), the mostrecent development from the European Commission has seen the body adopt anumber of new rules within its enforcement governing mandatory clearing ofinterest rate swaps, with the changes to the previous draft rules set to leadto a likely delay of the expected compliance date on April 2016.

The Commission has been vocal in its plans to introduce themandate by April next year, but the recent amendments could see this targetextended by up to three months, according to law firm Norton Rose Fulbright, whichsaid that while the formal adoption by the Commission started a scrutiny periodby the Council of Ministers and the European Parliament, the inclusion ofamendments could see this extended from one to three months.

The amendment extends the phase in period of mandatoryclearing for intragroup transactions with non-EU counterparties to three yearsafter the entry into force of the rules.

A moving of goalposts can be frustrating for companiesworking to ensure readiness, especially after work has begun, but the market isno stranger to delayed implementation of rules.

A timeframe is key, Jamie Gavin, head of institutionalover-the-clearing at Societe Generale Prime Services, told FOW: “That animplementation date and requirements are imminent gives companies a cleartimeline to work to; clients seem to recognise this. The mandate will crystallisethe timing expectations and we will likely see more clients come forward toprepare.”

“We are moving to a landscape of more robust timelines andguidance,” added Commerzbank’s head of execution and clearing service, EugeneStanfield. “We have both clients that are actively clearing and also currentlyengaged to be ready for clearing as of Q1 2016. Efforts have significantlyincreased and we expect to be very busy, helping firms to ensure readiness fromSeptember for the rest the year.”

A London-based managing director of a clearing house toldFOW that that work toward new obligations is the focus at the firm, ahead ofwork toward structural changes, with protection and readiness to follow.

But nuances certainly remain, with SocGen’s Gavin adding: “Themarket is not wholly ready; the majority of the market has made strong progressbut there are still some clients that are being presented to. There is now thefeeling that things are being taken seriously, especially from the buy-side;they know that this is definitely happening.”

CME Clearing Europe chief executive officer, Tina Hasenpuschis pragmatic about the pace of work; “Implementation of these changes requireseffort and cost ahead of a transition period to allow firms to get familiarwith the new regulations and technologies.

“There are a lot of structural changes coming and they areset to have a considerable impact on the market,” she added.

Front-loading

Discussions over the preparedness of companies for theimpending mandate raises the contentious issue of front-loading requirements

Earlier this year Esma raised concerns over plans to exemptinternal transactions made by non-European firms from the clearing mandate inthe draft regulatory technical standards (RTS).

At the time the body said it backed the European Commission’smodifications on its front-loading section, but notes that further work isneeded here as front-loading can "create additional systemic risk whichcan be caused by the counterparties of such contracts adapting them in order totake into account the clearing obligation."

Commerzbank’s Stanfield said that this adds anotherdimension to firms’ work. “Firms are now formulating their clearing plans andfront-loading actually adds to the complexity of the scope of work ahead.Whilst Esma has questioned the benefits of frontloading and appears to besupporting its removal in its Emir Review Report #4 such that the market wouldgo straight into a clearing landscape, it would seem a little late for this tobe done in time for the introduction in January.”

“Mandatory clearing is falling into place with front-loadingrequirements potentially set to take place from January next year for directmembers under Category 1 and April for Category 2 and then full clearing beingimplemented by May for Category 1 and November for Category 2 and Categories 3and 4 thereafter,” he added.

Gavin from SocGen Prime Services, agreed, stating that firmscan use the requirement to support the transition to operations under themandate.

“Starting to clear early will help firms and clients; youmay be able to secure better credit lines and pricing, and it also takes awaythe uncertainty surrounding the front-loading issue for Category 2 clients; itwill help firms to move into the new world,” said the head of institutionalover-the-counter clearing.

Adopting a pragmatic approach, Stanfield said: “Thechallenge and potential removal of the front-loading requirements, whilsttechnically possible, by the rejection of the current RTS by the EuropeanParliament and Council, would be a significant and unlikely undertaking at thislate stage.”

Costs

Balance sheets remain a core issue for companies to consideras we move into the new regulatory landscape, with technology, marginrequirements and the fees associated with clearing all on the agenda.

CME Clearing Europe CEO told FOW: “Costs will subsequentlyincrease due to education, technology requirements and upgrades, but thisultimately leads to a safer marketplace.”

“Balance sheets remain a significant factor in allcommercial decisions,” added Stanfield, while lawyer at Dechert, Abbie Bell,warned that central counterparties are still not sufficiently capitalised andthe considerable potential costs around fees and initial margin requirementsshould be considered.

Bell said that additional charges, such as the requirementfor clearing member to contribute to a default fund, could push up overallcosts. “For cleared over-the-counters, counterparty risk becomes less importantas risk is centralized via the central counterparty,” she added.

Gavin warned that factors other than cost must be consideredby firms when signing new relationships ahead of and for adherence to themandate: “Firms should think keenly about pricing before signing with a firm;there is a lot of re-pricing going on, so while this means more research isrequired, it should result in better-aligned long-term partnerships.”

A London-based managing director at a clearing house who didnot wish to be named told FOW that direct clearing is a significant cost forclients, but this cost will not initially hit at an industry or clearingmember-level, and warned that when it comes to the mandate, the market may haveto contend with a bottleneck situation.

What next?

Increased clarity in terms of timelines has certainlyruffled feathers – and balance sheets - across the market, and has sparkedextensive development work across clearing firms, members, banks and brokersalike, some challenges remain, suggest industry experts.

Gavin from Societe Generale Prime Services warned that morework needs to be done by some companies. “Clients shouldn’t wait and should getclearing broker partnerships agreed now as they are a finite, diminishingresource. Clients need committed organisations to work with.”

Ensuring that agreements are in place ahead of the clearingmandate kicking in is key. “Clients want multiple relationships and they needto have these in place from day one from a risk management perspective,” addedHasenpusch.

Impact

But how will implementation of the mandate affect thoseoperating across the market? 

Lawyer Bell is hopeful, stating that the market could enjoy“potentially more competition through greater transparency.”

CME Clearing Europe’s CEO also expects this to be an areafor opportunity to the creation of new relationships. “When looking at theclearing broker and client relationship – this could be the first time thatfirms have used a clearing broker.”

Stanfield from Commerzbank is eyeing a spate of new marketparticipants from a particular area, “There are a number of new ventures thatare coming to market, offering collateral optimisation and mobilisation; thefintech space is bringing the buy-side together and negating requirements forthe sell-side.

“We see collaboration between clearing members, banks andthe fintech space in order to achieve collateral mobilisation; banks arelooking for solutions that minimise the impact on limited resources such asbalance sheets or risk-weighted assets,” he said.

The mandate will certainly introduce requirements, but, aspublished in an article on FOW.com in June, Tomas Kindler, head of clearing services,SIX Securities Services, said that while many jurisdictions are yet to mandatecentral clearing, voluntary clearing is on the rise.

“At the same time, a surge in CCP numbers means the marketis set to fragment further,” he warned. “We welcome competition, but we alsoneed to ensure that risk mitigation is not hampered by, on the one hand, marketparticipants having to disperse their collateral across more and more CCPs and,on the other hand, CCPs not indulging in unrealistic pricing strategies toattract business in an increasingly competitive environment.”

When considering the long-term impact of the mandate, Bellsaid that we may see some standardisation of economic terms of OTC contracts.“However, the uncleared OTC market will continue to be important in thedevelopment of exotic OTCs; there are classes of OTC derivatives which willlikely never be suitable for clearing. [Also there is the] potential forfuturisation of OTC contracts which could push down costs as marginrequirements for futures contracts are lower than for OTC trades.”

Post-implementation

Looking to a post-implementation landscape, overall it seemsthe introduction of client clearing holds many opportunities for tech firms,banks, brokers and law firms alike, with clearing providers generally geared upand ready for the new dawn.

The long-term impact on the buy-side remains to be seen,however, though the market suggests that post-implementation, the new landscapewill simply become the ‘new normal,’ with FOW sources suggesting that we willalso see a spate of new market entrants, with fintech tapping opportunities asthe mandate looms, though CME’s Hasenpusch sounds a note of caution on newentrants: “The biggest question central counterparties have here is thescalability of new players.”

The new European market landscape will present challenges,however: “I think we will see what happened in the US echoed; people got usedto the process. It is human nature to leave things to the last minute,” saidSocGen’s Gavin.

“There will be a last minute rush, resulting in short-termpain and teething problems, but the market will get used to it,” he added.

Stanfield added: “The market is preparing for the clearinglandscape ahead, and I expect this to become a more commoditised product, withthe complexity and technology challenges of today to be removed and replaced bystandardised client solutions available to all.”

Looking ahead, Hasenpusch warned of another area toconsider: “Another impact, on a long-term basis, is how collateral managementcan be undertaken efficiently. This is the next big question as it will causepositive change and help to transition the market to a new landscape.”

But the future is far from gloomy, it seems. Indeed Commerzbank’sclearing head told FOW: “I remain optimistic; in the future, clearing will bean implemented and bedded down process, accepted as part of the general dailymarket operations of a business.”

Indeed, CME Clearing Europe’s Hasenpusch said that as wemove into the new dawn it should be remembered that on the client side “thereare a significant number of entities that have not centrally cleared before… The long-term buy-side impact is likely to be positive; thesemarket changes will prove to be catalysts to provide innovation acrossworkflows and process.”

But with some market participants’ readinesslagging, the new requirements present both threats and opportunities.