Avoid a derivatives shake-up shock

The regulations will compel derivatives trades to be centrally cleared, sweeping aside 25 years of exclusively bilateral, over-the-counter agreements on how they are valued, collateralised and reported.

The issue is so complex and the rules have been so long in the drafting that many money managers have taken their eye off the ball. That has left much of the industry woefully underprepared in what is an essential element of their trading and investment strategy.

The danger is of a last minute rush to meet a complex and interlocking set of regulations, which in turn could squeeze the flow of interest rate swap deals – a market worth around USD600 trillion last year.

OTC derivatives trading moved into regulators’ sights as G20 leaders raked over the ashes of the financial meltdown at the Pittsburgh Summit in 2009.

While swaps did not directly cause the crisis, they were seen as a high leverage/low transparency product. So when investors began doubting the creditworthiness of major derivative players at the beginning of the crunch, no one had any idea who owned what, or the size of one counterparty’s exposure to another, including the web of cross holdings between major banks and credit institutions. The result: fear and reduced liquidity in a market already worth some USD600 trillion, prime broker lockdown, waylaid collateral and, in the case of Lehman Brothers, default.

The US Dodd-Frank Act quickly followed in 2010, although opponents held out hope for repeal or at least budgetary starvation, all the way through last year’s US presidential campaign. Obama’s victory put an end to such a possibility. That means from this March, the most active derivatives users falling under Dodd-Frank will be required to clear through the handful of major clearing houses that have platforms up and running.

Similarly in Europe, the continent’s debt crisis failed to deflect political pressure for a system of greater checks and transparency. The EU’s European Markets Infrastructure Regulation (EMIR) looks set to impose similar requirements on financial firms from spring or summer next year, forcing millions of the most-commonly traded derivatives to be cleared. A second regulatory push will require some of those derivatives to be traded on exchanges by as early as 2015.

These are profound changes. They add several layers of complexity for money managers while imposing new, and potentially punitive, collateral demands on investors who have never had to bear such costs before.

While hedge funds may be well-versed in the daily drill of margin postings and collateral transfers through their prime brokers and bank counterparties, in general asset managers and other ‘real money’ players are not. For them, Dodd-Frank and EMIR represent not just a new paradigm, but a whole new world that will overturn long-established custom.

Many of the smaller, less active or more vanilla money managers grossly underestimate the sheer complexity of a switch to OTC clearing or the speed with which they need to act.

Just to be legally compliant (not to mention commercially protected), a firm has a daunting ‘to do’ list: determine risk limits, define collateral, assess liquidity, clarify intraday funding needs, agree lock-up periods and cut-off times for cash transfers, nominate executing brokers, and so on.

What is more, this legal pillar is just the first of eight on which a well-designed OTC platform must rest before a firm can feel confident about facing the new regulatory regime. Many money managers are palpably shocked when they grasp the scale of the task.

If more firms don’t accelerate their clearing programmes, the worry (when scaled up across the European and US financial sectors) is of an 11th-hour stampede to one of the 10 or so clearing brokers with the capacity to process large or complex swap portfolios. Late arrivals risk receiving a rush job - or no job at all.

The work-around for those firms which don’t need a made-to-measure OTC interest rate swap or FX option is to use listed futures, since they replicate many of the features of OTC derivatives. The question is whether that market could cope with the influx, at least in the short term. The volume of fixed income OTC alone is so big that if just four per cent switched into listed contracts, the futures market would double in size.

Then there is the issue of non-cleared transactions – trades that are ineligible for clearing which may carry on in the ‘old world’ for many years potentially. Who would relish paying a double margin on a portfolio of inflation swaps (which aren’t yet eligible for clearing) when they are hedged by vanilla swaps (which are clearing-mandated and therefore independently margined)?

It is a bewildering scene for new players who may have not even chosen a clearing broker. The advice to them is simple: start planning now and get advice from several shops. The new regulatory structure protects against another Lehman-like disaster by locking away and registering collateral. But firms still need to employ at least one back-up broker to avoid being stranded if their primary broker fails or if they simply want to ‘port’ their positions to another provider offering a better deal.

Clearing brokers don’t have all the answers and won’t have them until the regulatory landscape settles. But their customers should not use that as excuse to delay. Questions about which clearing house or affirmation platform to use can wait. The priority right now is to avoid the rush before a new era in derivatives trading arrives. 

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