FIA Europe CEO, Simon Puleston Jones delivered a keynote address at FOW Post-trade event in London on 11 May. His remarks, as prepared for delivery, follow:
Good afternoon everyone, it’s a pleasure to address you all on the topic of post-trade.
This afternoon’s 3 topics of:
- changing business models;
- the challenges relating to collateral; and
- the role of technology
strike at the heart of the issues currently faced the cleared derivatives industry.
Basel III and the heavy investment in technology and infrastructure mean that there has never been a more challenging time to be a clearing broker and a better time to be a third party vendor.
Over the next 20 minutes or so, I’ll raise questions and observations in 4 areas:
- regulatory capital;
- collateral;
- the regulations driving changing demands to middle and back office technology; and
- the changing focus of CCP’s risk management.
The common thread throughout will be the relentless drive for further efficiencies in our business models and in our operational practices.
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What is driving the current re-evaluation of today’s clearing models?
In a word – capital.
With respect to both clearing members and their clients, the impact of the leverage ratio and the capital surcharge for GSIBs cannot be overstated.
JPMorgan’s analysis concludes that:
- the capital surcharge threatens to increase capital for cleared trades by between 3 to 6 times
- the supplementary leverage ratio could raise capital for US clearing brokers by a further 5 to 6 times.
Whilst that is the view of an American bank, the leverage ratio is just as much a concern for European as it is in the US.
What do these increased costs mean for clearing members? A relentless, laser like, focus on capital and on the efficiencies of its business processes.
I can assure you that if each of you gave me £1 for each time Andy Ross says the phrase “capital” or “leverage ratio” during the next session, I would very rapidly hit the balance of my fund raising target of £5,000 that I’m looking to raise by next month for the cleared derivatives industry charity Futures For Kids!
In practice, as we’ll hear in today’s first session, it will lead to further consideration of the extent to which today’s clearing model is economically viable going forward. With BNY Mellon, State Street and RBS having headed for the exit over the last 18 months, Jeffries selling its F&O clearing business to SocGen Newedge and Nomura reportedly considering its OTC client clearing business in Europe, it is clear that the combined pressures of regulatory capital and capital investment are proving increasingly impossible for clearing brokers to bear.
Ultimately, any business that has shareholders is required to generate an acceptable minimum level of return. The return on equity (or, indeed, the return on any other metric) for clearing businesses is not where it needs to be in order to support the G20 objectives of a healthy, diverse, choice of clearing members that stand ready, willing and able to provide clearing for their direct and indirect clients. Basel III sits at the core of this problem.
That message is starting to hit home – for some time, FIA Europe has pushed markets regulators to discuss this concern with their prudential regulation colleagues. We now see this happening in Europe and the US.
As part of our global advocacy strategy regarding capital, FIA Europe, together with our colleagues at FIA in the US, have been meeting with numerous central bankers around the world to push for the leverage ratio to be amended so as to recognise the exposure reducing effect of segregated margin.
That recognition of the exposure reducing effect of segregated margin is the absolute minimum change that clearing members need to Basel III if clearing is to remain a commercial viable business proposition and if the objectives of EMIR are to be succeed.
So, how are we seeing the industry react to the challenges presented by these capital rules?
In short, clearing brokers are either:
- withdrawing from the market;
- adapting their business models.
What is the rate of withdrawal?
The US data published by the CFTC is informative.
10 years ago: 190 clearing members
1 year ago: 90 clearing members
End of March 2015: 74 clearing members. If you strip out the affiliates, the number drops further to the mid to high 60s.
There are only 20 clearing brokers to choose from for swaps clearing.
All this is leading to greater concentration of the access points to clearing – for F&O and OTC clearing alike. For F&O, 73% of the market is cleared by the top 10 FCMs. For swaps, 97% of the market is cleared by the top 10 clearing brokers.
For those that are not withdrawing – how are they adapting?
We’ll hear more about this in detail in today’s first session, but here are just 5 things that I see –
Clearing members are reviewing their client lists, focussing on outsourcing and the role of technology, heavily using compression services;
CCPs are reaching out to the buy-side to offer direct participation models
The days where insurance companies have a greater role to play cannot be too far away.
Taking each of these 5 areas in turn:
- Reviewing their client lists: a number of clearing members have exited some of their larger clients, so as to remould the portfolio of derivatives that they clear for clients into a more leverage ratio-friendly shape. Accordingly, it is getting HARDER, not easier, for end users to access clearing. This is not the intent of these regulations, and puts further pressure on ensuring that the models for indirect clearing are legally enforceable and operationally scalable (the current EMIR and MiFIR requirements fail on both those counts)
- Outsourcing: Further outsourcing of middle and back office functions, as most recently evidenced by Barclays’ deal with SunGuard (as an aside, it is an interesting development that SunGuard are now reported as considering an IPO or an outright sale of their business…)
- Compression: There has been a huge increase in the use of compression services: it was reported last week that in 2014, LCH’s SwapClear service compressed UDS292.2 trillion in notional value
- Direct participation: CCPs in Europe and the US are looking at direct participation models, under which banks continue to finance margin calls for their clients, but those clients become direct participants in the CCP. Is this disintermediation? I would argue not, given the critical roles that banks still have to play in providing the necessary finance and other expertise required to make these models work.
- The rise of insurance companies: Insurance companies may also have a greater role to play in the industry going forward, particularly given their expertise in understanding and managing risk. CCP default waterfalls are the obvious place to start, but there may be other opportunities in the future.
As I mentioned a few minutes ago, if you are a vendor specialising in reconciliation, compression or reporting services, you are in the “box seats” of today’s industry. Your services will rarely have been in such high demand. They put a real focus, and premium, on automation. The world of cleared derivatives is a fairly small one. Yes, others in the financial services industry have transferrable skills, but it takes a while for them to get up to speed. Available human resource is therefore scarce in our industry. One solution this is to automate as much as possible.
One can envision that the next five years will involve many of the investment banks’ back office staff migrating out to vendors in the short term. But over the longer term, automation will likely make many of today’s operational roles redundant. Good news at a corporate level, bad news at an individual level.
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So that’s capital and some of its immediate impacts.
What issues are industry participants’ facing with respect to collateral?
I won’t go into much detail here as we have a panel covering this later this afternoon, but as FOW’s own survey published today shows, collateral management is the biggest technology challenge facing the back office today.
The question is often asked “Is there enough collateral to go round, to meet the demands of the global financial services industry?”
What we do know for sure is that if you are entering into derivatives, on either a bilateral or cleared basis, you will need to have access to significant liquidity in order to meet the calls for initial and variation margin.
Your relationship with your clearing broker and other liquidity providers will be critical. When I and my colleagues speak to our members, they often highlight liquidity and funding as some of their greatest day to day challenges.
I look forward with interest to hearing panellists’ thoughts on this collateral squeeze on the second panel today.
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Moving on – the third of the 4 topics I’ll address this afternoon is
The regulations that are driving changing demands for middle and back office technology
I’ve already alluded to the commercial drivers for greater investment in technology, but what are the specific regulatory issues that put middle and back office technology front and centre?
Most immediately, EMIR is already live with various requirements that impose significant demands on middle and back office – whether it be account segregation, reconciliation, reporting, compression, portfolio management or otherwise, EMIR has seen a huge shake up of post-trade operational requirements:
- Segregation: From a client and clearing member perspective, it is disappointing to many that Individually Segregated Accounts have been used by CCPs as a competitive tool. Whilst the CCPs say they are merely providing models that meet the demands and requests of members and their clients, one has to also consider the macro view: the range and complexity of the various different offerings has in practice led to an implementation nightmare, from an operational, cost and operational risk perspective. Most troubling is that such broad range of complex options has resulted in completely confused end users – it is very challenging to compare the different models on a like-for-like basis, as they are not like-for-like.
For all of these reasons, there is a reasonable expectation that pursuant to the review of EMIR that will be imminently conducted by the European Commission, market participants may push for further standardisation of CCP account models.
- Reconciliation has always been an important aspect of our operational processes, but EMIR puts reconciliation high on the priority list, whether you are looking at margining, account segregation, reporting or the specific reconciliation provisions in Article 11 as regards non-cleared trades. A key component of reconciliation is ensuring that systems are able to talk to one another and that data be capable of reconciliation, even if it is in different formats – third party vendors are putting much effort into removing some of the traditionally manual barriers to data reconciliation. Such automation has significant benefits for firms and will help reduce their human resource needs.
- Reporting requirements under EMIR and other regulations have also proved extremely challenging to implement in practise, given the lack of regulatory certainty as to how certain fields should be populated in the trade reports. The reconciliation process between trade repositories has also not been functioning as it should, hence over 1 billion trades remaining unreconciled between trade repositories. One can expect a loud call from all corners of the derivatives industry for single sided reporting in Europe, pursuant to the EMIR review. It’s not just regulatory reporting that needs refining: as FOW’s post-trade survey showed today, 47% of respondents said that greater accuracy of trade information is what clients most commonly request.
- Thanks to the leverage ratio in particular, Compression is also a critical tool, for both cleared and uncleared trades. The leverage ratio is calculated on the gross notional of trades and is not risk sensitive, so firms are incentivised to do all they can to reduce the outstanding gross notional of their positions. Compression also provides benefits to firms by bringing down the number of line items in their books and records, and reducing their operational risks and costs. Further, it also helps Non-Financial Counterparties under EMIR reduce their gross notional exposures for EMIR clearing threshold purposes.
As the technologies available to compress trades get ever more sophisticated, and the pressure for clearing members to reduce their leverage ratio exposure increases yet further, we can expect ever more outsourcing of compression services to third party vendors, CCPs and others.
- Portfolio margining has been around for many years in the OTC derivatives market, whether under an ISDA Credit Support Annex or a more bespoke “Global Netting Agreement”. The cost pressures on clearing members and end users alike, together with new provisions relating to portfolio margining under both EMIR and MiFIR, are seeing a range of offerings for CCPs.
Looking forward to MiFID II (if that is an appropriate phrase…), what other operational challenges can one foresee?
Indirect clearing under both EMIR and MiFIR add further requirements for new account structures at the CCP, with MiFIR potentially introducing two further categories of omnibus segregated accounts at the CCP – a GOSA and a NOSA. Creating a model for indirect clearing that is legally and operationally scalable has proven one of the greatest challenges of recent times and continues to be one of the biggest worries for industry and regulators alike. One hopes that we won’t see CCPs develop a range of interpretations of the GOSA and NOSA account structures.
Thinking of the EMIR review for a moment, what is clear is that mandating that clearing members offer clearing services to their indirect clients (with the intent that clearing for all be assured) will in fact be a path to ruin for clearing in Europe – it would push numerous clearing members closer toward, or just as likely through, the exit door.
So that’s indirect clearing, but what else?
Markets are already complex today, but with MIFIR’s non-discriminatory access provisions relating to open access to trading venues and CCPs going live from 2017, they could get a whole lot more inter-connected and complex. Some regulators have indicated that their expectation is that under these provisions, European CCPs must be prepared to clear ABSOLUTELY ANY form of financial instrument, regardless of what their specialism is today – by way of example, LME could be required to go live with the clearing of cash equities or interest rate swaps, within 6-9 months of first receiving an access request. These provisions envisage a huge web of inter-connected trading venues and CCPs across Europe.
Where access requests are granted and connectivity is to be put in place, the rate at which the level 1 text of MiFIR requires operational systems to be updated and human resource put in place is truly “break neck”: Brussels has only envisioned a 6 to 9 month window between the day you receive the access the request and the day you make it a fully fledged reality.
Despite FIA Europe’s best efforts, the European Commission, ESMA and others are clear in their mind that access is a matter for trading venues and CCPs only as far as they are concerned – a trading member or a clearing member having significant operational or technological issues with respect to those two venues connecting with one another will NOT be a ground for denial of access.
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The final, fourth, area on which I’d like to touch on briefly is the changes to CCPs’ risk management approach in an EMIR world, which is creating operational headaches for clearing members in particular
With respect to client clearing, CCP’s have in recent months widened their focus, so as to not only look at the portfolio that individual clients bring to the CCP, but to also consider the aggregate portfolio that the clearing member is bringing to the CCP, across all of that clearing members’ clients.
This is causing significant challenges for clearing members, who (economically) ultimately merely provide an agency service for their clients. A key feature of the economics of providing such a service is the ability of a clearing member, as intermediary, to pass through margin and other costs to those specific clients who are bring such costs to bear.
- The first challenge for clearing members is that some CCPs are now applying a concentration charge with respect to the overall client-cleared portfolio of the clearing member. Essentially, this is a charge applied to those clearing members that have significant open interest in particular currencies or products. The issue here is that because the charge is applied to the clearing member as whole, rather than broken out on a per client basis, the clearing members find it challenging to pass these costs back to individual clients. Some clearing members therefore have little choice but to fund such charges themselves.
- The second challenge for clearing members relates to the changes that some CCPs are making to their margin methodologies as those CCPs become EMIR-authorised. Whilst a 1 day SPAN calculation can be reverse engineered by a clearing member, the proprietary models used by certain CCPs to supplement that calculation in order to meet the EMIR requirements are proving to be less transparent than is needed, making it hard for clearing members to be sure that they are being margined correctly. A mechanism must be provided by the CCP to the clearing member to enable it to pass back those costs to the clients that generate them, to reflect the fact that client clearing is ultimately an agency business and that clearing members need to manage their clients to ensure they stay within the portfolio and margin financing limits set by the clearing member.
So, in conclusion
We can reasonably expect the clearing models of tomorrow to look different to the clearing models of today.
Outsourcing will increase significantly as the decade continues.
Standardisation, automation and electronification will continue to lie at the heart of the commercial needs of the cleared derivatives industry for years to come.
It is too early to tell whether direct participation or the role of insurance companies in our industry will increase, but a changing regulatory environment and significant cost pressures leave the door open for significant disruption.
With respect to collateral, a “fingers crossed” approach will lead firms to failure – it is critical that access to both clearing and collateral be secured as soon as possible, as the demands for collateral across the industry will balloon over the remainder of this decade and beyond, notwithstanding the postponement of the go-live dates for mandatory clearing and for the margining of non-cleared trades.
One of the positives to take away from this decade’s wave of regulatory change is that it has forced industry participants to maintain a laser-like focus on efficiency, whether that be with respect to capital, other costs, operational practices and, dare I say it, the extent to which human resources can be replaced by electronic ones.
Despite the gloom that can be engendered by the apparently never-ending task of implementing regulatory change, the opportunities that are out there for clients, for clearing members, CCPs, third party vendors and others have never been greater.
Now is the time for the next great wave of innovation in our industry.
