With Malcolm Warne, Vice President, Product Manager, Risk Management, Nasdaq
There are three main regulatory and market drivers currently affecting clearing houses. The first relates to the forthcoming Basel 3 regulatory changes which will make it more capital effective for banks to clear products. There will be a greater capital incentive to clear products which did not exist before that will encourage CCPs to offer more sophisticated offsetting products.
The second issue is the management and clearing of interest rates swaps, which is coming into play for more currencies and which will have a greater impact in the coming months. In some cases, clearing is mandatory and banks will have to clear an increasing number of products.
The third regulatory driver focuses on the IOSCO set of guidelines that were developed a couple of years ago and which affect intra-day margining and portfolio margining. These guidelines raise the bar in terms of accuracy of CCP risk calculations, so the CCPs will naturally move closer to real time and will also produce increasingly sophisticated margin models.
These three issues combined are driving CCPs towards multi-asset clearing, for banks to clear more through them, and for CCPs to offer more sophisticated and faster margin solutions.
There is also a market-related driver to consider. Banks and their clients are being encouraged by the market to use their capital more efficiently. If, for example, a bank is able to clear interest rate swaps and interest rate futures at the same venue and receive some portfolio offsetting between them, that will lower their margin requirements. It means they post less collateral compared to clearing those two products at different venues and not getting that relief. Many CCPs now offer margin relief if more products are cleared through them, which lowers collateral requirements for the banks and that drives more business for them.
The industry is within reach of a ‘tipping point’ in the sophistication of clearing; as so much more is being cleared, products like capital relief and cross margin become much more interesting. And given that more is being cleared, it makes sense for banks and CCPs to investigate how they can do this as capital efficiently as possible.
Pressure on CCPs
CCPs are starting to offer a wider range of products, listed and OTC, and as a result of that developing new margin model sophistication. Many CCPs are moving towards a value-risk model for OTC derivatives. Many CCPs are looking at ways to optimise margin requirements across different margin regimes. Calculating the optimum set of positions from a listed account to move across to an OTC clearing account to lower the margin requirement for the clearing members requires fast and portfolio based margin models.
Another aspect is that banks are looking more closely at their choice of venues. CCPs are providing incentives to make the CCP a bit more ‘sticky’ for the clearing member. In addition, they are looking to add more value to their services to make them more attractive compared to the competition.
Regulation or market in the driving seat?
Four or five years ago CCPs recognised the need to centrally clear interest rate derivatives, and that it had to happen quickly. They realised that they could make a lot of money from such products and new levels of sophistication, so they welcomed the prospect of having an OTC clearing offering quickly.
One problem with the regulatory drive is that it has been much slower than expected which has meant that the market drivers have been slower too. CCPs are looking at these areas again to examine how they can provide this service at a lower cost, and how to make it more attractive by lowering capital requirements by having clearing across listed and OTC trades. If a clearing house is able to calculate margin and risk in real time, it means they can be less conservative when setting margin requirements as they are able to react quickly to changes in the market. This is of benefit to banks by lowering the amount of capital required without putting any further risk into the system.
Secondly, if a default does occur, knowing risk in real time and being able to very quickly macro-hedge defaulting clearing members’ portfolios insulates the market (basically the CCP and the non-defaulting clearing members) from further losses because the defaulted CCP’s positions have been hedged. Again, this benefits the market significantly.
Legacy infrastructure
The amount of time taken to change the infrastructure towards being increasingly real time will vary widely between clearing houses. The more legacy the environment that a house is moving, the harder it will be. It is difficult to have real time risk without having a clearing system that is capable of giving out real time positions. But, there is certainly interest amongst CCPs to change. Many of the risk systems currently in place are old and the costs involved to change them to meet the IOSCO and other regulatory guidelines are prohibitive. As a result, many CCPs don’t have much choice but to move away to a modern vendor solution, but the migration isn’t easy.
At Nasdaq, one of the things we do is to run the old margin model and the new margin model concurrently, so the CCP and their clearing members can compare the two before making the switch.
Long term future
The best case scenario is a single margin model into which CCPs can plug new products quickly and easily. This will allow them to broaden their product range as new products will be eligible for clearing quickly and efficiently without having to change the way that the margins are calculated. CCPs that can offer new products for clearing without having to significantly change their risk model are the houses that will succeed, especially when it is done within a margin-efficient and capital-efficient framework.
There is an evolutionary change taking place and it will be very interesting to witness the response of the regulators and market participants. A good example of this is the forthcoming Deutsche Borse- LSE merger. The issues are whether to have a wide range of CCPs with multiple choices of venues, or is the market happy with one or two huge players? If one of those players did fail, it would put a huge amount of strain on the financial system.
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Managing Risk In Clearing
