Next year the market is set to see the introduction of mandatory client clearing in Europe, after several false starts, but what effect 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; the mandatory clearing of standardised over-the-counter (OTC) derivatives, along with margin for non-cleared trades, were key goals of the European Union’s post-financial crisis regulation, the European Markets Infrastructure Regulation (Emir).
While the rules came into effect back in 2012, the clearing obligations 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 get their technological, trading and infrastructure-ducks in a row, with the European Commission back in June confirming that mandatory clearing rules for interest 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 services and stability, told a public hearing on the Emir review that "the first clearing rules for certain interest rate products might be in place as soon as April of next year."
At the time, the commissioner also said he expected that Europe’s supervisory authorities would deliver draft rules on margin requirements for non-cleared trades in the “coming months” with a view to implement rules in late 2016, in line with internationally agreed timetables.
However, at the time of writing (mid-September), the most recent development from the European Commission has seen the body adopt a number of new rules within its enforcement governing mandatory clearing of interest rate swaps, with the changes to the previous draft rules set to lead to a likely delay of the expected compliance date on April 2016.
The Commission has been vocal in its plans to introduce the mandate by April next year, but the recent amendments could see this target extended by up to three months, according to law firm Norton Rose Fulbright, which said that while the formal adoption by the Commission started a scrutiny period by the Council of Ministers and the European Parliament, the inclusion of amendments could see this extended from one to three months.
The amendment extends the phase in period of mandatory clearing for intragroup transactions with non-EU counterparties to three years after the entry into force of the rules.
A moving of goalposts can be frustrating for companies working to ensure readiness, especially after work has begun, but the market is no stranger to delayed implementation of rules.
A timeframe is key, Jamie Gavin, head of institutional over-the-clearing at Societe Generale Prime Services, told FOW: “That an implementation date and requirements are imminent gives companies a clear timeline to work to; clients seem to recognise this. The mandate will crystallise the timing expectations and we will likely see more clients come forward to prepare.”
“We are moving to a landscape of more robust timelines and guidance,” added Commerzbank’s head of execution and clearing service, Eugene Stanfield. “We have both clients that are actively clearing and also currently engaged to be ready for clearing as of Q1 2016. Efforts have significantly increased and we expect to be very busy, helping firms to ensure readiness from September for the rest the year.”
A London-based managing director of a clearing house told FOW that that work toward new obligations is the focus at the firm, ahead of work toward structural changes, with protection and readiness to follow.
But nuances certainly remain, with SocGen’s Gavin adding: “The market is not wholly ready; the majority of the market has made strong progress but there are still some clients that are being presented to. There is now the feeling 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 Hasenpusch is pragmatic about the pace of work; “Implementation of these changes requires effort and cost ahead of a transition period to allow firms to get familiar with the new regulations and technologies.
“There are a lot of structural changes coming and they are set to have a considerable impact on the market,” she added.
Discussions over the preparedness of companies for the impending mandate raises the contentious issue of front-loading requirements
Earlier this year Esma raised concerns over plans to exempt internal transactions made by non-European firms from the clearing mandate in the draft regulatory technical standards (RTS).
At the time the body said it backed the European Commission’s modifications on its front-loading section, but notes that further work is needed here as front-loading can "create additional systemic risk which can be caused by the counterparties of such contracts adapting them in order to take into account the clearing obligation."
Commerzbank’s Stanfield said that this adds another dimension to firms’ work. “Firms are now formulating their clearing plans and front-loading actually adds to the complexity of the scope of work ahead. Whilst Esma has questioned the benefits of frontloading and appears to be supporting its removal in its Emir Review Report #4 such that the market would go straight into a clearing landscape, it would seem a little late for this to be done in time for the introduction in January.”
“Mandatory clearing is falling into place with front-loading requirements potentially set to take place from January next year for direct members under Category 1 and April for Category 2 and then full clearing being implemented by May for Category 1 and November for Category 2 and Categories 3 and 4 thereafter,” he added.
Gavin from SocGen Prime Services, agreed, stating that firms can use the requirement to support the transition to operations under the mandate.
“Starting to clear early will help firms and clients; you may be able to secure better credit lines and pricing, and it also takes away the uncertainty surrounding the front-loading issue for Category 2 clients; it will help firms to move into the new world,” said the head of institutional over-the-counter clearing.
Adopting a pragmatic approach, Stanfield said: “The challenge and potential removal of the front-loading requirements, whilst technically possible, by the rejection of the current RTS by the European Parliament and Council, would be a significant and unlikely undertaking at this late stage.”
Balance sheets remain a core issue for companies to consider as we move into the new regulatory landscape, with technology, margin requirements and the fees associated with clearing all on the agenda.
CME Clearing Europe CEO told FOW: “Costs will subsequently increase due to education, technology requirements and upgrades, but this ultimately leads to a safer marketplace.”
“Balance sheets remain a significant factor in all commercial decisions,” added Stanfield, while lawyer at Dechert, Abbie Bell, warned that central counterparties are still not sufficiently capitalised and the considerable potential costs around fees and initial margin requirements should be considered.
Bell said that additional charges, such as the requirement for clearing member to contribute to a default fund, could push up overall costs. “For cleared over-the-counters, counterparty risk becomes less important as risk is centralized via the central counterparty,” she added.
Gavin warned that factors other than cost must be considered by firms when signing new relationships ahead of and for adherence to the mandate: “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 is required, it should result in better-aligned long-term partnerships.”
A London-based managing director at a clearing house who did not wish to be named told FOW that direct clearing is a significant cost for clients, but this cost will not initially hit at an industry or clearing member-level, and warned that when it comes to the mandate, the market may have to contend with a bottleneck situation.
Increased clarity in terms of timelines has certainly ruffled feathers – and balance sheets - across the market, and has sparked extensive development work across clearing firms, members, banks and brokers alike, some challenges remain, suggest industry experts.
Gavin from Societe Generale Prime Services warned that more work needs to be done by some companies. “Clients shouldn’t wait and should get clearing broker partnerships agreed now as they are a finite, diminishing resource. Clients need committed organisations to work with.”
Ensuring that agreements are in place ahead of the clearing mandate kicking in is key. “Clients want multiple relationships and they need to have these in place from day one from a risk management perspective,” added Hasenpusch.
But how will implementation of the mandate affect those operating 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 area for opportunity to the creation of new relationships. “When looking at the clearing broker and client relationship – this could be the first time that firms have used a clearing broker.”
Stanfield from Commerzbank is eyeing a spate of new market participants from a particular area, “There are a number of new ventures that are coming to market, offering collateral optimisation and mobilisation; the fintech space is bringing the buy-side together and negating requirements for the sell-side.
“We see collaboration between clearing members, banks and the fintech space in order to achieve collateral mobilisation; banks are looking for solutions that minimise the impact on limited resources such as balance sheets or risk-weighted assets,” he said.
The mandate will certainly introduce requirements, but, as published 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 mandate central clearing, voluntary clearing is on the rise.
“At the same time, a surge in CCP numbers means the market is set to fragment further,” he warned. “We welcome competition, but we also need to ensure that risk mitigation is not hampered by, on the one hand, market participants having to disperse their collateral across more and more CCPs and, on the other hand, CCPs not indulging in unrealistic pricing strategies to attract business in an increasingly competitive environment.”
When considering the long-term impact of the mandate, Bell
said that we may see some standardisation of economic terms of OTC contracts.
“However, the uncleared OTC market will continue to be important in the
development of exotic OTCs; there are classes of OTC derivatives which will
likely never be suitable for clearing.
Looking to a post-implementation landscape, overall it seems the introduction of client clearing holds many opportunities for tech firms, banks, brokers and law firms alike, with clearing providers generally geared up and 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 landscape will simply become the ‘new normal,’ with FOW sources suggesting that we will also see a spate of new market entrants, with fintech tapping opportunities as the mandate looms, though CME’s Hasenpusch sounds a note of caution on new entrants: “The biggest question central counterparties have here is the scalability 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 used to the process. It is human nature to leave things to the last minute,” said SocGen’s Gavin.
“There will be a last minute rush, resulting in short-term pain and teething problems, but the market will get used to it,” he added.
Stanfield added: “The market is preparing for the clearing landscape ahead, and I expect this to become a more commoditised product, with the complexity and technology challenges of today to be removed and replaced by standardised client solutions available to all.”
Looking ahead, Hasenpusch warned of another area to consider: “Another impact, on a long-term basis, is how collateral management can be undertaken efficiently. This is the next big question as it will cause positive change and help to transition the market to a new landscape.”
But the future is far from gloomy, it seems. Indeed Commerzbank’s clearing head told FOW: “I remain optimistic; in the future, clearing will be an implemented and bedded down process, accepted as part of the general daily market operations of a business.”
Indeed, CME Clearing Europe’s Hasenpusch said that as we move into the new dawn it should be remembered that on the client side “there are a significant number of entities that have not centrally cleared before… The long-term buy-side impact is likely to be positive; these market changes will prove to be catalysts to provide innovation across workflows and process.”
But with some market participants’ readiness lagging, the new requirements present both threats and opportunities.