June 2016 should see the European Markets Infrastructure Regulation (Emir) come into effect. For buy-side firms the rules have long been anticipated and discussed but there are still very significant decisions to be made. The rules represent Europe’s take on obligations to clear and report over-the-counter (OTC) derivatives trades, decided in 2009 by the G20 countries.
With Japan and the US having started clearing in 2012 and 2013, Europe is playing catch-up. Its highly democratic process of creating directives and regulations is not geared towards efficiency. In this instance the challenge has extended to international negotiation with overseas regulators. For investment managers, there are several issues which will require immediate action in order to ensure their migration into the new clearing regime is as smooth as possible, while any additional costs that the process incurs are controlled within reason.
Transaction reporting has been a requirement since August 2014 with mark-to-market valuations of positions and on collateral value provided daily to trade repositories, however there is no commonality in the level of preparedness for other requirements, although larger firms are commonly said to be far ahead of the curve.
“They are all ready to varying degrees, ranging from completion to fairly early stages of engagement in preparing for mandatory clearing,” says Angus Canvin, senior advisor for regulatory affairs at buy-side trade body the Investment Association.
Get in a relationship…
The first matter of concern is the selection of a clearing broker to allow connectivity to the relevant central counterparty. Many brokers are still evaluating their own cost base and the viability of this businesses. Several have been hard pressed to provide transparent guidance around their Emir disclosure of fees, and all emphasise that the costs are worked out with each client individually. That can make the process trickier, however the longer it is delayed the more problems can arise.
“Clients that have not selected clearing brokers and are not live are definitely playing catch-up,” says Eugene Stanfield, head of head of derivatives execution and clearing services at Commerzbank. “They run the risk of a situation where the clearing brokers have limited or no resource availability such as balance sheet or even from a man-power perspective to on-board those clients.”
…with a local?
Another serious issue that requires consideration is the lack of equivalence between the US and European regimes.
Miles Courage, chief operating officer at JPS Alternatives Group, a credit-focussed hedge fund says: "You can form a view on a regulation in isolation but the critical detail is often how it interacts internationally, especially for managers with EU and US operations and offshore funds.”
Despite the European authorities having approved the majority of regimes in major Asia-Pacific financial centres – bar China and India – along with Canada, Mexico, South Africa and Switzerland, the US has not passed muster. With disagreement over margin requirements ongoing, there is no obvious reason for optimism. Consequently investment firms are seeking to avoid exposure to non-equivalent regimes.
“Where clients are falling under Emir, they are discontinuing relationships with brokers who are subject to Dodd-Frank and vice versa,” says Jörn Tobias, head of Agent Fund Trading and Collateral Services at custodian State Street.
Although the interpretation of the G20 2009 mandate has been nuanced in every jurisdiction, there are reasons to think the global market will not be fractured, as long as equivalence can be achieved, says Radi Khasawneh, Analyst, Fixed Income Research at Tabb Group.
“We are seeing a proliferation of clearing entities in regions and what the clearing entities and the trade repositories do functions as a canary in the coalmine for likely activity of the wider market,” he said, speaking at the Fixed Income Leaders Forum on 14 October 2015. “So after trading venue and clearing house fragmentation into regional silos, we expect to see them then reverse flow as they get comfortable with equivalence where it exists, and then we will see this huge dispersion start to reverse itself.”
Getting and protecting collateral
Moving to a cleared model, requiring both initial margin to cover the value of a contract and variation margin to cover changes in value will require a mechanism to source the instruments needed for margin.
A major cost and/or risk for asset managers will be the acquisition and protection of collateral. For larger firms or those with funds that typically have the assets required, either cash or high quality bonds, collateral management may be viable in-house. However other firms will need to weigh up if the value of outsourcing collateral management to a broker or custodian can reduce the operational costs or at least create a buffer to any future changing costs by mutualising cost via a single supplier.
The challenge of developing and managing a system also includes considerable risk and cost, where a tried and tested platform provided by a third party can be delivered more rapidly than an in-house system. A decision must also be made about the account selected to protect those assets.
“There are a range of options available, and not every clearing house has the same range,” says Canvin.
The two main categories of account come in a variety of flavours, often with similar names. Typically the options offered are for a fully or individually segregated account in which the collateral held will be marked out and in the event of a default by the clearing broker, the exact assets can be returned as deposited. There is little or no co-mingling of assets and they are held to support the initial margin for only that client.
The second type is an omnibus account, in which the account is shared by many firms whose net or gross (both are offered) initial margin has to be covered by the value of the assets held. This holds far less security in the event of a default, but is decidedly cheaper.
“Clearing houses are offering the buy-side, through the clearing brokers, omnibus account structures which provide for the pooling of groups of clients,” says Stanfield. “This can be preferential to clients who can define their tolerance to fellow customer risk and select an appropriate omnibus account pool or for end users such as fund managers to aggregate all the funds under their management into a closed omnibus account. These clients are effectively saying they are happy for fellow customer risk but only to a known set of end users.”
Market participants report the two extremes of the account range are typically the only choices taken, offering the ability to choose between risk and cost.
“It would be the end-investors who quite rightly should be dictating according to the combination of their risk appetite and then the cost they are willing to bear,” Canvin adds.