OTC confusion gives rise to cross-margining revolution

As the deadline for clearing OTC swaps is pushed back yet again in Europe, market participants are left struggling to handle the uncertainty in the market. Some are choosing to stay ahead of regulators by investing in sophisticated cross-margining facilities


In June, Eurex, the clearing house of Deutsche Borse Group, announced it would be introducing new risk-management systems for its clients in Europe, including the possibility of cross-margining between interest rates swaps and fixed income futures. The announcement was greeted with measured enthusiasm in the industry; there was a lot of interest in the potential efficiencies to be made, but there was some trepidation – many wondered why Eurex should bother to clear these products at all when it was not required by regulatory authorities to do so.

The flagship Eurex Clearing Prisma can, as of September, use a plethora of new tools in order to drastically reduce its margining and risk management costs. Though there appears to be demand within the industry for these services, not a lot has happened – probably because the European Securities and Markets Authority (ESMA) released yet another draft proposal for the implementation of key regulatory framework as agreed by the European Parliament in 2012, leaving banks and clearing houses struggling to find their feet in an increasingly convoluted environment.

However, Eurex’s desire to remain ahead of the regulators speaks volumes about the current tense market in Europe. The fact that no other exchanges have yet launched similar products, speaks of the insecurities.

Rising costs
Products such as the ones Eurex Clearing Prisma is launching are already common in the US, where the regulations requiring the central clearing of OTC swaps are already enforced through the Dodd-Frank Act. As similar regulation is set to make it across the Atlantic, the cost of execution of OTC swaps has already risen in Europe, creating a market for swap futures contracts such as Eurex’s new launch. There, the (still relatively small market) for cross-margining swaps is dominated by the CME Group, a futures company and one of the largest options and futures exchanges. However, CME is yet to launch cross-margining products in this side of the pond.

The US has been leagues ahead of Europe when it comes to regulating
OTC swaps

“The Euro-Swap Futures provide our participants with a cost-effective product which tracks the risk of the underlying with the margin efficiency of a standardised futures contract and makes it possible to offset risk with our liquid benchmark government bond futures. The entire European interest rate market will benefit from this offering,” said Mehtap Dinc, a member of the Eurex Executive Board, in a statement made at the time of the launch.

Though Eurex remains confident that the uptake will be significant once the implementation period is over – actual clearing will not start for several months yet – it is a tough sell for many big businesses that will not be required to execute this type of clearing until 2016 under ESMAs new guidelines.

Published in the beginning of October, ESMAs latest draft – still pending approval from the various trade repositories and the European Parliament – declares that so-called ‘Category Two’ counterparties, those of the financial distinction, will need to fulfil stringent clearing obligations for all OTC trades, but not until at least the first quarter of 2016. A definitive date for this regulation to be enforced is still pending.

There are plenty of potential benefits to adopting a cross-margining system for OTC interest rate derivatives trading before the regulatory mandate stipulates. In its documentation Eurex cites higher capital efficiencies as well as more accurate netting effects for listed and between listed and OTC positions. However, because the facilities with which to execute this type of margining is still extremely limited, the cost in terms of time and facilities as well as money, is still relatively high.

Clients are hedging their bets
Cross-margining is not a new concept. Prime-brokerage houses have been offering this type of service for years. But it has not ever been applied to clearing assets before now. It works by factoring in correlations between cleared products – in this case interest rate swaps and fixed income futures – when calculating margin requirements, instead of determining collateral on each individual product. If the risk in each product is reasonably offsetting, which is the case when futures are used to hedge a portfolio of interest rate swaps, a lower net margin amount is possible. Efficiencies can be as high as 70 percent, though savings are highly dependent on the structure of listed and OTC portfolio, and how clients prefer to hedge their investments. So Eurex is hoping that despite high initial investment costs, the potential savings will be enough to push buy side firms to become early adopters.

Without the legal requirement for this type of clearing, the incentive for clients to start clearing these products has been drastically reduced. This type of clearing activity is likely to increasing in the coming months, as front-loading requirements stipulated by ESMA are more clearly defined. In the latest RTS, ESMA indicated that once its mandate was enforced, it would expect trades occurring in the months leading up to its implementation to already have been cleared through the new system – a process known as front-loading.

As with everything else in its latest release, ESMA has not released a date from when traders are expected to adhere to these demands. There will be some reaction in the market as people prepare to clear in order to avoid the confusion that front-loading causes. Clearing voluntarily ahead of the regulatory mandate is a way to avoid that, market participants suggest.

Cross-margining remains a fairly simple principle, however, in order to be put in practice, dealers and clients will potentially need to rethink the entire structure of their clearing apparatus. More often than not, clients will see their portfolios reorganised from top to bottom in order to achieve the type of efficiencies Eurex are promising. The implementation process for this type of clearing is going to be dependent on each individual client. Because mandatory clearing is still relatively in its infancy, banks and buy side clients are often still struggling with myriad operational issues and many may not yet be at the stage where they are ready to consider how to increase efficiencies.

Despite ESMAs decision to push back the deadline yet again, it seems as though Eurex and its partner banks will carry on offering the service as before. That may be mainly to do with the need to front-load clearances, but also partly because of the considerable cost savings the process can offer. In short, the future of the OTC market in Europe is still uncertain. ESMA and other relevant authorities are still clearly struggling to strike a balance between the widespread regulatory reform mandated by the European Parliament in 2012 and the laissez-faire approach the industry often favours. Going by their constant re-drafting of the proposed rules and dates for implementation, it appears as though regulators might be losing confidence in their own mandates.

This is turn leaves dealers and clients struggling to adapt their systems to impending regulatory changes in time. And, perhaps more dangerously, fosters a climate of uncertainty in the industry that can be lethal. In the meantime, the US has been leagues ahead of Europe when it comes to regulating OTC swaps, as the Dodd-Frank Act requiring these types of trades to be cleared and margined has been in force since May 2012.

According to Risk.net, early adopters in the US have suggested that their choice of clearing counterparty would largely be affected by the ability to cross-margin in-house would, alongside the significant potential savings, be factors when choosing OTC clearing providers. Mandatory clearing as a principle in itself is still relatively new to the international market, and companies are still struggling to find adequate systems through which to execute their trades, there is still some way to go before they start examining ways in which to make more significant efficiencies in this type of clearing. When it comes to clearing and cross-margining, the market and the regulators need to learn to crawl before it can run.