Yesterday's post looked at the big risks in the CCP landscape from simultaneous requirements for mandatory margin, novated contract terms, complex portfolio and collateral valuations, reference data reforms, and default funds. Today we'll look at the competitive
differentiators that potential CCP members, sencond tier swaps dealers, and even end users should evaluate when deciding where to clear their OTC derivative transactions. Note that each of these three categories will end up with a very different risk profile
on these factors because of the influence of intermediation and waterfall effects.
Swaps Clearing Eligibility: Each CCP will have a different range of eligible derivative transactions that they can clear and margin. Since the real benefit of clearing derives from netting efficiency, it is important to choose a CCP that matches
the scope of the member/end user portfolio as nearly as possible. In a bilateral netting, the netting efficiency will be 100 per cent between the parties (excluding any independent amounts). As CCPs will only accept "standardised" swaps for clearing, the
netting benefit will be less - perhaps much less if there are more exotics in the portfolio. Some of the key implications are:
- The demand for initial margin will be much greater, especially from end users. The CCP will require initial margin on the swaps being cleared at the CCP, and the swap dealer will also require initial margin for swaps which remain bilateral. This
will squeeze end users who are not natural holders of margin-eligible asset classes. Indeed, corporates don't tend to hold large, deep pools of securities at all. Those end users who do hold deep pools of high quality securities (that's you pension funds
and insurance companies) may find themselves targets of clearing members trying to gain mandates over their assets for their own proprietary liquidity and collateral transformation purposes (e.g., see Lehman Brothers International and MF Global litigation).
- You could end up posting variation margin to the CCP and/or to the swaps dealer even when you are in the money, increasing your exposure to default and other risks. Valuation of a bialteral swaps portfolio always produces one net number, positive
or negative. Split that portfolio into two - a CCP cleared portfolio and a residual bilateral cleared portfolio - and you are going to produce two net numbers - one for each subsidiary portfolio. As you can be in the money on one, and out of the money on
another, you can end up paying variation margin that increases your net default credit exposure.
Collateral Eligibility and Haircuts: Swaps dealers and end users will hold assets which are attractive to them given their individual geography, investment objectives, liquidity needs and business models. Hedge funds, pensions and insurance companies
may have a pool of high quality, liquid securities that will be eligible for initial margin collateral. Corporates may have just what they need for treasury management. In the nature of things, end users will hold a lot of less liquid, more difficult to
value, equities, corporate debt, municipal debt, money market instruments, etc. This means there is going to be
arbitrage in collateral transformation, with a lot of scope for things to go wrong -
badly wrong. Collateral transformation will also cost fees, require operations for monitoring, etc. And the top tier firms don't just want your margin assets, they want all your assets to be subject to a pooling and margin arrangement, subject to a mandate
allowing them to lend, repo and margin those assets at their discretion, profoundly changing custody expectations and protections. As a result, members and end users will generally want a CCP that will take the assets they have as margin, minimising transformation
costs and risks.
- From Betting the Business:
Once the dealer gets the securities it has the incentive to re-use them in many different ways to boost its returns beyond the commissions paid by the corporation for the collateral transformation services. As the bottom section of the figure shows, upon
receiving the securities from the corporation, the dealer can exchange them into higher yield assets through swaps, sell them outright and invest on a cheaper synthetic through derivatives and get additional leverage. In all these transactions the dealer is
taking higher risks, as well as counterparty risk. And remember that when the corporation decides to close the derivatives trade in the CCP, it returns the cash to the dealer, which in turn is obligated to give the securities back to the corporation. Because
the investments made by the dealer do not match the securities that have to be returned to the corporation, the dealer is exposing itself to additional risks and can face big problems.
Valuation Models: Each CCP will use a proprietary methodology for marking cleared swaps to market for purposes of calculating variation margin payments. As these may be different than the valuation methodology used by swaps dealers as counterparties,
and different still from the methodology used by end user hedge funds, institutional investors and corporates (who have different business model objectives than traders), there can be a risk that variation margin payments arise when unexpected. This will
naturally pose liquidity stress and risk as variation margin payments must be met daily, and intial margin demands may be higher than expected. Swaps dealers and end users will want to evaluate CCP valuation models to ensure that they broadly agree with the
principles and methods being applied, and that they can handle the projected volatility and variation that may arise under stress scenarios. It is worth remembering that CCPs will not exercise the discretion and tolerance that are common in the OTC market
when a disputed valuation arises. The CCP will insist on payment of variation margin when due, and delivery of initial margin when demanded. This makes the system overall much more fragile and difficult to predict.
Segregation Models: There are three different segregation models emerging, and even these three are not entirely clear as to how they will work to protect CCP members and end users as
the law keeps shifting. The three models are (a) Net Omnibus Segregation (prevalent UK model with shared client risk); (b) Gross Omnibus Segregation or "Legally Segregated Operationally Comingled" (incoming US model); and (c) Individual Client Account
segregation (only being offered from Q2 2012 by Eurex). I'll go into the details of segregation options in a further post to follow, as it is important to address segregation risks arising in the clearing member as well as in the CCP.
Generalising here, pooling and netting are in the interests of dealers (minimising initial margin at the CCP and so optimising asset liquidity and re-use opportunities) and account level segregation is in the interest of end users (better protection and
portability in a default). Each potential clearing member, second tier swaps dealer and client is going to have make choices between cost, convenience and protection. MF Global's collapse has left a lot of end users more wary and looking for better protection,
so we are likely to see some differentiation as intermediaries self-sort with some offering more old-fashioned fiduciary protections.
Default Guaranty Fund Exposures: Clearing members will have to contribute to the Default Guaranty Fund of a CCP. Because losses that deplete the Fund should be uncommon if the CCP does its risk management and margining job right, the risk of a loss
that hits members should be seen as a tail risk. In that case, capitalising that risk will be very expensive and lock up quality capital, depleting market liquidity. Supervisors are looking at other options which incorporate mutualising the contingent risk
among the clearing members in ways that would only hit the members for contributions if losses occur. How the Default Guarantee Fund is structured, funded, capitalised and administered therefore has serious implications for clearing members' credit, reserve,
liquidity and liability management. It's worth remembering that - just like deposit insurance - the time when a Deposit Guarantee Fund needs top-up from the members is likely to be a time of high stress and low systemic liquidity, complicating any draw on
members. Supervisors are likely to take different views on what is best for the CCP, best for the clearing members, and best for systemic financial stability.
That's enough for today. Some of the points require much more complex analysis, such as segregation and default guarantee funds, and I'll address these subjects in later posts. More to follow!