Phil Matricardi, Manager-Business Consulting and Adam Kott, Associate Business Consultant, Sapient Global Markets
Prior to the global financial crisis, OTC derivative trading was highly profitable and allowed management to overlook manual processing and large support staffs. Now, the same banks find themselves in a very different environment, with expensive and inefficient proprietary systems entrenched within their firms’ operating models. Mergers that firms used to grow during the good years (and enacted during the crisis for both strategic reasons and at the request of regulators) have left them with a proliferation of platforms and parallel operational channels.
“The client-FCM relationship involves significant credit, capitalization and concentration checks because the FCM must guarantee the client to the clearing house”
As a result of US Commodity Futures Trading Commission (CFTC) and European Securities and Markets Authority (ESMA) regulations drastically increasing the number of swaps being cleared, and internal inefficiencies, banks face decreasing returns amidst client pressure to offer high-cost clearing services.
Small or regional non-Futures Commission Merchant (FCM) banks that have traditionally done a good business in corporate finance are very concerned that a key component of their structured finance offering is missing now that they have lost access to the swaps market (formerly conducted through introducing brokers but packaged into one product for the client) due to their inability to clear trades. The client- FCM relationship involves significant credit, capitalization and concentration checks because the FCM must guarantee the client to the clearing house. Therefore, a small bank that attempts to provide debt issuance to clients and introduces them to an FCM to hedge the interest rate component may put itself at risk for competitive poaching. These large and sophisticated competitors quickly learn all they need to know to deepen and strengthen the relationship and provide the small bank’s best clients with a more complete offering.
While the financial impact of clearing has largely been placed on buy-side participants, banks must now provide connectivity to various institutions throughout the lifecycle of a swap: middleware vendors, FCMs, clearing houses and SEFs. The costs of creating these pipelines are not insubstantial.
Becoming an FCM involves a significant up-front capital outlay: To self-clear at LCH. Clearnet's Swap Clear, clearing brokers pay up to £2.25 million annually, £10 million toward a default fund and an additional£3million in respect of Swap Clear's Tolerance Contribution Amount. Default funds and capital requirement changes for FCM’s will force clearing members to charge between 20 basis points (bp) and 45bp on initial margin just to break even on funding and counter party risk costs.
Firms that offer client clearing may need to invest in highly complex collateral optimization systems that analyze how to allocate collateral as efficiently as possible. They also face client requests to report swaps to regulators, since ESMA has mandated that both counter parties of a swap must report trade details to a trade repository. Banks may feel pressured to offer this expensive service without guarantee of enough of a client base to warrant the high costs.
Navigating the Risks
The risks of client clearing are present at both sides of a clearing broker's relationship. Clearing brokers assume the risk of their clients and must guarantee and/or immediately sell off their positions in case of a client default. Lack of automation within the sector has forced banks to employ large staffs across various teams such as client on boarding and servicing, compliance and operations. The immediate rewards of maintaining this relationship are few and far between and include small fees that, at best, recoup the cost of the service. As previously mentioned, an FCM's relationship with a clearing house is largely asymmetrical. FCMs must put up capital for membership and must provide connectivity to the clearing house as well as react swiftly to CCP changes in reporting and collateral requirements.
Shifting Business Models
Firms that cannot, or will not, offer client clearing due to the costs and complexity of the infrastructure needed are in an untenable position. Regional banks are the most at risk; they face stiff competition from larger firms with an established capital markets arm and nation-wide commercial banking relationships. These competitors have the ability to offer both structured financial products and clearing. Firms that do not offer client clearing have limited options. Banks may try to creatively structure their clients' swaps so that they do not require clearing, but the final margin requirements for uncleared swaps, as published by the BCBS and IOSCO, will significantly increase margin requirements for these swaps over the coming years. Rather than simply giving up on these relationships, firms must begin to embrace the industry-wide push toward clearing and take advantage of the rising industrialization of this sector.
To help offset the upfront and running costs of offering client clearing, banks are moving toward creating a client servicing utility platform for OTC derivatives. Creating a market utility is a challenging but worthwhile effort that requires forming a consensus on a number of levels, from high-level concepts, such as membership commitments and product scope, to the more focused details like vendor selection and client on boarding. This type of cross-market collaboration would have been largely unthinkable in years past, but today, firms across all sizes and geographies are working together to better meet their clients’ needs.
As rising costs have made it more difficult to retain clients, the market has recognized that it is more important than ever to maintain a full service offering to clients. Client clearing is just one service that has proved to be a necessary expense. Banks have determined that offering client clearing services keeps clients engaged in more profitable lines of business such as bond issuance and structured financing. Firms that do not offer clearing must give up client contacts and data to their competitors and risk losing long-time customers. The high cost of this service offering puts an emphasis on the need for a rational data structure and automated back-office processing. Banks that cannot afford to offer client clearing on their own must find innovative solutions, such as establishing an industry utility, to keep up with their clients’ demands.