Hans-Ole Jochumsen President, Global Trading and Market Services, NASDAQ
The clearing landscape is at an important crossroads. Regulatory reform is prompting unprecedented change and the upshot will be a very different clearing regime to what we have today. The overall aim is well understood – to create greater stability and transparency. However, the real challenge will be achieving this while balancing the needs of participants with those of the market and society as a whole.
This will require some careful navigation of the detail and, crucially, a re-think of clearing practices. While regulators iron out the specifics, CCPs have an important and collaborative role to play in defining this future. Three areas stand to have the greatest impact – capital efficiencies, investor protection and technology innovation.
The rise of cross-margining
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Achieving capital efficiencies will remain an important consideration as participants look for ways to do more with less. Today, this is largely related to margin levels but that’s all about to change.
Decisions around what to trade and clear will be influenced not only by the product but also by the levels of margin required. This will become increasingly important with mandatory clearing, given that participants will clear more products while having to hold larger amounts of capital.
Cross-margining has emerged as a valuable tool to tackle this challenge. Currently, this is done to varying degrees across the industry, whether it’s cross-margining across OTC and exchange-traded products or net margining across multiple asset classes. It is where many CCPs have been able to differentiate their offerings based on their risk appetites. However, regulations will harmonise margin levels. Therefore, most participants could, eventually, achieve the same levels of efficiency through margining, regardless of where they clear trades. As a result, participants will be on the hunt for other ways to make the best use of capital.
Collateral management, while not new, will need to evolve to meet this need and it is this that will drive future capital efficiencies. Opinions and predictions differ on whether there will be a collateral shortfall and, if so, how great it will be. The reality will depend largely on how well these assets are managed. Therefore, the ability to optimise collateral in ways that are not related to margins will become highly valued.
On the broker side, efforts to address shortfalls on clients’ inventories or transform ineligible assets into suitable collateral will have a big impact. On the CCP side, there are several possibilities that could emerge.
One of these is integrated calculations between margin portfolios and collateral portfolios. This would allow full offsets where a participant holds the underlying security when trading, for example, an equity option. Clearing systems calculating the exposure in a participant’s portfolio against their underlying collateral is true collateral management.
Other opportunities include optimising cash, with total netting across all cash flows and full STP. This would apply to the entire cash flow, from instruction and confirmation to reconciliation of individual transactions. As a result, any excess collateral in cash could be used to cover cash settlement while a positive cash settlement could cover the margin requirement.
Delivering better collateral management will be subject to certain constraints – such as the time it takes to transfer cash and securities between parties. It will also depend heavily on technology. Dealing with the complexity of clearing requires greater innovation and this becomes highly relevant when considering open access and interoperability. Whether the latter becomes a reality soon is not yet clear. However, the drive to increase competition in clearing means that innovation in collateral management will have a marked impact on what participants choose to clear and, importantly, where they clear them.
Collateral management will also be driven by greater automation, standardisation and anything that improves efficiencies. Connectivity and the continual drive for STP is one example. The elimination of manual intervention of flows between the participant, client and CCP could well push through the standardisation of FIXML, FPML and Swift-based messaging. Automation would also deliver further capabilities, such as direct debit or credit transactions that automate the paying back of any cash surplus on a member’s account.
Raising the bar for client segregation
When creating stability, the future of clearing must support the fundamental principle that investors should not have to bail out a defaulting CCP. Client segregation is vital for this. The reason that firms are still unpicking the collateral held at Lehman brothers and MF Global is evidence that segregated clearing was not in place.
While client segregation is now mandated by the regulators, it is demand from participants that will drive future offerings. They will want increasing levels of protection that give them confidence and peace and mind – and the regulatory minimum might not suffice.
The Omnibus model is a case in point, with CCPs holding one account for multiple clients. This falls short of truly mitigating risk as it lacks transparency around what collateral and positions each client has. As such, they will prove difficult to transfer.
More robust offerings are required, so the future will demand account structures affording different levels of protection, covering both ICA accounts and fully segregated structures. This approach has already proved its worth in real market circumstances. As with collateral management, technology will once again be the driver. In particular, this technology will need to include systems and account set-ups to manage a large number of these different segregation structures.
The industry has a false impression that this level of true segregation is costly and complex. The reality is that it is not only a must-have, ensuring stability and investor protection, but also entirely accessible.
New approaches for recovery and resolution
If we assume that all CCPs will eventually catch up on client segregation, then the real opportunity for change in investor protection will be through recovery and resolution. Getting this right could have the greatest effect on reducing systemic risk.
Market infrastructure is important and there are some clear divides of opinion. On the one hand, a market with one or two large CCPs would be better for capital efficiency. On the other, it creates huge systemic risk because a single CCP default would have a massive impact on the financial markets. A palette of medium- and large-sized CCPs would allow for more robust recovery options – and that’s going to benefit the market and society far more. The roadmap to achieving this will need to address the commercial interests of all involved. However, it should evolve naturally as a result of regulations encouraging competition in the market.
Recovery and resolution in this landscape of multiple CCPs would need to consist of carefully considered tactics. Every recovery situation will be unique, so having a one-size-fits-all approach could have unwanted negative consequences. For example, forcing mandatory transfers of positions to another CCP would create additional risks if that CCP is not equipped to take them on. A more flexible and robust solution would be a voluntary recovery arrangement for fungible OTC contracts that are cleared by all CCPs. This would allow the market to find the best fit in any particular scenario.
This would call for a high degree of dialogue and cooperation, which would be a big shift for the industry. However, it is a good example of where collaboration is essential to deliver real benefits to the market.
Paving the way with technology innovation
Ultimately, technology is going to be the driver for the future of clearing. In the past, the front office received most of the limelight. The future will be very different, with regulatory reform, increased competition and client demands affording clearing far more attention – and a new wave of innovation.
What’s clear is that change is inevitable. Greater competition through regulation is a positive step – and with that comes greater choice. Participants will be looking for ways to tackle costs and deliver the most efficient and effective clearing processes. As a result, the industry must collaborate and innovate if it is to promote competition and make a more stable and transparent market a reality.