George Kaye, April 2017
Since the financial crisis of 2009, the financial industry has come under significantly greater regulatory scrutiny, in all areas from inducements to execution and reporting transparency. In Europe, two cornerstones of this regulation are the Markets in Financial Instruments Directive (MiFID) and the European Market Infrastructure Regulation (EMIR). The full scope of these directives is beyond the scope of this article. We will instead concentrate on new margin requirements on OTC derivative transactions, together with the more stringent reporting requirements associated with them, and present an argument for why a transparent, consistent, shared platform is no longer a ‘nice to have’, it is a regulatory necessity.
The Drive to Collateralise
In an effort to reduce risk for market participants, in addition to increased reporting and contract standardisation measures (Solum Financial, 2014) , EMIR has concentrated on two areas: clearing and collateral management. The first of these has mandated that all ‘standard and liquid’ over-the-counter (OTC) derivatives transaction entered into by financial counterparties, and some non-financial counterparties, be centrally cleared through a central counterparty (CCP), principal among which are LCH-Clearnet in the UK, LCH-Clearnet SA in France, Eurex Clearing in Germany, CC&G in Italy and MEFF in Spain. The second has mandated that OTC transactions be collateralised, whether centrally cleared or not. A CCP transaction works in the following way:
- Once a transaction has been agreed between two parties and registered with the CCP, the CCP inserts itself into the transaction, such that the original contract between A and B is split into two, with the CCP becoming buyer to every seller and vice versa.
- A given security is netted between members on a multi-lateral basis, such that delivery of one security between A and B can be netted off by delivery on the same security between C and D, etc. This provides much smaller net risk exposures than bi-lateral netting, with an associated reduction transaction costs.
The principal advantage in this mechanism is that CCPs are backed by a series of capital buffers, together with risk sharing amongst CCP members. For this reason, CCPs are deemed to be low-risk counterparties, with associated reduced regulatory risk capital charges. For the participants however, the advantages of central clearing are not quite so clear cut (ICMA Group, 2017).
- CCPs tend to specialise in particular products or asset class reducing the scope for netting across products, which institutions are currently able to do on a bi-lateral basis
- The initial margins and variation margins imposed by CCPs are very high compared to current market practice. Participants also incur an increased capital charge from clearing fees and contributions to the CCP default fund. The increase in the cost of margining is estimated at €10 per €1 million notional traded(Deloitte, 2014), whilst the increased capital charge is estimated at € 3 per €1 million notional. EMIR also imposes that all OTC and exchange traded derivative transactions be reported to a trade repository no later than T+1, together with information on historical trades. This includes valuation, collateral reporting, account segregation and record keeping, all of which imposes an additional cost on the transacting firm, estimated at €0.6 per €1 million.
The picture for non-centrally cleared transactions is even worse. OTC derivatives will be subject to strengthened risk management requirements, including the need to collateralise positions. There will in addition be increased capital charges and additional reporting costs. Deloitte estimates the overall increase in cost for non-cleared OTC derivatives arising from EMIR reforms at more than ten times the increase on cleared transactions. Margin costs alone are estimated at €50 per €1 million notional, five times higher than centrally cleared, and can be explained by the loss of advantage derived from multi-lateral netting and greater clearing efficiency of CCPs. Trades which until now were not subject to collateral arrangements are now going to be hit by expensive bi-lateral initial margin requirements, with an ongoing variation margin on top. An increase in capital charges will derive from protection against variations in the credit valuation adjustment (CVA), designed to measure asset valuation changes deriving from changes in counterparty credit risk. The additional reporting cost is much the same as per centrally cleared transactions. The reporting requirements imposed by EMIR will apply regardless of whether the transaction is centrally cleared or not.
The overall result of this increased regulatory burden is Europe is likely to be a higher cost of trading, together with a change in the product set offered by dealer banks to centrally cleared, less costly asset classes. Equally, end-users may end up using less precise, centrally cleared products as hedges against their portfolio, effectively leading to an increase in market exposure on their balance sheet. It would indeed be ironic if the move to reduce risk in financial institutions actually ended up by increasing it.
The Drive to Report
The above concentrated on moves taken to reduce the risk to the market of counterparty default, together with the significantly elevated transaction costs resulting from such a move. Hand in hand with this, we also have increased reporting burdens on financial institutions to their own clients, resulting from the new MiFID directive (MiFID II) and regulation (MiFIR) resulting from technical advice from the European Securities and Markets Authority (ESMA). The overall aim of these developments, of which MiFID II is due from implementation imminently in January 2018, is to provide greater transparency and protection to the users themselves of services provided by the financial institutions referred to in the previous section. The scope of the legislation is vast, covering conflicts of interest, remuneration, communications, inducements, product governance, execution, order handling, client suitability, complaints handling, safeguarding of client assets and client reporting, to name but a few. In this section we will concentrate on the last of these, client reporting.
Under MiFID II, various reports need to be provided to all clients, professional, retail and ‘eligible counterparties’ (broadly speaking financial institutions, insurers, pension funds and governments) in a durable medium, namely (Norton Rose Fulbright, 2015):
- Trade confirmations on a T+1 basis
- Reporting obligations in respect of portfolio management, namely the trading activity and performance of the portfolio during a given period, which should be quarterly at a minimum
- Statement of client financial instruments or client funds, also quarterly at a minimum. Statements must provide a clear indication of which assets are subject to client asset protection and which not, together with a robust estimate of market value where a direct market price is not available.
- Occasional reporting, when the value of the portfolio depreciates by 10% and further multiples of 10%.
ESMA has also indicated that, where clients have access to an online system (which qualifies as a durable medium), and where the firm can prove that clients access it in practice, the firm does not need to provide periodic statements. The importance of this condition cannot be overstated. Provided a firm is able to share information, in a dynamic manner, with its own clients, such that the information reported can be seen to be fair (marked-to-market), comprehensive, and transparent, the regulatory onus on the reporting institution, to say nothing of the operational risk and associated costs, will be significantly reduced.
Putting it all together – a common platform
We have shown, both from a transactional viewpoint, and a reporting one, that increased regulation both from new EMIR and MiFID directives is going to make business in OTC derivatives significantly more costly and time consuming. So what then is best practice, going forward? Clearly, applications to optimise collateral over multiple CCPs are a good first step in reducing margin costs through maximisation of netting benefits, but this is only a part of the picture. CCPs are not suitable for all types of market user. The access criteria and cost represent barriers to entry for smaller firms, coupled with the fact that netting is only effective for institutions with two way flow, i.e. brokers rather than end investors. In addition, netting requires standardisation of financial instruments, so that a bi-lateral arrangement may be the only possible route in many cases. The bigger picture, from a transactional viewpoint, is to reduce the cost of non-centrally cleared trades. One effective way of approaching this is to establish independent valuation standards, transparent to both parties of the transaction, thereby reducing the cost of collateral disputes. In other words, an independent, shareable platform for valuation and collateral management.
From a client reporting viewpoint, the case is even clearer. A shared platform will allow firms to be pro-active and timely in the reporting process, not only providing clients with required information, but demonstrably and actively involving them in the reporting process, every day, not just quarterly (by which stage any problems are likely to have become disputes). Such a platform, at a stroke, not only maximises client transparency, but removes out-right the need to go through a costly periodic reporting review, with the associated pain points of reconciliation and aggregation.
Back in 2011, when I originally conceived the idea of Derivitec, I decided on a cloud based approach as a means of providing me with the machinery I needed to provide a robust valuation infrastructure at a cost effective price point. It just so happened that the resulting web based application, and associated APIs, provided exactly the right solution to the onerous regulatory burdens faced by the financial industry today. Clients, whether they be retail, professional, or financial, can log in, evaluate the risk on their portfolios, clearly and consistently, shared with all members of their transactional network. Disputes are mitigated far in advance of their becoming problems, operational inefficiencies minimised through sharing across departments, and client facing transparency guaranteed by construction. Whilst we still have much to do to make our platform standard, we have at least started to establish what that standard is.
Deloitte. (2014). OTC Derivatives: The New Cost of Trading. EMEA Centre for Regulatory Strategy.
ICMA Group. (2017). What does a CCP do? What are the pros and cons? Retrieved from http://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/repo-and-collateral-markets/frequently-asked-questions-on-repo/27-what-does-a-ccp-do-what-are-the-pros-and-cons/
Norton Rose Fulbright. (2015, May). MiFID II Investor Protection (Conduct of Business). Retrieved from MiFID II / MiFIR series: http://www.nortonrosefulbright.com/knowledge/publications/121979/mifid-ii-mifir-series
Solum Financial. (2014). Regulatory sea change for OTC derivatives: The clearing and margining revolution. Solum Financial .