Preparing for CCP
2011 has seen a continued focus on regulation of markets and participants on a global scale. Derivatives and particularly the OTC world, seemingly the bête noire of press, politicians and regulators alike over the last few years, are the focus of much of this with Dodd-Frank in the US leading the way in terms of legislation. As with so much in life, where the US leads Europe follows.
With the exotically acronymed EMIR (European Market Infrastructure Regulation) soon to be presented, it is worth taking the time to set out at a high level some of the areas of impact facing the Investment Management community as they seek to meet the new challenges provided by impending regulation covering the implementation of Central Counterparties (CCP’s) for OTC derivatives.
2. Setting the Scene – Buyside Considerations
For the buyside, access to the CCP will usually come about through partnering with a Clearing Member or members. This is not unlike the existing relationship with clearing brokers in the Exchange Traded Derivative (ETD) world. However, that is not to underestimate the complexity in dealing with the challenges of implementing the new structure. Regarding selection of a clearing partner, there are a number of considerations to take into account including connectivity to CCP’s. These will include transparency of charging structures for each CCP and how these will be applied to the buyside party, given that each CCP is likely to have its own method of calculating margin.
The buyside will seek to investigate more closely how the Clearing Member(s) will seek to ensure and demonstrate cost minimisation for clearing while maintaining regulatory transparency and ensuring protection of client moneys, e.g. segregation of margin. Further consideration will also need to be given to the need or otherwise for a secondary clearer to mitigate against the effects of default by the primary clearer.
3. Operational Impact of Margining Changes
EMIR is likely to require CCP’s have the ability to call and collect margin intraday from clearing members. It is likely therefore that clearing members will require daily collection of margin from buyside clients. While this is at one level simply the extension of the existing ETD operating model, further consideration of the impact on the portfolio is required in a number of areas. Where currently collateral is not calculated and posted daily there will be operational and portfolio implications which need to be assessed such as how the margin obligations will be met operationally and what security will be posted. For equity based clients and portfolios and those which do not natively meet the minimum eligibility requirements for margin prescribed there may need to be some consideration of the use of collateral transformation through custodian or collateral service providers. With respect to margin, the way in which this will be segregated for clients from the clearers own positions will also be central.
While EMIR will require the clearing of eligible OTC’s, it will still leave scope for bilaterally traded OTC’s which do not fall under the clearing requirement.
Non-cleared transactions will not however escape EMIR which will require additional obligations covering requirements for electronic confirmation; Portfolio valuation and reconciliation; Daily mark-to-market procedures and reporting of non-cleared trades to a trade repository. Further, margin will need to be posted for non-cleared trades. It is interesting that Dodd-Frank explicitly requires the posting of Initial Amount (IA) margin as well as variation margin for non-cleared trades and it is possible that EMIR will look to harmonise.
While this presents some issues and a significant change to the non-hedge fund buyside collateral operating model, it does seek to mitigate the issues arising from over-collateralisation which, in combination with the English Law CSA being based on title transfer, resulted in some buyside firms being forced to join the queue of Lehman’s creditors when rehypothecated excess collateral was not returned.
This raises the issue of segregation of IA. In order to ensure comfort for the provider to recoup excess collateral, some consideration of the legal structure supporting the bilateral agreements is required. EMIR wording as it stands requires the “timely, accurate and appropriately segregated exchange of collateral”. There are of course a number of models for segregation but the most robust when taken in the context of title transfer would be the use of a tri-party collateral agreement between counterparties to the trade and custodial collateral agent.
4. Contractual Consequences
Of course, this is not the limit to legal work required prior to the legislation being confirmed. After selection of a clearing member or members, progress on which is well underway for some buysiders, there will need to be rework of ISDA’s to cover both cleared and non-cleared trades as well as rework to CSA’s to account for both the Mark-to- Market and Initial Amount legal rework of ISDA- between buy side and GCM to account for cleared/non-cleared trades.
Investment Managers will need to sign supporting agreements with each counterparty, determining such issues as how the trades are communicated, how they are ‘given-up’ and margin terms and conditions.
Further complications to the operating model arise from the fact that while trades entered into before clearing comes in escape the regulations, any such trade subsequently novated after they come in would then fall under the new regime. Hence a robust process is needed in advance for ensuring that the operational, legal and collateral processes which would then kick in manage the transition smoothly.
5. “Wait and See”
Some asset managers may be waiting for finalisation of regulations before acting. While it is clear from the above that preparation for the advent of EMIR and the brave new world of CCP will continue to be considerable, there will be a significant first mover advantage for those in the buyside who seek to engage actively. The concentration of service providers such as clearers, custodians and collateral outsource agents will of itself create bottlenecks as all continue to develop their offerings and engage with counterparties. Common sense dictates that all of these parties will have bandwidth limitations as the countdown to implementation of EMIR moves closer. Engaging at the earliest opportunity will ensure that the necessary relationships are well established.