THE CLIENT CLEARING OFFERING: balancing cost, risk and client service
Financial institutions are facing pressure to offer clearing services to their clients. This is a costly endeavor that offers little financial upside for firms: It is a low-margin service that requires a large capital commitment to clearing houses as well as a heavy investment in technology. Phil Matricardi and Adam Kott discuss the costs and risks of offering client clearing as well as how firms may begin collaborating in the future to meet their clients’ needs.
High-cost, high-touch banking and advisory services, such as over-the-counter (OTC) derivative brokerage, mergers and acquisitions advisory and fixed income capital markets, have been either slated for a gradual wind-down or discontinued outright at major capital market firms following the global financial crisis of 2007-08. This is largely due to decreased funding, merger and trading activity, as well as the onset of post-crisis regulation. However, new market models are emerging and some firms have already found that, in addition to cutting costs, they must also increase the services they offer to their clients in order to remain competitive.
Internal strategies and technology stacks within global investment banks continue to be carefully guarded secrets; however, there is a slow and steady shift toward industrialization. Investment in market-wide standards, best practices and utility platforms are becoming increasingly necessary as the twin drivers of decreased profitability and increased regulatory and compliance costs put pressure on closed business models. From global investment banks to smaller regional firms, this fundamental evolution toward commoditization in formerly highly bespoke markets, such as corporate finance advisory and financial derivatives, is necessary in order to maintain a full-service client offering in the new environment.
Prior to the global financial crisis, OTC derivative trading was highly profitable and Wall Street banks relied on OTC derivatives for 40% of their profits.1 The enormous profits that came with these trading desks allowed management to overlook manual processing and large support staffs. In 2014, the same banks found themselves in a very different environment. Expensive and inefficient proprietary systems became entrenched within their firms’ operating models. Even worse, the mergers that firms used to grow during the good years (and which they enacted during the crisis for both strategic reasons and at the request of regulators) had left them with a proliferation of software platforms and parallel operational channels. Transitioning toward a unified system represented a bitter pill for stakeholders to swallow: turn their backs on sunken costs and familiar operating models and either select one competing system from their current surplus or purchase and implement entirely new software.
The Regulatory Impact
Mandates handed down by the US Commodity Futures Trading Commission (CFTC), European Securities and Markets Authority (ESMA) and other regulatory bodies have drastically increased the number of swaps being cleared. A recent ISDA whitepaper estimates that regulatory requirements “are expected to increase the portion of the OTC derivatives market that is cleared to about 70% of global OTC derivatives activity.”2 Regulations mandating that swaps be executed at swap execution facilities (SEFs) and cleared via central counterparties (CCPs) have fractured what were once strong bilateral client relationships. As a result of these regulations and internal inefficiencies, banks face continually decreasing returns on equity amidst client pressure to offer these high-cost services. Yet firms must offer clearing services for their clients or they risk sending these clients into the arms of competitor banks.
A major use of interest rate swaps is to hedge floating rate debt issuance. 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, as seen in the Sapient Global Markets Cost of Clearing Study3, dealers also face rising costs to offer this service to their clients. 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.
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 SwapClear, clearing brokers pay up to £2.25 million annually, £10 million toward a default fund and an additional £3 million in respect of SwapClear’s Tolerance Contribution Amount.4 Default funds and capital requirement changes for FCMs will force clearing members to charge between 20 basis points (bp) and 45bp on initial margin just to break even on funding and counterparty risk costs.5 In addition, clearing houses force banks to typically source collateral from a limited pool: highly rated sovereign bonds, US treasuries and Government National Mortgage Association (GNMA)-issued mortgage-backed securities. Those that do accept forms of collateral with more volatile prices, such as gold, often impose steep haircuts to help hedge against this volatility. Firms that offer client clearing may need to invest in highly complex collateral optimization systems that are able to analyze how to allocate collateral as efficiently as possible. In addition to the costs associated with membership and collateral optimization, firms also face requests from clients to report swaps to regulators, since ESMA has mandated that both counterparties 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 onboarding 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. There is also a small but persistent threat that a clearing house could fail—though many believe these institutions are considered “too big to fail” and that a default would be met with swift and decisive action by regulators.
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. For more information about the link between industrialization and the new market infrastructure, see Ryan Baccus’s article, THE INDUSTRIALIZATION OF CAPITAL MARKETS—where are we now?.
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. These platforms offer a number of functions such as operations, transaction and collateral pass-through and connectivity. 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 onboarding. 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.
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 onboarding.
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 a light staff to oversee automated back-office processing.
While banks may want to begin offering client clearing to their customers, several barriers to entry exist—including the upfront cost, the complex and expensive infrastructure needed to operate and ever-evolving regulations. 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.
- PBS, “Interview: Brooksley Born,” PBS. PBS, n.d. Web. 14 (February 2014)
- International Swaps and Derivatives Association, “Non-Cleared OTC Derivatives: Their Importance to the Global Economy,” March 2013, <http://www2.isda.org/attachment/NTM2OA==/Non-Cleared OTC Derivatives Paper.pdf> (February 14, 2014)
- The drag on portfolio alpha in the new environment will range from between ~20bps to ~62bps for cleared trades, depending on the products, and up to ~91bps for traditional uncleared bilateral OTC trades, <http://www.sapient.com/content/dam/sapient/sapientglobalmarkets/pdf/thoughtleadership/Cost_of_Clearing_Study_final.pdf>
- LCH.Clearnet Group. N.p., “SwapClear.com,” <http://wwwlchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp> (February 14,2014)
- Mariam Rafi, “What Will Clearing Cost?,” Risk, September 6, 2012, <http://www.risk.net/risk-magazine/opinion/2200954/what-will-clearingcost>, February 14, 2014