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
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.