In this article, Mike O’Hara and Anna Reitman of The Realization Group take a look at how CCPs and clearing members of trading venues are using technology to address the challenges of overhauling post-trade infrastructures in an era of regulatory reform. Many clearing firms still rely on legacy technologies that are cumbersome, slow, expensive to adapt and not tuned into a real-time marketplace reality. Mike and Anna speak with a panel of experts – Tina Hasenpusch, CEO of CME Clearing Europe; Andrew Simpson, Head of Post Trade at Euronext; Urs Wieland, Chief of Staff and Executive Director at SIX Securities Services; Diana Chan, CEO of EuroCCP; and Tore Klevenberg, CEO of Baymarkets AS – to understand how buy and sell side are adapting to agile and lean operations as they tackle regulatory requirements and get positioned to lead the future.
The rise of the clearing house has been nothing short of revolutionary since the financial crisis. Long relegated to being a boring backroom function, the emergence of the Central Counterparty (CCP) into the spotlight has been both welcomed and heavily scrutinised. In both those aspects, global regulators have been major players, trying to calibrate the costs of risk mitigation in the bilateral OTC trading world post-Lehman collapse.
It’s meant the buy and sell side have had to figure out the path of least resistance in setting up systems and investing in technologies just to stay in the derivatives game. At a time of razor-thin margins and seemingly never-ending, sometimes unpredictable new rules from regulators, a “wait-and-see” approach has been the prevailing attitude. But that’s changing, and the leaders are going to be those firms that understand how post-trade infrastructures fit together.
For buy side firms, which represent the ultimate client tapping into clearing services, one of the major issues has been protecting assets in segregated accounts, explains Tina Hasenpusch, CEO of CME Clearing Europe. “It means making decisions about account structures, segregation models, collateral management and optimisation, and the setting up of systems to support those decisions”, says Hasenpusch.
“Clearing intermediaries are still struggling with providing scalability of these offerings, which is adversely impacting their ability to provide support.”
Tina Hasenpusch, CEO, CME Clearing Europe
OTC derivatives contracts have a significantly higher risk profile than other asset classes, like equities, and, consequently, present a greater challenge for CCPs. Both regulators and the buy side want collateral to be segregated, so, for example, a pension fund or corporate needing to give collateral to a CCP will want it ring-fenced rather than pooled. That’s because in the case of an adverse market event, there is clear ownership and the same collateral can be simply transferred to another CCP or clearing member.
It’s understandable why such an arrangement is desirable, but such features come with a mismatch in compatibility between regulatory jurisdictions, not to mention a certain measure of “sticker shock” when firms find out how much fully segregated models actually cost to set up and manage, once the price tag for enhanced segregation from clearing intermediaries has been factored in.
“We know that clearing intermediaries are still, to a certain extent, struggling with providing scalability of these offerings,” says Hasenpusch. “It is adversely impacting their ability to provide support in terms of their legacy middle- and back-office systems.”
New operating models are being trialled to accommodate the buy side. Deutsche Borse’s derivatives clearing house, Eurex Clearing, for example, is piloting a new category of clearing membership called ISA Direct (referencing individual segregated account structures) and changing the relationship between the client, banks and the clearing house. In brief, Eurex is providing direct access to clearing for the largest pension and insurance funds, while taking on the associated counterparty risk. By doing so, Eurex expects to alleviate capital charges that are challenging clearing brokers under incoming regulations.
For the last few years, the industry has been characterised by a focus on implementing G20 reforms, says CME Clearing Europe’s Hasenpusch: “If I look at the industry today and summarise it in a few words, then it is about getting the right structure in place, for the buy side and the sell side, to achieve regulatory compliance.”
That means compliance with initiatives born of the 2008 crisis such as Dodd-Frank in the US and EMIR (European Market Infrastructure Regulation), as well as CRD IV (Capital Requirements Directive IV) and a number of reporting and clearing-related elements across jurisdictions.
One of the more controversial regulatory measures has been the Leverage Ratio, a capital requirements calculation that has seriously dented profits, and as a result thrown into question business models built on providing intermediary services.
As clearing intermediaries increasingly scrutinise the bottom line, they are focusing on different parts of the value chain – the various components that comprise clearing services such as matching orders together, ensuring that deliveries are made to the correct parties and collecting margin money – and being forced to redefine what services they can continue to provide profitably. This also means that banks need to justify any costs of new systems and processes.
“When you talk to the banks and they’re finding their margins are getting cut and you’re asking them to invest in new infrastructure, you can see why economies of scale are more important than ever before,” says Andrew Simpson, Head of Post Trade at Euronext. As a result, treasury operations within banks, as just one example, are looking closely at how to build speed and agility into their processes.
With all of this happening within historically fragmented units operating in silos, like OTC desks, pulling those silos together presents some significant hurdles. To address those challenges, some major banks are creating centralised collateral desks and implementing collateral optimisation strategies, solutions that come with their own set of problems to solve such as where authority is placed to decide whether trades are economical and how to allocate and calculate transaction fees, all while trying to lead an organisation through a massive operational and technological overhaul.
“Modern and highly sophisticated systems must be implemented in the market in order to solve all these regulatory-driven requests.”
Urs Wieland, Chief of Staff and Executive Director, SIX Securities Services
Urs Wieland, Chief of Staff and Executive Director at SIX Securities Services, believes that technology will play a major role in an environment where impact is felt across the whole chain of trading, settlement and clearing: “Modern and highly sophisticated systems must be implemented in the market in order to solve all these regulatory-driven requests”, he says.
SIX x-clear, the clearing arm of SIX Securities Services, recently inked an agreement with Baymarkets AS, the Norwegian arm of technology vendor Baymarkets, to farm out the support, maintenance and development of its clearing platform, Clara, as well as to make the tier 1 clearing solution available to a wider range of clients, such as exchanges, multi-lateral trading facilities, clearing banks and clearing houses.
With change – whether driven by regulatory authorities, client demands, or other business drivers – comes the challenge of time-to-market, says Tore Klevenberg, CEO of Baymarkets AS: “There are many changes related to things like reporting, collateralisation…firms need to be able to react to these changes, from a technology perspective, quickly.”
Banks and clients now need a whole overview of their total risk in real-time risk management, says Euronext’s Simpson. “They’re monitoring the portfolio on a more regular basis than ever before, and that means all of the risk framework is more agile…It’s about a wholesale change in philosophy and belief that we’ve got to operate in a more agile and real-time environment.”
One of the big questions in the wake of regulatory reform is about the amount of collateral that will be required to cover risk exposure in the system and, perhaps more importantly, how collateral will get to the right place at the right time.
At the moment, exchanges “funnel through the buyer versus seller to the relevant CCP risk infrastructure”, explains Simpson. The CCP kick starts the process, but it doesn’t have to be that way. Pre-trade risk management systems, set up to catch, for example, rogue algorithms and protect markets, can be used to do pre-margin analysis as well.
“Before we’ve even closed out and sent the trade, people are able to do scenario analysis, cheapest-to-deliver type analysis, find out exactly what collateral they might need and make sure they’re starting to move that collateral and get it prepared for any margin call that they may have,” Simpson says.
“It’s about a wholesale change in philosophy and belief that we’ve got to operate in a more agile and real-time environment.”
Andrew Simpson, Head of Post Trade at Euronext
The task of moving the right collateral to the right place becomes exponentially more complicated when taking into account the reality of open positions across many markets being fed into multiple CCPs. It means understanding capital requirements before the margin call, a calculation that needs a connected process or at the very least one that is able to consume all the data from across the ecosystem.
It’s one of the reasons why interoperability has become a major talking point in the market: “Clients would like to use, whenever possible, a single entry point for their activities. They don’t want to be linked to five or six different market infrastructures,” says SIX Securities Services’ Wieland.
Taking control of risks requires a significant measure of integration among various clearing systems in order to get all the necessary data and do so in real-time, notes Klevenberg from Baymarkets. From a collateral perspective, the right links need to be in place.
“You have to support all the standard APIs, so you need interfaces to the collateral banks and the CSDs (central securities depositories) to streamline the whole process, making it easier both for the CCP and the end-clients,” he says.
For all the attention on it, however, there is no such thing as real-time clearing, says Diana Chan, CEO of EuroCCP, an equities clearing house. That’s despite operations such as intra-day real-time risk management and continuous netting being fairly standard practices.
“You could have real-time risk monitoring, but unless you can also collect the required collateral in real time on the running net positions, you are still exposed,” she says.
At its core, a CCP guarantees against counterparty risk by collecting collateral from each party. For a CCP to collect collateral along with every trade just doesn’t make any sense, and this is why end-of-day multilateral netting is used instead, although CCPs are able to collect collateral on intra-day net exposures as and when needed. Multilateral netting doesn’t require any particularly sophisticated technology, Chan notes.
“It’s batch. It’s capacity. It’s not latency. It’s the capacity to catch whatever comes down the pipe…The ability to process the batch in a short time window to deliver end-of-day report in time to the client,” she says.
Although EuroCCP is an equities clearing house, Chan watches developments in the OTC clearing space closely, and is the first to admit that derivatives face greater challenges; two of the biggest being market price and liquidity.
CCPs cannot very easily mark the OTC contract to market; because OTC trades are bilateral, getting a market price is difficult. Moreover, if traded instruments aren’t standardised and there is no liquidity, how does the CCP unwind a position?
“These OTC instruments could be a challenge to margin and close out when there is a default, because by definition there is no organised market,” she says.
“You could have real-time risk monitoring, but unless you can also collect the required collateral in real time on the running net positions, you are still exposed.”
Diana Chan, CEO, EuroCCP
Euronext’s Simpson explains that delivering real-time risk management isn’t hindered by a lack of technology, rather by the processes and operational aspects of moving assets correctly. There are also vested interests at play.
“Banks, and custodians, and the ICSDs (International Central Securities Depositories) of this world make a significant amount of money holding on to capital. This is something they are unlikely to give up easily,” Simpson says.
Perhaps the most optimistic gambit at play across the post-trade landscape is the emergence of distributed ledger technologies. Blockchain platform SETL has been first out of the gate with the launch of its Open CSD platform. SETL claims that any market participant can commission and run a permissioned registry service for payments, settlement and clearing of cash and other financial instruments such as securities, private equity, or as a platform for FX or e-money. The technology is benchmarked to settle billions of transactions a day in real-time, according to a SETL press release.
CME Clearing Europe’s Tina Hasenpusch notes that innovative technologies such as blockchain can be enablers to, for example, reduce costs in the financial industry. She points to the area of payments, and the ability to settle currencies in a shorter time-frame as “exciting areas to extrapolate or extract efficiencies”.
One of the ways CME Group is positioned to benefit from new technologies is via its subsidiary, CME Ventures, which makes investments into early-stage technology companies. CME Ventures has partnerships with a number of firms evolving the blockchain, such as Digital Asset Holdings, a firm founded by former JP Morgan executive Blythe Masters.
There is some debate over the meaning of ‘distributed ledger’, particularly in the context of financial markets. One interpretation pegs it as “just a smart database”. Another compares it to teenage sex: everyone’s talking about it but no one really knows what they’re doing.
Euronext’s Andrew Simpson says that there are some very good applications of distributed ledger technology, but not all problems need that kind of treatment. One of the areas where it does make sense in the post-trade environment, he says, is in securely settling multiple transactions. But there are some obvious limitations as well, such as speed.
He points to trade repositories as one of the infrastructures in line for disruption as a result of distributed ledgers in the OTC world. After the financial crisis was triggered post-Lehman collapse, DTCC’s trade repository managed to calm the markets by netting down the buys and sells of CDS (credit default swap) contracts from several hundred billion dollars of exposure to single digit billions.
“It’s all about agility really. The more agile you are, the easier it is to adapt.”
Tore Klevenberg, CEO, Baymarkets AS
Diana Chan from EuroCCP agrees on the trade repository aspect, and adds that tracking collateral rehypothecation, also known as “re-using” collateral in the derivatives marketplace, is another space to watch: “Blockchain is the mechanism by which all the records of the change of title of the asset is permanently embedded in the chain. So, when an asset changes hands, all previous owners are recorded. This traceability has a lot of applications. Whatever needs to have a very clear audit trail will benefit from the blockchain part of this new technology. In the case of rehypothecation, though, when the collateral taker goes under, even knowing where the collateral has ended up isn’t an assurance that you could get it back.”
Still, there is some way to go before it will be adopted wholesale for environments like a CCP, Simpson says: “We’re in a position where this is a very new technology. CCPs are a critical market infrastructure and we need to take care before applying new technology, especially when it’s bound up by significant regulation.”
It’s likely that distributed ledgers, and even newer technologies not yet part of mainstream discussions, will be the answer to more resilient infrastructures. Only one thing’s for sure: being able to adapt is definitely part of the equation.
“I look at technology – and particularly innovation – as an enabler, to reduce costs and really to help us unlock efficiencies as an industry”, concludes CME’s Hasenpusch.
Or as Baymarkets’ Tore Klevenberg puts it, “It’s all about agility really. The more agile you are, the easier it is to adapt.”