The ripple effect of the Dodd-Frank Wall Street Reform Act is finally starting to be felt, as the Securities and Exchange Commission and Commodity Futures Trading Commission begin issuing proposed rules to carry it out.
For fund managers, adapting to clearing their swap trades through a clearinghouse rather than solely with their counterparties will be a challenge.
The short answer: it won't be easy.
"Until now the buy side has not been involved much with central clearing," said Anshuman Jaswal, a senior analyst with New York-headquartered research firm Celent, which just released a report entitled "OTC Derivatives Clearing and the Buy Side in the U.S."
The subhead for the report, "Rough Road Ahead," encapsulates the sentiment of consultants and investment management software firms interviewed by Money Management Executive last week.
Large institutions active in the swaps market "are likely to witness their portfolios split between cleared and non-cleared positions and quite possibly with positions cleared on multiple clearinghouses," Jaswal said. "What this requires is an overhaul of trading platforms and connectivity of the buy-side firms and even that would only address half the problem."
The other half is a litany of technological and operational adaptations to accommodate electronic confirmations, reconciliation of cleared and uncleared positions; management of initial and variation margin, and additional documentation to allow for electronic trading and centralized clearing.
The reason for the lack of preparedness is two-fold. The first factor: Not all of the rules have been set in stone by the SEC and CFTC yet, and many have been postponed until 2012. So fund managers think it is safe to take a wait-and-see approach. The second: fund managers think they can either license a software package or rely on their prime broker, clearing agent or custodian bank to be do the work for them.
That's not always in their best interest. "It's a good idea to rely on prime brokers and custodians, if you think they are investing in the appropriate resources to comply with the regulations," said Zohar Hod, vice president of New York-based valuations firm SuperDerivatives. "But keep in mind that smaller prime brokers and custodians may be less prepared."
What's a fund manager to do? For starters, assess the capabilities of current systems and service providers. "Market leaders are seeing it as an opportunity to improve their operational efficiency and bottom line," said David Kubersky, president of investment management technology firm SimCorp in North America.
Next up: Ensure that the transaction can be affirmed with a broker-dealer through an automated platform such as MarkitWire, Bloomberg VCON, Clearport and ICELink, which can also forward trades to clearinghouses. Aswal estimated that buy-side firms will spend about $180 million in 2012 just to connect with swap execution facilities, clearing brokers and clearinghouses.
Fund managers shouldn't take picking a clearing broker lightly. "Fund managers need to assess the clearing broker based on a variety of factors, including their economic considerations, technology services, as well as their ability to transport collateral and report positions and variation margin in real time," said Mark Abrams, manager at OpenLink Financial, a Uniondale, N.Y.-headquartered firm specializing in operational risk management.
Selecting just one clearing broker isn't an option. Not only do clearing brokers have specialties in different asset classes but in the event of a default of the clearing broker, the fund manager might be able to move its business quickly to an alternative provider.
Executing and clearing brokers are likely to fulfill the requirements of the clients they already have on hand and stick with clients that are comfortable posting large amounts of collateral on short notice. That is because most clearinghouses will require clearing members to deliver collateral from their clients quickly so dealers might require "top up" or additional collateral.
The most difficult aspect of processing swaps: optimizing the use of collateral. Fund managers must first be able to reconcile all cleared positions and uncleared positions with their clearing brokers or counterparties. The reconciliation will require fund managers to bifurcate their portfolios into clearing eligible and ineligible buckets and track the margin requirements of each. To do that efficiently, they will need a combination of workflow management tools, reconciliation software packages and valuation systems to ensure the contracts are priced correctly on a daily basis.
Just as important will be understanding the amount of collateral that must be allocated for bilaterally and centrally cleared swap contracts by investment fund, asset class, clearing broker and clearinghouse. Knowing that will help fund managers project their potential margin requirements in time to ensure they have sufficient liquidity. Exposure simulation models, typically used to analyze uncollateralized counterparty risk, can also be used to assess future liquidity requirements.
"Although centrally cleared swap contracts will be collateralized, fund managers cannot presume they will be completely saved from counterparty risk because there will still be some residual risk involved," said David Kelly, director of credit products at Quantifi, a London and Summit, N.J.-based modeling and risk management firm.
Those residual risks include mark-to-market or foreign exchange risk for securities used as collateral. Clearinghouses minimize these risks by restricting collateral posted to either cash or high quality securities and enforcing daily margining. In bilateral transactions, a broader range of securities for collateralization may be acceptable and the "grace period" for posting that collateral is also less restrictive.
A better picture of collateral requirements will also give the fund manager a sense of whether or not it wants to change its trading strategy to trade more exchange-listed derivatives instead of swaps.
"The higher margins expected for bilaterally cleared swaps and even centrally cleared swaps compared to exchange-traded products could end up playing an important role in that decision," Jaswal said.
Just how to get that enterprise-wide view of collateral requirements-and how much has actually been posted-will be quite challenging for fund managers. That is because the information is often stored in different applications depending on the asset class involved. The fund manager will need to roll up the information into a single report and hope that it is accurate. That accuracy will in large part depend on whether there is a consistent view of the underlying data-the economic details of the transactions, their values, the counterparties involved and what clearing brokers have required.
"It will all come down to a data management and aggregation model," said Ebbe Kjaersbo, chief business consultant for SimCorp. "To ensure the best quality data, fund managers will need an enterprise data management system that aggregates transaction and position data across all asset classes and within parent and affiliate entities."
Buying a so-called collateral management software package won't necessarily ensure accuracy. Fund managers can't make the right calculations if they have disparate descriptive, position and transactional data on the same financial instruments.
And even if they do, clearinghouses have yet to publish the methodology they will use to calculate their initial and variation margins. "It's difficult for a software firm to build a collateral management system without knowing the algorithms clearinghouses will use," said SuperDerivatives' Hod.
SuperDerivatives, now in talks with clearinghouses and prime brokers to incorporate these algorithms internally, plans to offer a "do-it-yourself" query-based value at-risk service.
That service will allow users to identify their stress scenarios as well as the scenarios of the clearinghouses without requiring them to know the exact methodology for calculating initial margin.
The ripple effect of the Dodd-Frank Wall Street Reform Act is finally starting to be felt, as the Securities and Exchange Commission and Commodity Futures Trading Commission begin issuing proposed rules to carry it out.
For fund managers, adapting to clearing their swap trades through a clearinghouse rather than solely with their counterparties will be a challenge.
The short answer: it won't be easy.
"Until now the buy side has not been involved much with central clearing," said Anshuman Jaswal, a senior analyst with New York-headquartered research firm Celent, which just released a report entitled "OTC Derivatives Clearing and the Buy Side in the U.S."
The subhead for the report, "Rough Road Ahead," encapsulates the sentiment of consultants and investment management software firms interviewed by Money Management Executive last week.
Large institutions active in the swaps market "are likely to witness their portfolios split between cleared and non-cleared positions and quite possibly with positions cleared on multiple clearinghouses," Jaswal said. "What this requires is an overhaul of trading platforms and connectivity of the buy-side firms and even that would only address half the problem."
The other half is a litany of technological and operational adaptations to accommodate electronic confirmations, reconciliation of cleared and uncleared positions; management of initial and variation margin, and additional documentation to allow for electronic trading and centralized clearing.
The reason for the lack of preparedness is two-fold. The first factor: Not all of the rules have been set in stone by the SEC and CFTC yet, and many have been postponed until 2012. So fund managers think it is safe to take a wait-and-see approach.
The second: fund managers think they can either license a software package or rely on their prime broker, clearing agent or custodian bank to be do the work for them.
That's not always in their best interest. "It's a good idea to rely on prime brokers and custodians, if you think they are investing in the appropriate resources to comply with the regulations," said Zohar Hod, vice president of New York-based valuations firm SuperDerivatives. "But keep in mind that smaller prime brokers and custodians may be less prepared."
What's a fund manager to do? For starters, assess the capabilities of current systems and service providers. "Market leaders are seeing it as an opportunity to improve their operational efficiency and bottom line," said David Kubersky, president of investment management technology firm SimCorp in North America.
Next up: Ensure that the transaction can be affirmed with a broker-dealer through an automated platform such as MarkitWire, Bloomberg VCON, Clearport and ICELink, which can also forward trades to clearinghouses. Aswal estimated that buy-side firms will spend about $180 million in 2012 just to connect with swap execution facilities, clearing brokers and clearinghouses.
Fund managers shouldn't take picking a clearing broker lightly. "Fund managers need to assess the clearing broker based on a variety of factors, including their economic considerations, technology services, as well as their ability to transport collateral and report positions and variation margin in real time," said Mark Abrams, manager at OpenLink Financial, a Uniondale, N.Y.-headquartered firm specializing in operational risk management.
Selecting just one clearing broker isn't an option. Clearing brokers specialize in different asset classes and in the event of a default of the clearing broker, the fund manager might be able to move its business quickly to an alternative provider.
Executing and clearing brokers are likely to fulfill the requirements of the clients they already have on hand and stick with clients that are comfortable posting large amounts of collateral on short notice. That is because most clearinghouses will require clearing members to deliver collateral from their clients quickly so dealers might require "top up" or additional collateral.
The most difficult aspect of processing swaps: optimizing the use of collateral. Fund managers must first be able to reconcile all cleared positions and uncleared positions with their clearing brokers or counterparties. The reconciliation will require fund managers to bifurcate their portfolios into clearing eligible and ineligible buckets and track the margin requirements of each. To do that efficiently, they will need a combination of workflow management tools, reconciliation software packages and valuation systems to ensure the contracts are priced correctly on a daily basis.
Just as important will be understanding the amount of collateral that must be allocated for bilaterally and centrally cleared swap contracts by investment fund, asset class, clearing broker and clearinghouse. Knowing that will help fund managers project their potential margin requirements in time to ensure they have sufficient liquidity. Exposure simulation models, typically used to analyze uncollateralized counterparty risk, can also be used to assess future liquidity requirements.
"Although centrally cleared swap contracts will be collateralized, fund managers cannot presume they will be completely saved from counterparty risk because there will still be some residual risk involved," said David Kelly, director of credit products at Quantifi, a London and Summit, N.J.-based modeling and risk management firm.
A better picture of collateral requirements will also give the fund manager a sense of whether or not it wants to change its trading strategy to trade more exchange-listed derivatives instead of swaps.
"The higher margins expected for bilaterally cleared swaps and even centrally cleared swaps compared to exchange-traded products could end up playing an important role in that decision," Jaswal said.
Just how to get that enterprise-wide view of collateral requirements-and how much has actually been posted-will be quite challenging for fund managers. That is because the information is often stored in different applications depending on the asset class involved. The fund manager will need to roll up the information into a single report and hope that it is accurate. That accuracy will in large part depend on whether there is a consistent view of the underlying data.
"It will all come down to a data management and aggregation model," said Ebbe Kjaersbo, chief business consultant for SimCorp. "To ensure the best quality data, funds will need an enterprise data management system that aggregates transaction and position data across all asset classes and parent and affiliate entities." MME
