Buy Side Ambivalent on Clearing

Terry Flanagan

Institutional investment firms that use derivatives to hedge their exposures are busy preparing for the launch of centralized clearing for OTC instruments, but aren’t sure whether the benefits will outweigh the costs.

“A lot of people would debate the benefits of central clearing,” said John Griffin, Senior Risk Manager at The Hartford Investment Management Company (HIMCO). “The theory is that central clearing takes counterparty exposure risk away from the dealer community and provides regulators with more transparency into OTC markets and participant’s activities while potentially lessening leverage in the system. However, we’ve been able to actively manage our 15 OTC counterparty relationships on a bilateral basis. Now, those exposures will be aggregated onto one or more CCPs.”

John Griffin, senior risk manager, HIMCO

John Griffin, senior risk manager, HIMCO


Swap dealers, major swap participants and private funds active in the swaps market have all been required, from March 11, to begin clearing certain index credit default swaps and interest rate swaps.

All other financial entities will be required to clear swaps beginning on June 10, 2013, for swaps entered into on or after that date. Buy-side market participants transacting swaps must determine whether they are subject to the mandatory clearing requirement.

The move to central clearing will bring added costs in the form of legal documentation and onboarding expenses, margin requirements, and clearing fees.

On the legal documentation side, agreements between trading counterparties and clearing brokers need to be revised or created from scratch.

HIMCO has relationships with two futures commission merchants (FCMs) and will be adding two more, Griffin said.

“Everybody who trades clearinghouse eligible OTC derivatives needs to have an FCM Agreement, OTC Addendum and Execution Agreements in place,” he said. “These three documents are the ISDA equivalent of the legal agreements you sign with the dealers to trade and clear OTC products. It is a very similar documentation structure to that required for clearing listed derivatives, except that it contains the OTC Addendum. Some dealers have made minor adjustments to their pre-Dodd-Frank FCM Agreements to include language relating to cleared OTC derivatives, but most are relying on the OTC Addendum to contain the necessary terms and conditions required to support cleared OTC derivatives.”

Margin and clearing costs add another layer of costs associated with central clearing.

“For large institutions like ourselves, we historically have not had to post initial margin,” Griffin said. “IM is a big cost. You also have various fees charged by clearing brokers and CCPs [commonly referred to as ticket charge] that are assessed on a per-trade basis. Variation margin is largely a normal mark to market process, although CCPs may require more VM from smaller firms, as an insurance buffer of sorts.”

Derivatives industry members have expressed grave concerns regarding the initial margin (IM) requirements for swaps that aren’t cleared.

“We ask that you consider withdrawing or suspending any IM requirements until their consequences have been fully analyzed and clarified,” said Robert Pickel, CEO of ISDA, in an April 12 letter to banking supervisors that was also signed by the Association for Financial Markets in Europe and the Securities Industry and Financial Markets Association.

Regulators have imposed IM requirements in order to ensure that the playing field between cleared and non-cleared OTC derivatives is fairly level, but “we do not see the reason for such a goal, and the fact is, the playing field is already slanted towards cleared transactions,” the letter said. The IM requirements would significantly steepen the grade of the field.”

Clearinghouses or Centralized Clearing Platforms (CCPs) assume the counterparty risk involved after two parties (clearing members or their clients) have traded.

When a trade is successfully cleared at a CCP, the CCP becomes the legal counterparty to the trade, thereby ensuring its financial performance. If one party defaults, the CCP steps in to manage the default process.

“The public probably views central clearing as a good thing, because it may take some of the mystery out of OTC markets through the perception of greater transparency and potential for an orderly unwind of a Lehman-like situation via the CCPs,” said Griffin. “The theory is this will make it more manageable to liquidate a firm’s assets and re-assign their open, cleared trading exposures to other counterparties by having a CCP standing between the defaulting counterparty and those it faces thus hopefully resulting in significantly less of a disruption to financial markets and the economy.”

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