Buy Side Ramps Up for Clearing

Terry Flanagan

Buy side institutions are gearing up for mandatory clearing of OTC swaps, with legal documentation and operational issues looming large.

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.

“We have already selected one FCM [futures commission merchant], are in final negotiations with a second, and will later choose a third,” said Amy Caruso, director at Babson Capital Management, a fixed income asset management subsidiary of MassMutual. “The onboarding process with clearinghouses is not customer-friendly. Once you have your legal documentation in place, you need to get people on board from both your side and the FCMs.”

Caruso spoke at a panel at the FIA New York Expo on Thursday.

With the shift to central clearing and straight-through processing of OTC derivatives, brought on by new regulations on both sides of the Atlantic such as Dodd-Frank and Emir, paper-laden processes associated with OTC documentation are being streamlined and automated.

As part of the clearing requirements, swap dealers and their trading counterparties must establish swap trading relationship documentation before any trade is executed.

John Griffin, senior risk manager at The Hartford Investment Management Company, stressed the importance of doing live trades preparatory to mandatory clearing.

“We are in good shape from a legal documentation perspective, and as we get closer to [June 10] we are working with our portfolio managers and traders to make sure they understand the impact clearing will have on the economics of a trade,” he said. “We’re hearing that a lot of Category 2 users aren’t as far along as they should be.”

Automation of the document generation, negotiation and execution processes are seen as vital to increasing efficiency and control, as is the provision to lawyers and document negotiators of powerful clause library tools.

The relationship documentation required by the CFTC includes International Swaps and Derivatives Association (Isda) master agreements, swap confirmations and credit support annexes.

“There is definitely a documentation bandwidth concern for the buy side, not just with FCMs but also with CCPs,” said Cassandra Tok, vice president of derivatives clearing services at Goldman Sachs. “There are many other issues beyond documentation, such as how do you integrate your middleware with your order management system. You should aim to be ready before June 10.”

The pain should be worth it in the end, however.

“There is a reduction in systemic risk with clearing,” said Tok. “When you trade bilaterally, there’s not a lot of transparency. That said, there is additional cost associated with clearing for the buy- and sell-side, as well as CCPs.”

Isda’s Dodd-Frank documentation initiative provides a standard set of amendments, in the form of protocols, to facilitate updating of existing swap relationship documentation for Dodd-Frank compliance.

The first such protocol, formally titled Isda August 2012 DF Protocol, allows swap market participants to simultaneously amend multiple Isda master agreements.

The protocol consists of a series of amendments to existing documentation, as well as standardized questionnaires that must be completed by counterparties to satisfy new regulations.

These questionnaires must be delivered to each relevant counterparty for the amendments and compliance to be effective.
In a February 11 letter to market participants, Isda recommended that buy-side market participants communicate with their relevant counterparties about whether they are subject to the clearing requirement no later than March 11.

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