Cleared for Takeoff

Terry Flanagan

Babson Capital, an investment subsidiary of MassMutual, is approaching the upcoming mandatory clearing deadline for swaps as a business process optimization project, involving major system upgrades, workflow changes, and legal documentation.

“We are making sure the connections are in place with FCMs, clearinghouses, and middleware providers,” said Amy Caruso, director of the derivatives regulatory initiative at Babson Capital, which manages $160 billion in assets. “We have negotiated legal documents with counterparties for swaps in the past, but the number of different parties involved has increased from an operational standpoint.”

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 dealer community has been clearing interest-rate swaps and other products since well before the Dodd-Frank Act, and certain buy side members have been vocal about being able to have their own trades cleared, so this would likely have happened eventually [even without Dodd-Frank],” said Michele Kunitz, counsel and head of the legal regulatory and trading team at Babson Capital.

Providers of middleware are building out the necessary linkages between clearinghouses, FCMs, and banks.

MarkitServ, an electronic trade processing service for OTC derivative transactions, has built connections to multiple clearing houses to help the swaps industry comply with the mandate to clear OTC derivatives.

MarkitServ provides middleware for OTC derivatives trade processing for cleared and non-cleared trades, across electronic execution venues and off-facility execution in credit, rates, equity and foreign exchange derivatives.

Inasmuch as it has made due preparations, Babson Capital doesn’t foresee a Big Bang occurring on June 10, however.

“June 10 will come and go, and people will accept this as a new way of doing business,” said Jay Caggiano, managing director of quantitative management. “This will become easier over time as people get acclimated.”

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.

“It’s a three-dimensional matrix, which is quite complex,” said Caruso. “There are thousands of accounts throughout the industry that need to be onboard before June 10.”

MassMutual itself “has a sizable swap book, as do many insurance companies, that are used for duration or convexity management,” said Caggiano.

The clearing mandate will impose changes on the way those swaps are handled from a margin and collateral standpoint.

“Legally and operationally, the startup costs are significant,” said Caggiano. “There are a number of participants, including MassMutual, who never had to post initial margin, and once the switch goes on June 10 that will change.”

The Dodd-Frank Act “clearing mandate” requires that many, but not all, OTC swaps be centrally cleared. “Swaps that are now traded bilaterally will either be moved to central clearing or remain bilateral,” Caggiano said. “The new cleared environment will impose collateral requirements that were not present in bilateral, such as the posting of initial margin, and the requirement that variation margin be collateralized by cash.”

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