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May 18, 2015 - Banks providing over-the-counter derivatives clearing services to their clients are seeking innovative ways to keep those businesses alive as crippling capital and leverage requirements sap limited returns.
As a last-ditch effort to make the economics work, some houses are mulling deals with credit investment funds that would see the third-party entities take the responsibility of guarantor for swaps clients passing trades through clearing houses.
The replacement-guarantor set-up would theoretically relieve the bank from onerous supplementary leverage ratio requirements that treat client margin held by FCMs at the clearing house as a levered asset. Market participants have pushed back against the proposal and Basel regulators are understood to be close to making changes (see this section), but in the absence of any confirmation, alternative solutions are under consideration.
The third-party guarantor could take the form of a special purpose vehicle or could be taken on by the investment fund itself, said participants familiar with ongoing discussions.
"FCMs are under the gun from Basel leverage ratio requirements and we're looking at developing a number of different ways - including the replacement-guarantor set-up - to reduce regulatory burdens for firms in the derivatives market," said Brad Golding, managing director at Christofferson Robb, one of the firms in discussions with banks and one that has stepped into derivative counterparty exposures in the past.
The potential solution appears to be in its early stages and futures commission merchants that have been approached about the set-up say the idea is likely to raise some regulatory eyebrows.
"It's going to be a challenge to move the guarantee and mutualisation aspects of clearing off of an FCM - both the Fed and the CFTC would have to approve that and I don't see that happening," said the head of one major bank's clearing operations. "The SPV model caught a lot of heat prior to the crisis too - I think when you combine those two ideas in front of a regulator I think you're going to face a lot of challenges."
Golding told IFR that solutions vary and could be structured to fit specific firms and jurisdictions - and that it would be up to the banks to achieve regulatory approval. However, as some FCMs point out, there is also a question of whether clients would ever sign up for clearing services from a bank that was not acting as guarantor.
"What's a client going to say when you tell them they've got to pay a fee to you for clearing services, but if they end up in a default situation and need to find their guarantor? 'Here's a phone number at investment fund A'?" said another FCM official. "I don't think most clients are going to go for that."
The discussions, while perhaps a long-shot according to some, highlight the increasingly dire straits in which clearing providers find themselves. Last week, Nomura added its name to a growing list of high-profile names to shut down its international clearing business (see this section), while State Street, BNY Mellon and RBS were the first to go.
Banks that have remained in business have been forced to raise fees to cope with the entire regulatory framework.
"Though rising fees are not something we would ever hope for, in this situation we understand it is warranted because of the regulatory change and rising costs of business," said Lisa Cavallari, director of fixed income at Russell Investments.
"But the problem right now is that we don't understand the velocity and to what degree fees should rise. There are a number of different models being floated across the FCM market, and some regulations are not yet finalised so we could still see some changes. It's tough to tell at this point what makes sense from a fee-raise perspective."
Some are instituting "dollar per notional" rate increases where an FCM charges US$50 per US$1m in notional, according to asset managers. The translated US$5,000 per US$100m notional fee is a far cry from the US$250 per ticket that banks used to charge.
Others are introducing rate increases that multiply a negotiated basis point rate by the amount of initial margin posted by the end-user. A third model involves the multiplication of a basis point rate against gross notional exposures, rather than smaller net notional numbers that market participants say more appropriately reflect risk.
In either case, asset managers are not pleased.
"One provider tried to institute balance sheet charges on us," said the COO of one credit fund. "Obviously we're not doing business with them any more."
One proposal that continues to gain traction is for clearing houses to buy into "CoCo Insurance" by the product's progenitor, GSCA Capital.
This amounts to an insurance policy provided by a consortium of approximately 20 insurance firms. The group would guarantee a supply of cash into the default waterfall of the CCP at a specified level in the event of an end-client or FCM default.
"The CoCo insurance product would not be the whole solution, but it could be a part," said Christopher Cononico, founding partner of GSCA LLC.
The product was originally drawn up to provide relief to CCPs themselves - the firms are increasingly under pressure to put more of their own capital in the default waterfall, known as 'skin in the game'.
But now Cononico also sees it as a potential way to reduce the risks and costs for end-user clients associated with being a member of a clearing house.
"Depending on where in the waterfall the insurance protection slots in, it could take on mutualisation risk for end-clients or members of the CCP as well - not just the CCP itself," said Cononico.
"We view this as a potential way to allow end-user clients to be members of a CCP without having to be on the hook for other clients' losses or defaults."
A version of this story appears in the May 16 issue of IFR Magazine, a Thomson Reuters publication
Reporting by Mike Kentz; Editing by Helen Bartholomew