• White Paper
Cost of Trading and Clearing OTC
Derivatives in the Wake of Margining
and Other New Regulations
Recent regulations are affecting the OTC derivatives
markets in complex, interrelated manners that change the way
firms do business.
Executive Summary
Over-the-counter (OTC) derivatives markets
continue to be impacted by regulatory changes.
These changes are affecting the way financial
institutions do business in multiple, interrelated
ways. Rising capital requirements are impacting
profitability and return on equity. Market participants are now being forced to clear standard OTC
1
trades through central counterparties (CCPs)
and will soon face margin requirements for the
remaining, nonstandard, uncleared derivatives
(MRUDs). This is prompting firms to better assess
and manage costs (funding, collateral, capital) in
a consistent fashion at a trade, desk and business
unit level. The question is how much of these
costs can be passed on to clients.
These changes are not just impacting sell-side
firms. Central clearing and MRUDs are also
impacting buy-side firms on several dimensions:
funding, risk management and, naturally,
valuation and operations. This paper aims to
better understand:
• The various current and future regulatory initiatives – transactional and prudential.
white paper | february 2016
• The actual margin valuation adjustment (MVA)
and its mathematical determination through
initial and variation margin adjustments, with
numerical examples enriched with capital,
liquidity and leverage impacts.
• The
resulting market evolution from the
standpoint of pricing and volumes as well as
the potential outcomes for market participants.
Regulatory Landscape
Following the 2008 financial crisis, the banking
sector witnessed a plethora of regulatory
changes. While these regulatory prescriptions
cover every dimension of the banking world,
the OTC derivatives (OTCDs) market has borne
the brunt due to the derivatives’ opaque and
complex nature. While some regulations such as
2
3
4
the Dodd-Frank Act, EMIR and BCBS/IOSCO
MRUD are directly targeted at OTCDs, several
others, especially the leverage ratio, also have
far-reaching implications for the OTCD market.
Figure 1 (next page) presents a timeline of major
regulations impacting the OTCD market.
All these changes are leading to structural alterations in the OTCD markets, consequently placing
Regulatory Timeline for OTCD players
Mandatory central clearing of standardized OTCDs
U.S. (Dodd Frank) – Cat 1: 11th Mar 2013, Cat 2: 10th Jun 2013 and Cat 3: 9th Sep 2013. EU (ESMA) – Cat 1 starts from Q3 2015.
Margin (IM/VM) Requirements for Non-Centrally-Cleared OTCDs: BCBS/IOSCO
Final framework
published
Timelines extended
Phase-in starts from 1st Sep 2016 till 1st Sep 2020
2011
2012
2013
2014
2015
2016
2017
2018
2019
Final framework applies from 1st Jan 2017
Final
framework
published
Capital Requirements for Bank Exposures to CCPs – BCBS / IOSCO and SA-CCR
Phase-in for LCR starts from 1st Jan 2015 till 1st Jan 2019. NSFR from 1st Jan 2018.
Final LCR
rules issued
Final NSFR
rules issued
Basel III liquidity requirements – LCR & NSFR
Public disclosure
of Basel leverage
Basel leverage
rules issued
Final SLR/eSLR
rules issued
Revised Basel III (CVA)
rules issued
SLR/eSLR to be complied from 1st Jan 2015
Basel III Leverage Ratio and U.S. SLR /eSLR
Basel III (CVA) Implementation
Figure 1
opments that dictate the cost and profitability of
OTCDs (see Figure 2).
significant cost pressure on OTCD trading and
clearing activities. This section provides an
overview of the various recent regulatory devel-
Risk Components of Cost of Trading OTCDs
Cleared Trades
Uncleared Trades
Uncleared Trades
(MARGINED )
(UNMARGINED)
EMIR (EU) & Dodd-Frank
Act (US)
central clearing obligation
BCBS / IOSCO
margin requirements
EMIR (EU) & Dodd-Frank
Act (US)
central clearing obligation
BCBS / IOSCO
margin requirements
BCBS (incl. Basel III)
bank exposures to
CCPs & ctptys
BCBS (Basel III)
CVA Capital Framework
BCBS leverage ratio
(Basel III) and U.S.
SLR/eSLR
BCBS (Basel III)
global liquidity standards
Initial Margin (IM)
‘Close-out risk’
Covers the potential future
exposure to the counterparty that
builds up post default till close out.
• Daily, Unilateral
• CCP Collateral Eligibility
• N/A
• Daily, Bilateral, Segregated
• Supervisory Collat. Eligibility
• Daily, Unilateral
• Mostly Cash
• Weekly (Market Practice)
• Daily, Bilateral
• Supervisory Collat. Eligibility
• 2% Risk Weighted Assets
• No CVA
• Basel III RWA
• CVA Capital Charge
• Basel III RWA
• Reduced CVA
• 3% SLR + 2% (eSLR )
• 3% SLR + 2% (eSLR )
• 3% SLR + 2% (eSLR )
• LCR & NSFR
• High Quality Liquid Assets
• LCR & NSFR
• High Quality Liquid Assets
• LCR & NSFR
• High Quality Liquid Assets
Variation Margin (VM)
‘Position risk’
Covers the current exposure to the
counterparty based on the
mark-to-market P&L.
Capital (Risk-Based)
‘Bankruptcy risk’
Basel III standards strengthened
the global capital framework by
enhancing the risk coverage
Capital (Leverage)
Model risk’
Basel III (non-risk based) leverage
ratio supplements the risk-based
capital ratio
Liquidity
‘Solvency risk’
Two metrics for funding liquidity –
LCR (short term, 30-day)
and NSFR (longer term, 1 year)
No or low impact
Figure 2
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2
Medium impact
High impact
Very high impact
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Mandatory Central Clearing of
Standardized OTCDs
The EMIR in the EU region and the Dodd-Frank Act
for the U.S. are the major regulations covering the
central clearing obligation. The implementation
of mandatory central clearing for standardized
OTCDs requires market participants to adhere to
the CCPs’ stringent requirements including initial
and variation margins (IMs and VMs). Margins, in
particular IMs, which are not prevalent in bilateral
deals, lead to significant funding cost for collateral.
Other costs such as contributions to the default
and guarantee funds of CCPs also add to the
cost burden. From a broker-dealer’s self-clearing
portfolio perspective, there are certain benefits
accrued in terms of obviation of credit valuation
adjustment (CVA) and multilateral netting.
With an objective to incentivize
central clearing and make the
residual non-cleared OTCD markets
more resilient, global regulators
have issued margin requirements for
uncleared derivatives (MRUDs).
Margin Requirements for Non-CentrallyCleared OTCDs
Even after the full implementation of clearing
mandates, there would be a portion of OTCDs
that remain non-clearable (non-standardized or
standard but transacted by parties not covered
by regulation or in currencies that cannot be
cleared). With an objective to incentivize central
clearing and make the residual non-cleared OTCD
markets more resilient, global regulators have
issued margin requirements for uncleared deriva5
tives (MRUDs). Starting September 2016, for
non-centrally-cleared OTCD transactions, large
banks will be required to exchange daily IMs and
VMs with counterparties. The IM requirements
are particularly onerous since it is stipulated to
be a gross two-way exchange with segregation
requirements. The collateral eligibility conditions
(for both IMs and VMs) are quite stringent and
will strain firms’ liquidity. From a cost perspective,
the margin requirements reduce the CVA capital
charge associated with the trades but increase
funding cost, represented by the margin valuation
adjustment (MVA).
exposures to CCPs was released in April 2014 by
7
BCBS in consultation with CPMI and IOSCO, and
will come into force from January 2017. Notably,
a new 2% risk weight is applicable to the eligible
clearing members for exposures to qualifying
CCPs; BASEL III capital standards apply for the
8
transactions facing clients. The most prominent
regulation addressing CCP resilience was adopted
by CPMI and IOSCO in April 2012 in the form of
Principles for Financial Market Infrastructures
9
(PFMIs), the ‘level 3’ assessment of the imple10
mentation of which started in July 2015. The
“skin in the game” requirements (for example,
in the EU CCPs are required to contribute 25%
of regulatory capital to the default waterfall)
and other aspects of these regulations place significant cost pressure on CCPs which will trickle
down to the clearing members and ultimately to
the clients and end users.
Basel III Standards
Basel III reforms are a comprehensive set of
regulatory measures from BCBS to improve banks’
resilience and strengthen their risk management
and governance. They affect different aspects
of banks’ balance sheet management – capital,
liquidity and leverage.
• The
risk coverage of capital standards was
enhanced in the relation to counterparty credit
risk – stressed inputs, CVA, wrong way risk
(WWR), etc. CVA requirements have been of
prime importance to the OTCD markets as CVA
is an adjustment to the fair value (or price) of
11
derivative instruments. Introduced as part of
Basel III, CVA capital charge corresponds to the
capitalized risk of the future changes in CVA.
CVA capital charge adds significantly to the
cost of trading non-collateralized OTCDs. BCBS
recently issued a consultation paper inviting
comments by October 1, 2015, on proposed
revisions to the CVA framework in order to
better capture exposure risk and align with
other regulatory and accounting practices.
• The
liquidity framework was strengthened
by the introduction of two ratios – liquidity
coverage ratio (LCR) to promote short-term
resilience and net stable funding ratio (NSFR)
to address longer-term funding risk. These
have increased funding costs for high quality
liquid assets and accentuated the incorporation of funding valuation adjustment (FVA) into
the cost of trading.
Prudential Regulations
Bank Exposures to CCPs
The final policy framework for the treatment of
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• The leverage ratio requirements, especially the
U.S. versions – supplementary leverage ratio
3
(SLR) of 3% and the enhanced SLR (eSLR) of
an additional 2% (or 3%) – pose an additional
(tier 1) capital burden by including OTCD
and other off-balance-sheet exposures. The
inclusion of client-facing legs of cleared OTCDs
and the prevention of offsetting by segregated
collateral posted contribute to the total cost of
trading. Being more risk-sensitive, the potential
adoption of the new standardized approach
for counterparty credit risk (SA-CCR) could
mitigate this burden to some extent.
Finally, the uneven progress of cross-border
regulatory implementation has exacerbated
OTCD players’ woes. Some notable examples
include uneven product coverage and availability
of CCPs across various jurisdictions around the
world;12 fragmentation of the liquidity pools as
can be seen in the euro IRS inter-dealer market
where the share of exclusive European dealers in
the market has risen from an average of 73.4%
in the third quarter of 2013 to 94.3% between
July and October of 2014, coinciding with the
introduction of U.S. swap execution facility rules
in October 2013;13 margin period of risk (MPOR)
of two-day net for EU CCPs versus one-day gross
for U.S. CCPs; threshold differences in MRUD
between the U.S. and EU, etc.
The uneven progress
of cross-border regulatory
implementation has exacerbated
OTCD players’ woes.
Cost of Trading OTC Derivatives
MVA and Cost of Funding for
Centrally-Cleared OTCDs
constitute the components of MVA:
• Initial
margin cost adjustment (IMCA): Total
cost of funding initial margins.
• Variation
margin cost adjustment (VMCA):
Total cost of funding variation margins.
• Variation margin benefit adjustment (VMBA):
Total benefit from the variation margins posted
by the counterparty.
The total MVA, which is a cost to the bank, can
accordingly be defined as:
MVA = IMCA + VMCA – VMBA
IMCA: Cost of Funding the IMs
IM is a capital charge calculated by the CCP daily
and is based on the whole netting set of the client’s
trades with the CCP. So, in principle a new trade
could decrease the margin required to be posted.
It protects the CCP against the closeout risk of a
client portfolio. It was recommended by regulators
that IM be evaluated as a VaR of the portfolio
(e.g., with 99% confidence and a 10-day horizon).
Usually it is calculated as a historical VaR based on
the shifts of underlying market factors.
IMCA can be defined as the expected discounted
cost of funding future initial margins, IM(t). Similar
to FCA, the cost portion of FVA, IMCA is proportional to an institution’s “borrowing” spread SB
which means that the institution borrows funds
at risk free rate + SB. The cost is calculated over
the life of the transaction or until either the CCP
or the institution defaults, whichever occurs first.
Assuming that there is no wrong-way risk, that
the CCP can’t default and that borrowing spread
is non-stochastic, the expression for IMCA is:
T
Margin Valuation Adjustment (MVA)
To evaluate the total cost of clearing, it is important
to estimate MVA – the total cost of funding IM and
VM – for the life of a portfolio of trades with a CCP.
The concept is similar to the funding valuation
adjustment (FVA) whose two components are
the cost (funding cost adjustment, or FCA) and
benefit (funding benefit adjustment, or FBA) of
funding hedging strategies for non-centrallycleared trades. MVA will also become an integral
part of the funding costs for non-centrally-cleared
OTCD trades when recent regulations compel the
counterparties to start posting IMs.
Similar to FVA for uncollateralized trades, MVA
is the sum of cost and benefit adjustments
arising out of funding the margins. The following
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IMCA = –
0
SB(t) · EIM(t) · qI(t) · p(t) · dt
Where EIM(t) is expected future initial margin, p(t)
is expected discount, and qI(t) is an institution’s
T
survival probability.
VMCA = — SB(t) · NEE(t) · qI(t) · p(t) · dt
0
The biggest challenge in evaluating IMCA is
calculating the expected future initial margin –
EIM(t). SinceT current-day IM is calculated based
VMBA = SL(t) · EE(t) · qI(t) · p(t) · dt
on historical
0 shifts including the most recent
data, IM(t) will be based on market future shifts
up to time t. Brute-force Monte Carlo simulations,
which can incorporate historical data path-wise,
could be used for this but it will be extremely slow
since the portfolio has to be reevaluated at each
time point on each path – around 1,300 times for
a five-year look-back period.
4
The following simplifications could be considered:
• Assume
that the EIM profile and borrowing
spread are constant in time:
IMCA = SB * IM * RiskyDurationI
• Assume
that EIM reduces linearly to 0 at
portfolio maturity T, i.e. EIM(t) = IM * (1-t/T).
Then a good approximation is:
IMC = SB * IM * RiskyDurationI / 2
• Evaluate EIM(t) by shortening maturities of all
trades by t. After maturities are shortened,
one can use the same historical shifts and
recalculate IM.
• Evaluate
EIM(t) by setting the pricing date
at time t and applying some scenarios for
future curves. Then one can apply currentday historical shifts and recalculate IM. To
gain more efficiency, one can calculate delta
and gamma values (with pricing date set at t)
and apply them to the current day’s historical
shifts. Note that this methodology is consistent
with market practices and with the ISDA SIMM
proposal of using deltas for calculating initial
margins on non-cleared trades.
Once EIM(t) is evaluated, it can substitute expected
positive exposure EE(t) in the FCA calculator, to
get the total cost of funding initial margins.
VMCA and VMBA: Cost and Benefit of
Funding Variation Margins
Variation margin (VM) reflects a change in P&L
of a client’s netting set with the CCP. VMs can
be positive or negative and can be significant,
depending on market movements. As is the
case with IMCA, evaluation of VMCA and VMBA
constitute an important aspect of the cost of
OTCD trading. Cost arises when mark-to-market
value is negative for the institution, as it would be
required to post VMs to CCP. The institution will
have to borrow money at risk free rate + SB, and
borrowing spread SB constitutes the cost for the
institution. Similarly, benefit arises when markto-market is positive as VM posted to the institution generates cash at lending spread, SL, which
can be different from the borrowing spread.
To estimate VMCA and VMBA, computations
similar to FVA could be used. In fact, while FCA
(FBA) is a cost (benefit) of funding the hedge
trade, VMCA (VMBA) will be a cost (benefit) of
funding the original trade itself. Thus, VMCA
(VMBA) is proportional to negative (positive)
exposure. Another difference with FVA is that
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netting in the case of VMCA/VMBA should be
done on the portfolio of trades with each CCP.
But all other computational aspects of FVA such
as own default
risk and WWR should be taken
T
into
account
VMCA/VMBA
as· p(t)
well.· dt
IMCA
= – Tfor
SB(t)
· EIM(t) · qI(t)
IMCA = – 0 SB(t) · EIM(t) · qI(t) · p(t) · dt
Under the 0same simplifying assumptions as
above, we get for VMCA:
T
VMCA = — T SB(t) · NEE(t) · qI(t) · p(t) · dt
VMCA = — 0 SB(t) · NEE(t) · qI(t) · p(t) · dt
where NEE(t)0 is the expected negative exposure
(assumed toTbe positive). And for VMBA,
VMBA = T SL(t) · EE(t) · qI(t) · p(t) · dt
VMBA = 0 SL(t) · EE(t) · qI(t) · p(t) · dt
0
where EE(t) is the expected positive exposure.
Unlike EIM(t) in the case of IMCA, NEE(t) and
EE(t) are much easier to calculate, and are in fact
already part of CVA, DVA and FVA evaluations.
Total Funding Cost of Clearing
To evaluate the total cost of clearing for banks,
MVA, as calculated above, needs to be added to
the cost of the 2% contribution to risk weighted
assets (RWA). One has to be able to calculate it
on an incremental basis for each new trade with
the netting based on the current portfolio with
the CCP. Recently implemented by U.S. regulators,
the supplemental leverage ratio (SLR) increases
capital cost for clearing dealers due to the
inclusion of the exposure of trades they clear for
clients. Some dealers pass on this cost to clients
Recently implemented by U.S.
regulators, the supplemental
leverage ratio (SLR) increases
capital cost for clearing dealers due
to the inclusion of the exposure of
trades they clear for clients.
as an extra fee proportional to the initial margin.
While the contribution of this fee to total funding
cost of clearing might not be that significant for
a single trade, for a large portfolio it can add up
to a substantial amount. Finally, the liquidity ratios
introduced as part of the Basel III regulations –
LCR and NSFR – add to the funding costs of the
trades as they necessitate the funding of high
quality liquid assets (LCR) and stable sources of
capital-like funding.
5
Profitability Analysis for Centrally Cleared and
Bilateral IR Swaps
Profitability Analysis for IR Swaps
To analyze the contribution of each cost
component for centrally cleared as well as
bilateral trades, we ran tests for three USD IR
receive-fixed swaps, all with 10-year maturity.
The following scenarios were considered:
• ATM swap coupon C = 2.7%, rates flat 2.7%
(current coupon, current curve).
• ITM swap coupon C = 4.5%, rates flat 2.7%
(legacy coupon, current curve).
• OTM swap coupon C = 2.7%, rates flat 4.5%
(current coupon, increasing rates).
While the ATM scenario reflects costs for new
trades and future rates close to the current
level, ITM can be thought of as a legacy trade,
and OTM is a current trade with rates increasing
to the pre-crisis level. To investigate the effect
of volatility, we ran two volatility scenarios: flat
market vols 25% and flat stressed vols 50%.
To better compare the results, each cost was
converted into a positive par rate adjustment. For
this conversion the following were used – DV01 of
8.74 (rates 2.7%) and DV01 of 8.03 (rates 4.5%).
For calculating default probabilities, counterparty credit spread of 200 bps, own spread of 100
bps, and recoveries of 40% were assumed along
with the assumption that the CCP can’t default.
For funding costs, FVA and MVA, a borrowing
spread SB of 1% and lending spread SLof 0 (i.e.,
there are no funding benefits) were assumed.
Cost of Centrally Cleared Trades
For clearing costs, MVA and a 2% RWA contribution costs were calculated.
For IMCA, IM was first computed as a 10-day 99%
Monte Carlo simulated VaR. Then an assumption
that EIM(t) reduces linearly to 0 at portfolio
maturity T was considered, leading to:
IMCA = IM * SB * T/2, where T=10 and SB =1%
KVA and Cost of Bilateral Trades
For bilateral costs, calculated XVAs comprise BCVA
(bilateral CVA, i.e., CVA-DVA, consider non-negative), FVA and cost of regulatory capital (KVA).
KVA reflects the total cost of funding capital
requirements defined by RWA (Basel II) and CVA
VaR (Basel III). In general, it also includes capital
costs for funding market risk capital charges, but
in our calculations we assumed that trades are
hedged and market risk is negligible.
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Calculating KVA would seem similar to FCA, but
there is no uniformity in the market as to which
capital funding spread SKVA is to be applied. Most
market participants cite KVA as the biggest
source of pricing disparity. While standard
accounting practice is to multiply the capital
requirement by the return on equity, the same
borrowing spread SB could be used in order to
have consistency with FCA calculations.
As with EIM(t), it is a highly challenging task to
estimate expected capital requirements at various
times in the future, but one can approximate it using
simplifications described in a section on IMCA.
For calculating RWA, the internal models method
(IMM) was used, and CVA was subtracted from
exposure at default (EAD) as recommended
under Basel III regulations. Then the capital
requirement was calculated as 8% of the RWA.
Cost of RWA capital, KVARWA, was calculated at
capital funding spread SKVA which was assumed
to be 10%, using the following formula:
KVARWA = 8% * RWA * SKVA * T / 2, where T=10 and SKVA=10%
For evaluating KVACVA we calculated CVA_VaR
using a standardized-IMM formula assuming a
counterparty rating of BBB and weight 1% and
then applying the following formula:
KVACVA = CVA_VaR * SKVA * T / 2, where T=10 and SKVA=10%
Note that CVA VaR calculations were revised in
the consultative document, Review of the Credit
Valuation Adjustment Risk Framework, published
by BCBS in July 2015. This document proposes
replacing current standardized and advanced
approaches with new methodologies that are
more aligned with those set down under the
Basel Fundamental Review of the Trading Book
(FRTB) framework and also with accounting
practices of evaluating CVA.
Costs for Bilateral Trades with Margining
As mentioned in the previous section, starting
September 1, 2016, banks and large nonfinancial institutions will have to post to each other
both IMs and VMs on non-centrally-cleared OTCD
trades as well. This will lead to the reduction
of counterparty risk and hence converging of
funding costs for non-centrally-cleared and centrally-cleared trades. It is expected that there
will be almost no BCVA, FVA and KVACVA. Instead,
even the non-centrally-cleared OTCD trade costs
will include MVA.
6
While VMCA and VMBA are the same as for
cleared trades, IMCA will be different due to the
evolving standardized initial margin methods.
ISDA published a proposal for the standard initial
margin model (SIMM) in December 2013 and a
14
revised draft in June 2015.
trades and margined uncleared trades. For
unmargined trades, the IM component is ignored.
The LCR cost is derived by applying the funding
spread of 1% over the net cash outflows
determined from the contractual cash flows
and IM/VM exchanges. The IM exchanges were
ignored for the unmargined trades. The NSFR
cost considers the derivative receivable amounts
net of payables (if receivables are greater than
payables) on top of the IM and default fund
contributions. A required stable funding (RSF)
factor of 85% is applied to IM and default fund
contributions in line with the BCBS guidelines.
The default fund contribution factor is ignored
for margined and unmargined uncleared trades.
IM is additionally ignored for the latter.
We used the SIMM model, which is based on
weighted risk factor sensitivities, to estimate
initial margin and then applied the same formula
for IMCA as for cleared trades.
SLR and NSFR/LCR Funding Costs
In addition to all the valuation adjustments
described above, we also calculated funding
costs arising from leverage (SLR/eSLR) and
liquidity ratios (LCR and NSFR).
SLR cost is computed by applying the capital
funding spread of 10% over the increase in the
Tier-1 capital requirement which is determined
from potential future exposure (PFE, computed
through the current exposure method), replacement costs and IMs posted in the case of cleared
The following section outlines the results with
notable observations.
Comparison
1. Across all types of trading, ITM costs are much
higher than OTM and ATM costs, reflecting the
Results
Costs for Cleared OTCD Trades in B.P. Adjustments to Par Spread
ATM
IMCA
VMCA
2% RWA
SLR
NSFR/LCR
Total
Vol 25%
1.6
2.1
0.5
3.8
4.2
12.1
Vol 50%
3.0
4.1
1.1
7.1
7.0
22.3
Vol 25%
1.4
0.5
5.5
53.2
8.0
68.6
Vol 50%
2.8
2.3
5.5
51.7
10.6
72.9
Vol 25%
2.8
8.8
0.0
2.2
8.1
22.0
Vol 50%
5.5
10.5
0.2
3.7
13.3
33.1
ITM
OTM
Figure 3
Costs for Non-Centrally-Cleared OTCD Trades,
in B.P. Adjustments to Par Spread
ATM
Vol 25%
BCVA
1.8
FVA
1.9
KVA-RWA
4.6
KVA-CVA
10.5
SLR
3.2
NSFR/
LCR
1.0
Total
23.0
Vol 50%
3.6
3.6
9.2
20.9
5.7
1.0
44.0
Vol 25%
16.0
8.3
47.8
105.3
52.6
5.2
235.1
Vol 50%
17.5
9.9
48.0
106.2
50.4
5.2
237.1
Vol 25%
0.0
0.4
0.0
0.1
0.9
2.3
3.7
Vol 50%
0.0
2.0
1.1
3.2
0.9
2.3
9.5
ITM
OTM
Figure 4
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7
Costs for Non-Centrally-Cleared OTCD Trades with Margining
ATM
IMCA
VMCA
KVA-RWA
SLR
NSFR/LCR
Total
Vol 25%
2.3
2.1
4.6
5.0
5.5
19.4
Vol 50%
2.3
4.1
9.2
7.5
5.5
28.5
Vol 25%
2.4
0.5
47.8
54.7
9.9
115.3
Vol 50%
2.4
2.3
48.0
52.5
9.9
115.1
Vol 25%
2.1
8.8
0.0
2.7
6.1
19.7
Vol 50%
2.1
10.5
1.1
2.7
6.1
22.5
ITM
OTM
Figure 5
Summary Table
OTC type
retain market share continue to be a priority.
ATM
cleared 12.1
ITM
OTM
68.6
22.0
23.0
235.1
3.7
non-cleared margined 19.4
115.3
19.7
non-cleared
• Lack of consistency on the offer side: Which
components should be considered and at what
level to maintain my client base and yet cover
the risks?
• Changing market conditions not being applied
Figure 6
higher market value of legacy trades when
rates were higher; OTM and ATM in most cases
are comparable.
2.For ATM trade, doubling vols in general leads
to doubling of all costs except for non-cleared
margined case where SIMM-based IMCA and
NSFR/LCR are volatility independent.
consistently on the offer side creates uncertainty on the client side: Why not always go to
the best price?
Some key market participants – ISDA, JPMC – have
highlighted the “abnormal” costs and suggested
adjustments:
• ISDA
in December 2014, in response to the
report on clearing incentives from the OTC
Derivatives Assessment Team (DAT) of the
Basel Committee, expressed the concern that
certain aspects of the leverage ratio potentially render clearing prohibitively expensive for
certain types of clients, thereby creating disincentives for banks acting as clearing members.
3.Since regulatory-based capital adjustments
– KVA, SLR – are calculated at a 10% funding
spread rather than at 1% as other funding costs,
they dominate costs across all types of trading.
4.For ATM and ITM trades, clearing trades
centrally would be the most profitable. For
bilateral trades, the new margining regime
will provide capital relief. For OTM trades, the
absence of margining obviously impacts the
IMCA and also brings additional transparency
and the controversial NSFR impact. Finally, for
ITM trades, we can see the large CVA capital
charge impact when there is no IM.
• JPMC
during its Investor Day late February
2015, pointed to the potential exit of key OTC
clearers that are G-SIB or SLR constrained.
• One key logical regulatory evolution is the use
15
of the SA-CCR that allows firms to offset the
client exposure with their segregated, non-rehypothecable collateral, versus the current
CEM which does not.
Market Evolution
Repricing
As previously seen, many pricing components
have recently been added to the clearing costs
equation: MVA, FVA, RWA, leverage including U.S.
Enhanced SLR, and Federal Reserve extra-charge
for global systematically important banks (G-SIBs).
However, very few market participants are ready
to fully transfer these costs to clients:
Overall, the market is still unclear. However, a slow
but significant repricing seems inevitable.
• Only one major player is said to have applied
a four-fold increase to its prices, but not for all
16
the clients.
• The
phase-in of IM/VM requirements for
bilateral trades from 2016 (MRUD) should also
bring some balance and increased volumes to
the cleared world.
• The lower-than-expected and declining volumes
(see Figure 7, next page) imply that efforts to
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8
Gross Notional Outstanding: IR OTCDs (in Billions of U.S. Dollars)
400,000
350,000
343,316
v 26%
300,000
250,000
200,000
150,000
253,453
206,744
v 24%
156,116
v 29%
136,572
100,000
97,337
50,000
0
Cleared
Uncleared
Jan-14
Total
Aug-15
Source: CFTC
Figure 7
• This is evidenced in Figure 6 (previous page) for
>> The
cleared-to-uncleared volumes ratio is
stable at around 60%, albeit far from the
initial target of 75% to 80%, which proves
the lack of regulatory incentives to clear
centrally. Again, a significant evolution would
materialize only after the start of the MRUD,
which was recently postponed to September
2016.
new ATM trades with no incentive to clear and
obviously less operational complexity. Hence,
the research by many buy-side firms to stay
under the radar of regulatory thresholds.
Exchange-Traded Derivatives (ETD):
• Owing
to recent OTCD reforms, which are
still ongoing for large parts in Europe and for
bilateral trades globally, little attention has been
given to the changing ETD environment.
• Client
collateral requirements: OTCD increase
and ETD stabilization.
>> While client collateral requirements can vary
• The growth of swap futures, which can be more
for many reasons, including market volatility
in CCP risk models, the client collateral for
OTCDs have more than doubled in 20 months,
despite the volume decrease (see Figure
8, next page). This confirms an ongoing
repricing in parallel with significant market
shares’ developments between the main
futures commission merchants (FCMs).
attractive than OTCDs by virtue of their shorter
close-out period (two days versus five days), has
been one of the most visible events.
• However,
the introduction of capital requirements for clearing brokers, regardless of the
nature of the trade (ETD or OTCD), has been a
key negative event for ETD clearing, as margins
are narrow with little room for integrating an
additional risk buffer.
>> Meanwhile, client collateral for ETDs has only
increased a little over 3% to $165 billion in
August 2015, compared with $160 billion in
January 2014. This highlights that there is
minimal room for price improvement in a very
mature market with stable market shares.
• Among other factors, the above have accelerated the “merger” of ETD and OTCD clearing
businesses at major providers.
Market Evidence
• Decreasing
volumes and stable cleared-touncleared ratio:
>> As experienced by market participants and
Resulting Revenue Models, Market Structure
• Business strategies – from market share acquisition to profitability:
evidenced in Figure 7, OTCD volumes have
decreased approximately 26% between
January 2014 and August 2015.
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>> In line with any new market, the capital-inten-
sive OTCD clearing business has experienced
a classical initial hunting phase, but with
9
Share of Funds in Cleared Swap Segregation of a Player vs. Total Such Funds
25%
20%
18%
20%
16%
15%
11%
10%
16%
15%
11%
12%
10%
9%
9%
7%
5%
8%
5%
6%
4%
4%
3%
3% 2%
0%
BARCLAYS
CAPITAL INC
CREDIT
SUISSE
SECURITIES
(USA) LLC
CITIGROUP JP MORGAN MORGAN
GLOBAL
SECURITIES STANLEY &
MARKETS
CO LLC
LLC
INC
Jan-14
GOLDMAN DEUTSCHE
BANK
SACHS & CO
SECURITIES
SECURITIES
MERRILL
LYNCH
PIERCE
FENNER &
SMITH
WELLS
UBS
FARGO
SECURITIES
SECURITIES
LLC
LLC
Aug-15
Source: CFTC
Figure 8
some key differentiation between two groups
of market participants:
»» Large broker dealers entered the market
to first protect their trading market shares
and discounted the prices for clients that
traded and cleared at the same shop.
»» Securities services firms were also trying
to capture market share as they were
betting on their collateral management
services to offset some of the costs.
>> The
MRUD implementation will eventually
force clients out of the bilateral world and
into the cleared world. This will, however,
take time.
• Alleviation tactics:
>> Ever since the
announcement of various
rules, banks and other market participants
have been trying to persuade regulatory
authorities to attenuate the impact.
»» For example, industry groups have been
lobbying for a change in the treatment
of client collateral in the leverage ration
computation (to permit margin offset).
>> Unfortunately, the lack of volumes growth
combined with increased regulatory costs
have seriously hurt the initial business plans.
»» Several key names have already left the
market or significantly reduced their
service offering – e.g., BNY Mellon, State
Street, RBS, Nomura, who all had less than
1% market share in 2014.
>> In the meantime, several players are devising
other ways to circumvent the problem:
»» De-recognition of client margins on the
balance sheets. However, this would mean
legal isolation and passing on the interest
earnings to clients.
»» For other participants, it is an endurance
race with limited complementary strategic
options: internal and external consolidation, price increase and hope for some
regulatory adjustments.
• Clients’ reactions and adaptation:
>> One could obviously argue that
»» Treatment of variation margin as
settlement – as opposed to collateral.
This could potentially lead to significant reduction in the leverage and riskweighted capital due to reduced effective
maturity (to the settlement date) and
thereby PFE. In fact, major CCPs have
already sought approvals for the same.
The success of such a conceptual change
would require addressing concerns over
things like price alignment interest that
is currently paid by margin receiver on
interest earned from the posted margin.
clients
would:
»» Reduce their derivatives’ usage: this is
currently the case but will remain limited
given hedging requirements.
»» Flight-to-cheapest FCMs: This will be
temporary, as regulatory costs will need
to be embedded by all FCMs sooner or
later. Additionally, the largest FCMs will
pose concentration risks that need to be
factored in.
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>> Regulators seem to be responding to some
of these concerns, instilling hope that there
might be light at the end of the tunnel.
10
»» It has been claimed that the Basel
Committee will soon consult on moving
from CEM to SA-CCR for leverage ratio
computation. SA-CCR being more risksensitive is expected to result in reduced
derivative exposures.
Conclusion
The fast-changing regulatory landscape increases
clearing costs and therefore trading costs to an
extent that had not and could not have been
anticipated by the market, given some late and
impactful regulatory reforms. This is evidenced
by recent market exits of major financial institutions, repricing which is currently taking place,
leveraging and active applied research for
analyzing and formalizing various costs – MVA,
RWA, leverage, FVA, etc.
Once the derivatives reforms are complete, on a
global level and for both uncleared and cleared
derivatives, one can expect cleared volumes to
pick up and market prices to adjust. Meanwhile,
we can assume that a few more renowned institutions will need to exit the market, leading to
additional consolidation.
Footnotes
Yet to start in Europe.
1
The Dodd-Frank Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) is considered
the most comprehensive regulatory reform of the financial sector in the U.S. Mandatory central clearing of the standardized OTC derivatives formed a major constituent of the swaps marketplace reform
initiatives of the Dodd-Frank Act. http://www.cftc.gov/lawregulation/doddfrankact/index.htm
2
The European Markets Infrastructure Regulation (EMIR) came into force on August 16th, 2012, introducing requirements aimed at improving the transparency of OTC derivatives markets and to reduce the
risks associated with those markets. It includes the obligation to centrally clear certain classes of overthe-counter (OTC) derivative contracts through CCPs or apply risk mitigation techniques when they
are not centrally cleared. http://www.esma.europa.eu/page/OTC-derivatives-and-clearing-obligation
3
4
Basel Committee on Banking Supervision (BCBS), a standing committee of the Bank for International
Settlements (BIS); IOSCO – Board of the International Organization of Securities Commissions.
The initial margin requirements for the covered entities is phased in based on their aggregate monthend average notional amount of non-centrally-cleared derivatives activity. As per the revised timelines from the Basel Committee on March 18th, 2015, entities with notional greater than €3.0 trillion
need to comply from Sept. 1st, 2016, followed by those greater than €2.25 trillion from Sept. 1st, 2017,
€1.5 trillion from Sept. 1st, 2018, €0.75 trillion from Sept. 1st, 2019 and all covered entities starting
Sept. 1st, 2020. The phase-in for variation margin requirements start from Sept. 1st, 2016, for those
covered entities with greater than €3.0 trillion notional and all covered entities from March 1st, 2017.
http://www.bis.org/bcbs/publ/d317.htm
5
http://www.bis.org/publ/bcbs282.htm
6
The Committee on Payments and Market Infrastructures (CPMI), a standing committee of Bank for
International Settlements (BIS).
7
The clearing member’s exposure to client needs to be capitalized as per CCR standardized (SA-CCR) or
internal models (IMM) approach, as applicable.
8
https://www.bis.org/cpmi/publ/d101.htm
9
http://www.bis.org/press/p150709.htm
10
http://www.bis.org/bcbs/publ/d325.pdf
11
http://www.fsb.org/wp-content/uploads/OTC-Derivatives-10th-Progress-Report.pdf
12
http://www2.isda.org/news/cross-border-fragmentation-of-global-derivatives-end-year-2014-update
13
http://www2.isda.org/functional-areas/wgmr-implementation
14
CEM: Current Exposure Method; SA-CCR: Standardized Approach for measuring Counterparty Credit Risk.
15
Risk Magazine, May 24th, 2015.
16
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About the Authors
Serge Malka is the Capital Markets and Risk Practice Co-Leader for Cognizant Business Consulting
in North America. He specializes in derivatives trading and risk management. Serge has conducted
many organizational, regulatory and IT projects with a strong European footprint. His recent regulatory
work focused on EMIR/BIS IOSCO, DFA, Basel III, Fundamental Review of the Trading Book (FRTB), and
the U.S. Fed FBO regulations. Since 2014, Serge’s work has focused on the derivatives overall costs’
evolutions, including a conference in Paris with Quantifi, Axa IM, HSBC and Vivescia. He can be reached at
[email protected].
Dmitry Pugachevsky is Director of Research at Quantifi, responsible for managing its global research
efforts. Prior to joining Quantifi in 2011, Dmitry was Managing Director and head of Counterparty Credit
Modeling at JP Morgan. Before starting with JP Morgan in 2008, Dmitry was Global Head of Credit
Analytics at Bear Stearns for seven years. Prior to that, he worked for eight years with analytics groups
of Bankers Trust and Deutsche Bank. Dr. Pugachevsky received his Ph.D. in applied mathematics from
Carnegie Mellon University. He is a frequent speaker at industry conferences and has published several
papers and book chapters on modeling counterparty credit risk and pricing derivatives instruments. He
can be reached at [email protected].
Rohan Douglas is CEO of Quantifi. He has over 25 years of experience in the global financial industry.
Prior to founding Quantifi in 2002, he was a Director of Research at Salomon Brothers and Citigroup,
where he worked for 10 years. He has extensive experience working in credit, interest rate derivatives,
emerging markets and global fixed income. Rohan is an adjunct professor in the graduate financial
engineering program at NYU Poly in New York and the Macquarie University Applied Finance Centre
in Australia and Singapore. He is the editor of a book, “Credit Derivative Strategies,” published by
Bloomberg Press.
Krishna Kanth Gadamsetty is a Senior Consultant within Cognizant’s Banking and Financial Services
Consulting Group, working on assignments for leading investment banks in the risk-management domain.
He has more than seven years of experience in credit risk management, capital markets and information
technology. Krishna is a Financial Risk Manager – certified by the Global Association of Risk Professionals — and has a postgraduate diploma in management from the Indian Institute of Management,
Lucknow. He can be reached at [email protected].
S L K Prasad Thanikella is a Senior Consultant within Cognizant’s Banking and Financial Services
Consulting Group. He has more than seven years of experience in financial risk including implementation of complex regulations such as regulatory capital rules under Basel III, capital adequacy, capital
buffer measurement and management. He is a Financial Risk Manager certified by the Global Association of Risk Professionals (GARP), a gold standard in financial risk management. He has an M.B.A. with
specialization in finance. He can be reached at [email protected].
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About Quantifi
Quantifi is a specialist provider of analytics, trading and risk management solutions. Our suite of integrated
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