Clearing contradictions in derivatives regulation
Stephen Ingle is associate principal, financial services, at eClerx
There’s one challenge that regulators seem unable to address, and that is regulation itself. Today’s evolving regulatory environment seems to be beset by a range of internal contradictions. One such contradiction affects those banks acting as clearing providers for derivatives businesses, writes Stephen Ingle. associate principal, financial services, eClerx
On the one hand, both Dodd-Frank and EMIR direct market participants towards undertaking clearing – banks make these services available to their clients as general clearing members of the Central Counterparty providers such as LCH, ICE and Eurex. On the other hand, the Basel III capital rules oblige banks to place collateral against their transactions, not only with their transaction partners, but also with the clearing houses behind those transactions. And then they also penalise cash collateral pledged by clients against these positions. From a capital perspective, banks are getting hit very hard when they make clearing services available to their clients. If we can use a technical term – it’s a double whammy.
What does this mean in practice? The first point to consider is that although Dodd-Frank and EMIR push market participants towards clearing of OTC derivatives positions, both listed and OTC Cleared businesses are impacted by the capital rule amendments, which affect clearing businesses globally. The second point is that it obliges banks to take a much harder look at their RoA (return on assets) for the derivatives business. This is the key issue. It’s true that banks in general are repositioning their business portfolios to ensure the most efficient deployment of scarce capital resources within the new regulatory environment. It’s also true that they are reassessing their operational cost structures to ensure that an adequate RoA is achieved from each business and it’s also the case that banks undertake these strategic business profitability assessments all the time. However, the current regulatory climate has given the clearing process a greater intensity. We’re not talking about an inherently low-cost/high-return activity, but rather a platform business that processes high volumes with low margins.
There isn’t a strong commercial or financial case for banks to provide clearing services for derivatives as stipulated by Dodd-Frank and EMIR, on the terms laid down by Basel III. For those banks currently intending to continue with this activity, tight(er) cost controls are crucial. They must find a way to reduce the expense drag, and ensure that they receive sufficient remuneration for their deployment of capital.
In the current climate, however, there isn’t a compelling business case for doing so, as there are other routes to clearing. Some CCPs, for example, are working hard to offer end-clients direct clearing, which bypasses banks’ clearing workflows. Yet, here again, we bump up against that regulatory double-whammy, described above. To be in this derivatives business at all is to face a regulatory obligation that goes against what we might as well call commercial (revenue-driven) logic. That is to say: “Why would you continue to deploy capital for a low-return activity from which you could exit without a significant downside?”
There’s a further complicating factor. Technology. In the absence of harmonised global rules, or ‘equivalence’ as it is known, it may become problematic to build a single scalable operation with a single technology stack to handle all comers, across all jurisdictions. This isn’t a challenge unique to the derivatives clearing space, of course, but it adds another dimension to the key question, “Why are we in this business at all?” What all this means in practice is that banks are considering pulling out as they just can’t make the numbers work for them.
End of story? No. Everything I have said so far not only describes the challenges but also points to the solution. The industry as a whole faces the same challenges, and as such it is the industry that needs to come together to become the solution. The first step is cooperation through industry organizations that can help explain the regulatory conundrum clearly to the regulatory authorities. This could work to resolve at least some of the capital punishment that is being meted out through Basel III.
The second step – cost reduction – can be achieved through leveraging relationships with vendors which provide business-critical processing services to global banks. In my conversations with the senior executives of the world’s top investment banks focused on clearing services the banks make it clear that they are seeking to solve the cost equation through low-cost delivery locations, coupled with a multi-tenant model which offers best practices, gleaned from supporting multiple clients, across operational teams. Even though client banks may be operating unique and wholly different technology stacks, a global provider can offer clients benchmarking insights for comparing the efficiency of their stacks against those of their competitors. Not everyone wants to give up their technology stacks, so is there a place for a soft utility provider in the service space?
It seems safe to assume that, from a regulator’s perspective, pushing banks out of the clearing derivatives business would qualify as an unintended consequence. Yet regulatory activity has increased the cost of delivery of clearing services; if there weren’t so many rules, there wouldn’t be so much investment required in technology. True enough, but there is a positive side. At eClerx, for example, we partner with industry organisations, technology providers and jointly with all of our customers to deliver value across the industry.. This is an example of the efficiencies that can be achieved across the industry if we successfully bring people, processes and technology together. After all, even unintended consequences can sometimes lead to new efficiencies – necessity being the mother of invention. It’s crucial for all of us, industry participants, service providers and regulators alike, to face our challenges together.
