BNY Mellon and Rule counter OTC derivatives conundrum

BNY Mellon: Asset managers should prepare for central clearing of OTC derivatives

Asset managers should take five simple steps to counter the effect of rising collateral requirements for OTC derivatives, according to a joint study by BNY Mellon and Rule Financial.

According to the BNY Mellon/Rule Financial joint paper, To Clear or not to Clear … Collateral is the question, only 20% of buy-side firms have finalised their adjustments to meet the new rules, despite the fact that they are due to take effect in the US from January 2013 and in Europe from 2014.

EMIR in Europe, Dodd-Frank in the US mandate the central clearing and reporting of the bulk of OTC derivatives, while Basel III makes the remaining OTC products much more expensive to use by increasing the collateral requirements. The aim of the legislation is to reduce systemic risk in OTC derivatives markets, which were blamed by the G20 nations in 2009 as a contributor to the recent financial crisis.

However, the need to post large quantities of collateral as margin at CCPs introduces costs for buy-side firms. The amount of initial margin that must be sourced can be substantial – around 1-3% of the notional value of the contract for a typical 5-year vanilla interest rate swap, according to BNY-Mellon-Rule Financial. For long-dated or complex contracts, the amount of collateral required increases substantially because of the greater potential future exposure, to around 10% of notional for a 30-year and 15% of notional for 50-year tenors. In addition, the Investment Management Association has identified as “not unusual” the requirement for CCP-eligible collateral equivalent to 20% of the investment value of test portfolios to be able to meet initial and variation margin obligations on typical OTC derivatives strategies under mandatory clearing

The research by BNY Mellon and Rule Financial suggests that asset managers should review OTC derivatives strategies to establish which cleared contracts will be used, model the initial margin requirements of their current or projected OTC derivatives portfolio, identify incremental costs under the new rules, consider strategic and tactical changes to the investment process, and evaluate service offerings that can mitigate costs. But above all, the report emphasises the need to engage with clearing brokers and custodians to evaluate alternative sources of collateral, and where necessary, to agree on changes to investment mandates and counterparty documentation.

“There is an opportunity here for those institutional investors that are natural holders of CCP-eligible collateral, and these assets will be subject to intense demand from banks and other institutional investors to cover margin,” said Nadine Chakar, executive vice-president, global collateral services at BNY Mellon. “The ability to lend such assets, subject of course to adequate risk controls, could therefore be a means of offsetting some of the costs of compliance with the new rules as well as augmenting depressed yields.”

Some 43% of buy-side respondents to the BNY Mellon-Rule Financial research thought that collateral charging would have a significant effect on their returns; a further 24% said it was too early to say, while 24% thought it would have limited impact. Only 9% thought it would have no impact.

Part of the difficulty facing many buy-side firms has been the ongoing uncertainty over exactly when the new rules will take effect, given the changing deadlines presented by the EC in particular, as well as over the scope of which instruments will fall under the remit of the new rules.

At present, the International Swaps and Derivatives Association estimates that 51% of the global interest rate swap market, which accounts for over 80% of the gross notional volume of the OTC derivatives market, is now centrally cleared. CCPs are also beginning to clear FX non-deliverable forwards and FX options contracts, but many other OTC derivatives contracts are yet to be standardised. A CCP sits between counterparties, in theory reducing the risk if a major financial institution goes bust, such as happened with Lehman Brothers in 2008.