Capital Markets Advisors

Turning Change Into Opportunity


Aug 01, 2014

Cross-margining offered by Europe’s biggest clearing houses has been called into question by clearing members, amid concerns competition in this area will increase risk in the derivatives market. Clearing firms have highlighted that a potential race to the bottom could lead to under-collateralisation and risk cross-contamination between default funds.

Under the new regulatory regime of centrally cleared swaps, firms are required to post collateral as initial margin for OTC derivatives, thus increasing the cost of trading. In response, central counterparties (CCPs) are offering collateral efficiencies through margin offsets between OTC and exchange-traded derivatives, a move championed by the buy-side, due to the cost savings. According to sources though, with margin offsets being used in a competitive fashion, there is risk of under-collateralisation in a crisis.

Firms have also been calling for more transparency around CCP risk models in order to meet their own real-time risk management requirements. “I think the general concern is that there is a race to the bottom between CCPs,” said one person familiar with the matter. “Concerns really originate from the fact that the prudent FCMs (futures commissions merchants) are at risk from the poor risk management standards of others and are effectively at risk of being exposed to losses.”

CCPs are scrambling to accommodate market participants who were facing higher capital costs or risk them not trading the market at all. In’s most recent poll, market participants voted that clearing arrangements were the most attractive results of increased competition in Europe’s derivatives markets. “As a clearing member ourselves we are very, very sceptical and against this move by the CCPs,” said Gildas Le Treut, global director prime clearing, ABN AMRO Clearing.

Le Treut highlighted that with default funds per product, there should not be cross-contamination between funds. “If you are only dealing with equities you don’t want to be blown up because a dealer has made issues on IRS,” he continued. “Cross-contamination should be avoided, and once you do an offset between two products, there is a link in the default funds. So the GCM would rather have a very straight CCP in terms of risk management and safe CCP, rather than it doing cross-asset correlation.”

Ultimately with concerns over a collateral shortfall and the increased cost of trading OTC products forcing participants out of the market, there has been a huge demand for cross-margining efficiencies from the buy-side. One of the CCPs spearheading the margin offsets has been Eurex. “The last thing we as a CCP want, is to run the race to the bottom on the margining side,” said Matthias Graulich, chief client officer of Eurex Clearing. “That is something we as CCPs would like to avoid and also our clearing brokers would like to avoid. Ultimately CCPs and clearing members both have skin in the game aligning their interest on risk adequate margins.”

The German exchange became the first CCP in Europe to offer margin offsetting within asset classes and across OTC and listed derivatives earlier this year. In a white paper, Eurex also outlined how buy-side firms can substantially lower their capital and funding cost by actively pooling clearing business on an integrated cross-product CCP. The CCP added that benefits could also be taken from cross-product exposure netting, an integrated default fund structure and collateral management services.

The clearing members have the power to avoid such race to the bottom because they are represented in the risk committee of the CCP and if they realise such practises in risk management standards then they can address it with the CCP and the regulator,” added Graulich. Addressing the default funds, he added that different approaches are taken by different CCPs. “There are different default fund approaches taken by CCPs, we have a single segmented default fund, others have completely ring-fenced default funds.

“As a matter of fact, what happens in a crisis situation is that different products tend to go in different directions. So you have a portfolio effect if you have a broad product coverage under a single default fund. The risk is lower because you have offsetting effects between different products, which in the end leads to lower risk and consequently lower default fund contributions.”

But while the benefits for the buy-side are clear and CCPs are justifying the efficiencies, according to Le Treut, clearing firms have been forgotten in this decision process. “They forgot that the clearing members, those who are guaranteeing stability, might not like this,” he added. “The CCPs are not taking the risk, we as the GCMs are guaranteeing our clients in the event of a default.”

Jon Watkins

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