The real cost of clearing
Derivatives clearing has been mandated in Europe for the buyside (Category 2) for over a year, since May 2016, with the start of clearing for GBP, USD, EUR and JPY IRS.
Whilst the mandate for Category 3 participants has been delayed (to 2019 or possibly beyond), various drivers are accelerating
the shift from bilateral to cleared:
- The emerging spread between bilateral and cleared (due to increased regulatory capital pressures on the dealers for bilateral trading), favouring clearing even when not mandated
- Recognition of the opportunity for margin efficiencies through selectively clearing to reduce cleared IM liability by offsetting mandated positions
- The potential for operational efficiencies through moving flow from bilateral to cleared (setting up a clearing infrastructure carries a large fixed cost independent as to the extent of derivatives cleared).
The focus for most participants since May 2016 has been to establish a working clearing service under a basic “one size fits all” model, often with a single clearing
broker and CCP. As a result, the cost of clearing hasn’t (to date) been a major consideration as volumes have been low and meeting regulatory deadlines has been a far more pressing concern. However with the materiality of the cleared portfolio for many now significant (and increasing), a comprehensive review of the cleared fee model is now justified for many participants, especially with the regulatory deadlines (at least for clearing) in the rear view mirror.
Trend towards clearing and accelerating cost to the buyside
One key question is to determine the tipping point at which the cleared portfolio will be sufficiently material to justify investment of time and effort in any clearing fee optimisation investigation. A good proxy as to the pace of the transition from bilateral to cleared is the client IM lodged at CCPs. And a closer inspection of publicly available data from the LCH over the 12 month period to 2016 reveals the scale of this trend. Table 1 illustrates the change in client (buyside) initial margin over that time.
Notable data points include:
- Client (buyside) initial margin requirement at the CCPs
- Proportion of new derivatives transacted cleared v bilateral
What is the true cost of clearing to the buyside (top down view)?
As highlighted above, client IM is a good indicator of the magnitude of derivatives cleared (in terms of risk) and LCH data shows that client IM requirement doubled from £16bn to £33bn between 2015 and 2016.
As client IM is a major cost driver of any fee model, this can be used as an indicator of the cost of clearing across the market. For clearing members, client IM influences several factors including capital requirements and default fund contributions. And for the CCPs, fees are also often a function of client IM.
Public EMIR cost disclosures from Clearing Members indicate IM based clearing fees range from 15bp to 50bp. Assuming an average of 25bp, the total client IM of £33.5bn translates into ~£100m of cost to the buyside at the LCH alone (based on 2016 figures). As clearing is expected to continue increase rapidly over the next few years from this low base, the end state will be much higher. If fivefold growth is assumed before steady state is achieved, the annual cost of clearing for the buyside could approach £0.5bn for IM based fees alone. Add in other fees (transaction fees, account fees, etc.) and this may well double to £1bn.
The case for investment in technology and processes to reduce the cost of clearing?
A logical buy-side response to such projections should be to evaluate opportunities to aggressively manage such costs down. A 30% reduction in clearing costs is a reasonable target through investment in strategic infrastructure to facilitate optimisation, translating into £300m of potential savings p.a. This surely presents a case for investment in technology and processes to deliver such benefits. An enhanced optimisation platform will likely deliver many more business benefits as by-products over and above the core fee savings.
Hence now is an opportune time for many buyside participants to comprehensively review their current clearing model, focusing on the fee model.
OTC Derivatives Clearing Fee Model
Before identifying potential focus areas for optimisation, it is worth reviewing the components which constitute the OTC fee model. As a general observation, the OTC model is still immature and far more complex than the ETD equivalent, which means there is (not yet) common market practice across CCPs and Clearing Members.
Figure 1 shows the many distinct fee types which any end user of clearing services might incur. In general, both CCPs and Clearing Member split fees into 3 types:
- Trade fees, applied when any new trade is cleared
- Maintenance fees, incurred either on an annual basis or daily (based on IM)
- Account level fees, fixed / flat cost, applied against every open account
How to approach cost of clearing “optimisation”
Rather than follow the framework above for the purposes of fee optimisation and reduction, an alternative is to focus on the causes or main drivers of fees, which in turn will lead to a reduction in the cost of clearing. There are 3 driving much of the cost of clearing:
- IM management / reduction
- Gross notional management / reduction
- Other techniques
IM Management / Reduction
A “razor like” focus on managing down the IM liability as much as possible using every available tool is likely to yield substantial cost reduction, as IM is arguably by far the largest driver of cost in any clearing service:
- Clearing members often apply a bp fee (typically 25-75bp), i.e. $100m of IM carries a charge of $0.5m.
- CCPs apply an IM based bp fee of around 10bp, resulting in an annual charge of $0.1m
- Other notional based fees are indirectly related to IM (e.g. trade fees or some annual maintenance fee types, which are based on gross notional
Hence any reduction in IM results in a corresponding sizeable reduction in the cost of clearing and justifies investment in the technology and processes necessary to achieve this. IM is a large driver of cost for clearing members as the regulatory capital and risk based charges as well as CCP default fund contributions are related to the size of client IM. Hence clearing members aim to recover this cost by using an IM based fee model. The buyside should therefore focus on treating the cause rather than the symptom and focus on techniques to reduce IM in the first place.
Examples of drivers which are IM based and are most likely to deliver high cost benefit include:
- Elective clearing
- CCP fee model selection (standard or high turnover plan)
- Treasury management (multi-currency margining)
- Treasury management (buffers)
- Absolute IM management
A second category of fees are based on the gross notional of derivatives which can have a significant bearing on the cost of clearing including:
- CM or CCP trade fees (per mm notional based fee)
- CCP maintenance fees (per mm notional based fee, charged annually) and some CM fee types
- CM leverage ratio fee (notional based)
Reducing the gross notional of derivatives and using compression (and partial compression where available) is one technique to reduce some notional based fee types (maintenance and leverage ratio fees). For many participants, the cost of investing in tools to assist with this process is more than justified by the cost savings that would result. For some asset managers, the problem may be complicated by the need to “preserve” specific trades which are part of a strategy and exclude from any compression run. However, the benefits through selective and/or partial compression are will still likely outweigh the additional cost in tools which would be required to support such an approach.
Other techniques which could be used to optimise the clearing model include:
- CCP account model selection
- Adoption of cross product margining
- Optimisation of the number of clearing members
- Optimisation of the number of CCPs
CCPs are required to offer two types of account under EMIR: OSA and ISA. ISA accounts attract an annual CCP fixed cost (e.g. €3500 p.a. in the case of the LCH) whereas OSA are “free”, reflecting the additional operational costs of supporting an ISA account. Clearing Members may also add a fixed monthly or annual fee for all open ISA accounts (typically $1000-$3000 per month, based on EMIR fee disclosures). Hence for some participants the (slightly) lower protection offered by the OSA account may be worthwhile taking in return for a significant reduction in account fees. This is especially true at the LCH, where at a minimum the value of assets are returned even in an OSA account – hence for low volume cash posting participants an OSA account may be a more appropriate selection.
Cross product margining has been talked about for years on the conference circuit but has never really taken off as the benefits have been marginal at best. However with an increase in cleared OTC volumes, a (re) evaluation of the potential benefits could be worthwhile.
Many participants have adopted a single CCP/ (active) Clearing Member strategy to get up and running. However, a periodic assessment of this arrangement is recommended; factors to consider include:
- Liquidity and pricing of products traded (other CCPs may be more competitive)
- Size of “absolute IM” (could be beneficial to split portfolio across two CMs or CCPs to “cap” multipliers for very large portfolios)
Quantifying the opportunity
Table 2 summarises many of the clearing cost drivers and estimates the potential opportunity for a medium to large user of cleared derivatives. For a participant with IM of $100m+ the opportunity for cost savings could be as high as $5m+ (depending on the composition of the portfolio), more than justifying the necessary investment in technology and processes to achieve this.
An interesting case study is to consider the relationship between compression and fees charged. The LCH standard plan charges maintenance fees at 3 per million notional (e.g. $30 for $10million notional) or 12 per million notional for inflation for the life of the swap. If we consider a model portfolio comprising say 150 IRS with average 30 year maturity and 50m notional, the annual LCH maintenance fee equates to £30,000. If nothing else changed in the portfolio, this translates into a £900,000 cost (or £3.6m for inflation). If compression was run regularly and this reduced the gross notional by 30%, the total cost would then decrease to £630,000 (or £2.5m for inflation). Whilst this might not appear significant, for an asset manager with multiple funds, the cumulative savings over multiple years could start to become material (e.g. over 20 funds running compression, cumulative savings could reach £10m+). Investing say £1m in technology and processes to regularly run compression then looks like a good return. Some clearing members might also apply a leverage ratio based fee (based on the gross notional) which further strengthens the case for regular compression.
As a second example, we can consider the difference between the LCH standard and high turnover plans for instance – in summary, the two plans are as follows:
- Standard Plan: per mm notional charge on new trades (of 1-18 dependent upon residual maturity), annual per mm notional charge on open trades
- High Turnover Plan: flat fee of $25 per trade, maintenance fee of 10bp on the IM requirement
If we use a (sizeable) test portfolio with the following average characteristics:
- 200 new trades p.a.
- 3000 days residual maturity
- 500m average notional
- 400m average IM.
Simulating the cost of this test portfolio against each fee model in turn comes out at £1m on the standard plan compared with £0.4m for the high turnover plan, representing a potential £0.5m saving p.a. (and much larger for portfolios with inflation)
Whilst the two case studies above are arguably relatively immaterial in isolation in the context of the model derivatives portfolios used, the theme of this article is that any clearing fee optimisation should be comprehensive and evaluate ALL fee types (10+). Taken together optimisation across all fee types is likely to yield significant savings justifying the investment required. It is somewhat similar to the “marginal gains” approach adopted by Team Sky in the cycling world which has squeezed out extra performance across a large number of small areas to cumulatively deliver results.
MiFID II also brings bring greater transparency and scrutiny on fees charged which means in the “best ex” era, asset managers could benefit from putting in place a process to continually review and optimise clearing fee models to continually ensure cost of clearing is as tightly managed as possible.
This article was first published in edition 10 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.
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Clearing is now mandated globally which means for many high volume products their processing takes place via a CCP. With this bifurcation of cleared and un-cleared business, new clearing costs occur, but also from having trades in two environments. In this webinar we are going to consider:
- Whether your firm should move as much business into clearing as possible
- Whether your cleared portfolio is big enough to justify a cost reduction programme
- How client clearing affects cost
- The options for reducing initial margin and default fund
- The components of clearing costs including CCP direct and indirect fees, clearing broker / member fees and other add-on fees
- The many optimisation services available
- The tools necessary to analyse your cleared portfolio to support a cost reduction programme
- An action plan on how to start to reduce your clearing costs
Peter Walsh, from Razor Risk, is a banker by trade (ACIB) and a qualified practitioner in managing IT intensive programmes allied to a lifetime of City-based roles and experiences. His experience and knowledge of the risk measurement and management disciplines helps provide clarity; with his background in banking, regulatory compliance and risk systems he is uniquely placed to discuss and describe how technology enablers can be deployed to deliver effective and efficient solutions in the most demanding situations, including the bewildering array of regulations and changes that the FRTB will dictate.
John Lund (JXL Consulting) has worked in capital markets for 15 years+ (10 at Accenture and 5+ as independent consultant). He has extensive experience in derivatives and collateral management having worked both with the sell-side (clearing members) and buy-side (asset managers) and currently focuses on regulatory driven business change. He has previously worked with HSBC, Barclays, Morgan Stanley and Accenture.
We promise this will give you considerable food for thought and could easily lead to reduced costs for your business. Scouts Honour.