Is this the most challenging time ever for custodians and their clients? For some big players, making particular reference to the proposed new central clearing requirements for over-the-counter derivatives as a means of increasing transparency and reducing risk, the answer is a clear yes. Central clearing will have a series of implications, and challenges, for clients and custodians.
Zohar Hod, a vice-president at pricing and market analytics data provider SuperDerivatives, says custodians will need to increase their relatively unsophisticated internal capacity by hiring more people who understand the derivatives business. He points out, too, the simple operational difficulties of transferring the large volumes of the settlement price data needed to calculate daily net asset values and revised collateral requirements in a correct and timely manner.
However, change also presents opportunities, especially in the collateral management arena where much of the action will eventually be taking place. “Collateral management will become more complex,” says John Southgate, product manager, derivatives servicing, at Northern Trust. The upgrading of collateral will become an increasingly important aspect of the collateral management process, generating additional costs.
However, those costs may be offset by lower costs resulting from the standardisation of trades, according to John Van Verre, head of global custody at HSBC Securities Services.
Significant change is on its way and the sooner asset managers realise what it means operationally, the better for them and their clients, according to Bikram Singh, Citi’s head of OTC derivatives services. A recent paper Mr Singh co-authored on the subject and highlighted in an earlier FTfm supplement, identifies five areas where the buyside could begin making preparations for the big day. These include determining the regulatory classification of their organisation, appointing a clearing member firm for clearance of eligible trades and establishing trade connectivity.
Other areas clients could be working on in the interim period include ensuring that internal operations and technology staff can meet the new reporting and reconciliation guidelines. Internal staff – or an outsourced middle-office provider – must also be able to split portfolios into clearing-eligible and clearing-ineligible buckets and to track and administer the increased margin requirements. Finally, clients should be assessing the impact of central clearing on margin and collateral levels and eligibility and consider the potential impact of margin and collateral increases on portfolio management.
Although risk reduction is one of the principal driving forces behind central clearing, it is clear that it will not be a panacea. It will not eliminate risk, only restructure it while increasing costs for end-clients, according to Martin Higgs, a senior vice president at State Street, who says the more sophisticated clients have either already appointed their clearing members or are conducting the relevant interviews.
The nature of collateral management will change with daily resetting, marking to market and posting of variable capital pushing out current less demanding practices. This is good news for custodians, says Rob Hegarty, global head of market structure for the Enterprise Solutions business at Thomson Reuters, as it will increase the need for top quality collateral management. But they will have to move fast, he warns. If the custodians do not invest in the technology required to improve existing collateral management capabilities, third-party players will.
The bifurcation of capital that will take place in a market where some trades are cleared and some are struck bilaterally will almost inevitably complicate processes and push up costs. Despite the determination of clients to benefit from more services at less cost, it is they who will ultimately pay for the raft of initiatives facing the industry, introducing a new drag on investment performance.
One point for custodians to address, in their own purely commercial interests, is the potential loss of income if significant volumes of pension fund assets that are currently in their custody are moved elsewhere as part of the new-look collateral management world, in which segregation of assets will be required at the clearing level. This is clearly not in a custodian’s best interests, but neither is it in the client’s best interests, argues Steve Ingle, derivatives product manager at Bank of New York Mellon. “The clearing houses have put custody arrangements in place according to their own criteria and clients will find themselves having to pay an extra set of fees.”
Unsurprisingly, custodians argue the case for revisiting processes and systems so they do not lose custody of such assets. They suggest a clearing house could open an account with the custodian to enable quick, efficient and safe book transfers to take place. They claim this would make more efficient use of capital while reducing external instruction risk and financial cost.
Helene Viretto, head of collateral management at BNP Paribas Securities Services, says: “We need clarification on certain points, including the extraterritoriality sought by the USA, and we need to be flexible in finding a tactical solution within the timeframe.”
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