March 12, 2012

While central clearing of swaps transactions is intended to reduce the risk of the $600-trillion derivatives market, it won't be achieved without a lot of hard work (and costly investment) across Wall Street. To make the swaps market safer, under the Dodd-Frank financial reforms, the clearing of trades will be transformed from opaque, bilateral deals into transparent, multiparty transactions that shift the risk to central clearing facilities — a mandate that could take effect as soon as July.

To comply with the pending rule changes, however, dealers, investment managers and hedge funds will need to build a new technology environment and overhaul existing systems and processes. Dealers already have begun to voluntarily clear their credit default swaps and interest rate swaps trades through central counterparties (the CME for credit default swaps; and the CME, ICE and LCH.Clearnet for interest rate swaps). But despite a deadline that many believe will come before the end of the year, there is a perceived lack of urgency on the part of buy-side firms to make the technology investments necessary for compliance.


EASING THE PAIN OF SWAPS REFORMDodd-Frank's unintended consequences are proving painful, particularly in the $600 trillion derivatives market. WS&T's March digital issue examines the challenges to central clearing of OTC derivatives and offers tips on how to ease the pain of swaps reform.

Acknowledging that the deadlines for clearing are somewhat ambiguous, Kevin McPartland, principal and director of fixed income research at Tabb Group, cautions that the buy side shouldn't wait much longer. "It's time for everybody to get their ducks in a row," he advises.

The bigger and more sophisticated asset managers, such as the BlackRocks and Pimcos, along with the largest brand-name hedge funds, are looking to build out proprietary systems, according to McPartland. "This will be the core infrastructure [for the whole industry]," he says. "Once it's 2014 and we're up and running, the bigger firms that do much higher transaction volumes will want to keep the infrastructure in-house."

It's no surprise, however, that for many asset managers and hedge funds, the burden of centrally clearing swaps seems overwhelming. We identify the three biggest pain points the buy side faces in building central clearing infrastructure and offer a road map for overcoming them.

1: Establishing a Swaps Ecosystem

A new swaps ecosystem needs to be established in order to enable central clearing. "You're talking about a whole reinvention of the entire market," says Henry Hunter, global head of product development at MarkitServ, a provider of middleware and online confirmation and affirmation services to the buy and sell sides in the derivatives space. "That's a massive infrastructure change that is happening over a period of years."

Some buy-side firms will rely on their dealers to supply the necessary connectivity, some will turn to their custodian banks and still others will install their own trade matching systems from technology providers. Key to any solution, according to experts, will be middleware providers, since buy-side firms will need connectivity with multiple executing brokers, known as futures commission merchants (FCMs), as well as clearing brokers and central counterparties (CCPs).

The Buy Side Must Take Three Difficult Steps to Achieve Central Clearing of Swaps
  1. Establish a Swaps Ecosystem
  2. Post Collateral
  3. Understand Risk

Meanwhile, capital markets technology providers are enhancing their systems to meet the new regulations around swaps clearing. Calypso Technology provides OTC clearing systems to six CCPs (including the CME in the U.S., the SGX in Singapore and Bovespa in Brazil), as well as end-to-end solutions to clearing brokers and FCMs that cover CCP connectivity, clearing workflow, margin and risk management. "Having six CCPs currently using Calypso as their in-house infrastructure for clearing, the connectivity challenge becomes simpler," asserts Sanela Hodzic, managing director, strategy and business development, at Calypso.

Like other middleware providers -- such as MarkitServ, Bloomberg VCON and Ice Link -- Hodzic says her firm will provide "agnostic" connectivity to swap execution facilities (SEFs), which, once they are established, essentially will function as exchanges on which multiple executing brokers can make markets for derivatives. Ted Leveroni, executive director, derivatives strategy, at Omgeo, says, "The SEF is basically taking the place of what used to be a phone call to your broker."

According to MarkitServ's Hunter, "The initial buy-side submission -- the agreement between the executing broker and the buy-side client of the trade details -- has to be electronic." Typically, he says, that message will go through a platform such as MarkitServ, which has 2,500 buy-side firms connecting to its pipes. While money managers may bunch orders to trade them as a block, after the trade is completed, Hunter adds, they will need to make the appropriate allocations to individual funds. "The allocation process has to happen before the trade clears."

After the buy-side firm and executing broker agree on a trade's details, then it can go to the clearing broker or to the CCP, which then sends it to the clearing broker. "There needs to be some mechanism for that messaging to be received from the CCP and the clearing broker back to the client," Hunter explains.

Jason Swankoski, executive director in OTC client clearing sales at Morgan Stanley, says Morgan and other clearing brokers will take in messages and display them back to clients. "In the pre-SEF world, there will be bilateral execution with matching and affirmation done on various middleware platforms," he explains.

"It's a complicated mess," says MarkitServ's Hunter, who notes there could be as many as six different players involved in any trade -- the client, the executing broker, an execution venue (i.e., the SEF), a CCP, a clearing member acting for the client, and possibly a clearing member acting for the dealer as well. "Managing that choreography can get complicated, so that's where the middleware comes in."

And the mess doesn't stop there. Clearing brokers have the burden of modifying their electronic trading infrastructures and processing systems. According to Morgan Stanley's Brock Arnason, executive director and global product manager for the Matrix platform, "The infrastructure that is required to support a clearing business is quite significant." Clearing brokers must capture their clients' voice and electronic trades and then run them through validation rules to determine clearing eligibility, he explains.

To connect with the new swaps clearing infrastructure, Morgan Stanley built TriClear, a cross-product clearing engine for OTC derivatives transactions. The platform takes trades that are booked in a variety of systems and, by connecting to the various CCPs and downstream systems, ensures that the correct transactions are recorded, says Arnason.