Asset managers and hedge funds have less than a month to prepare for a mandatory swaps clearing deadline.
According to a white paper by consulting and research firm Woodbine Associates waiting is not an option because firms need to finalize FCM, select a central counterparty (CCP) and vendor arrangements by the June 10 deadline for category 2 participants.
If firms are not ready, they could face disruptions or restrictions in trading swaps and hedging, or hit operational that can only be avoided with thorough systems testing with live transactions, Woodbine warns in the whitepaper.
[For more on See OTC Derivatives Clearing Raises Challenges for Collateral Management. , see Ivy Schmerken's related story.]
“Firms choosing to wait until the last minute may find selected FCMs unable to process and onboard their accounts due to industry wide capacity constraints during the final days leading up to June 10 and thereafter,” wrote Sean Owens, director of fixed income at Woodbine Associates, a consulting and research firm in Stamford, Conn.
In a 13-page white paper entitled “The Fast Track to Central Clearing and Optimal Margin Management,” Owens lays out a practical but detailed roadmap for approaching readiness.
Five key steps that need to be taken by the buy side to prepare for the rapidly evolving infrastructure of swaps clearing are: CCP selection, futures commission merchant or FCM selection and documentation, middleware selection and implementation, FCM onboarding and system testing. However, a well -designed approach would be to follow a particular timeline. In the whitepaper, he advises firms to finalize their documents and register with a CCP and begin onboarding by May 13. Owens tells firms to set incremental deadlines. For example, they should begin or continue user acceptance testing (UAT) and live trade testing by May 24.
In addition, the white paper provides in-depth guidelines for selecting CCPs and FCMs. For instance, it provides a chart comparing the three main CCPs, CME Clearing, ICE Credit and LCH SwapClear with their specific product, currency and asset classes. Firms want to allow for position consolidation at fewest number of CCPs and also have the “greatest potential" for the potential for risk netting, wrote Owens. Net initial margin requirements (IM) and also portfolio margining will be key considerations in selecting CCPs, particularly for those customers with with offsetting risk in cleared swaps and futures contracts.
Asset managers and hedge funds must also complete documentation to register with each CCP, which is typically completed in conjunction with FCM requirement, and is another reason not to procrastinate. Firms need a minimum of two FCMs at each CCP to ensure seamless trade operations in the event of an FCM default, notes the whitepaper. As major service providers for centrally cleared swaps, futures and options, FCMs are not only involved in managing margin and providing credit enhancement for clearing customers, but they play a major role in financing collateral and sourcing liquidity.
Middleware providers are critical to the workflow for centrally cleared swaps, since they provide connectivity, data transmission between CCPs, FCMs, execution venues, data repositories and clearing customers. Buy side firms also need to pick affirmation platforms or APs , which compriseanother critical piece of the workflow. After the trade is executed, APs handle communication between the firm and its FCM and between the FCM and CCP as the trade is confirmed submitted and accepted for clearing, explains Owens in the report. Asset managers and hedge funds will select from three primary APs: Markit SERV (Markit Wire), Bloomberg VCON or ICE Link.
One of the more labor -intensive components of the time line for swaps clearing is customer on boarding and testing for establishing new clearing arrangements. Onboarding involves account creation at the CCP and FCM, customer and FCM system set-up , middleware set-up and establishing connectivity.
“Firms must set up static data feeds, modify internal systems and back-office processing, and adjust workflows to include FCM margin calls and daily collateral management," according to Woodbine’s whitepaper, Under normal circumstances this process takes 6 to 12 weeks, but with full commitment from FCM and APs, firms should be able to complete the task within three weeks, barring any significant technology issues.
As far as cost goes, the new world of swaps clearing is more expensive than the OTC bilateral world. In most cases, the cost of clearing an interest rate swap is 2.5 to 3 times that of a risk equivalent futures contract. Among other topics, the white paper examines margin analytics, setting up segregated accounts at FCMs and collateral management.Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio