Guest commentary by Sean Owens.

Sean Owens is director of fixed income at Woodbine Associates, a Stamford, Connecticut-based consulting and research firm serving the capital markets. In addition to his research, he has served on industry panels and roundtables and is a frequent speaker at industry events. His latest work, the “The Fast Track to Central Clearing and Optimal Margin Management,” is a comprehensive examination of the impact of new swap clearing and margin rules on asset managers, hedge funds, traders and banking institutions. For more information, or to obtain a copy of the guide, click HERE.

The derivatives markets are about to change in a big way.

The mandated June 10th swap clearing deadline is the line in the sand that will lead to fundamental changes in derivatives trading. Establishing operational readiness – while critical – is only the first step.

The new derivatives paradigm will have broad impact on many elements of asset managers’ and hedge funds’ business, including trading, operations, risk management and cost. Firms expecting to trade derivatives after the Category Two deadline must take definitive, broad-based steps to ensure they are ready. Failure to do so will leave the very heart of their businesses exposed and potentially uncompetitive.

Firms will face new challenges under a cost structure for derivative transactions that rewards generic and standardized products for transferring risk. Those already clearing swaps are beginning to realize the cost impact with clearing costs for swaps between 2.5 to 3 times those of equivalent futures contracts. This dynamic is beginning to impact liquidity and trading across risk-equivalent products. Asset managers and hedge funds are already rethinking approaches to trading these instruments and related risk management practices.

Trading in the New Paradigm

Firms must implement business, operational and technology features to achieve efficient, cost-effective trading and hedging. The endgame is an optimal framework for margin management, cost reduction and risk mitigation. An optimal margin management framework encapsulates several key features:

  • Capital efficiency
  • Margin analytics
  • Real-time capabilities
  • Automation and STP
  • Collateral management
  • Integrated risk management

Capital efficiency and margin minimization for centrally cleared transactions will be an important industry-wide focus for the foreseeable future. Firms will aggressively seek ways to realize efficiencies through netting, portfolio margining and trading the most capital efficient products. Expect increases in listed futures and options trading as firms seek cost-minimizing solutions.

Margin and pre-trade analytics will be central to determining the all-in-cost of a transaction, which will be a key metric driving trading and hedging decisions.

Enhanced automation and STP will be instrumental to meeting expanded real time requirements and decisions relating to CCP and FCM obligations.

Collateral needs will grow with the amount of cleared risk and play a more integral role in funding and liquidity management.

Firms will need to more comprehensively integrate overlapping facets of market and counterparty risk.

Embedding these key features and enhancing capabilities will lead to more efficient and cost effective trading, processing, and risk management practices.

Operational Readiness

Category Two firms must act quickly to finalize central clearing arrangements before swap clearing becomes mandatory. Firms unnecessarily risk their trading ability by waiting until the last instant. Delay risks subjecting participants to industry-wide capacity constraints compounded by potential system integration issues during the final days leading to the June 10 deadline. This risk is entirely avoidable.

Asset managers and hedge funds must move swiftly through the steps required for readiness: CCP, FCM and middleware selection; documentation; onboarding; and testing to avoid risk and deadline-related challenges. Firms need to finalize documents, complete registration and begin onboarding if they hope to be ready.

Customer onboarding and testing are the most time-critical elements involved in new clearing arrangements. The onboarding process – including account creation, systems set-up, integration with affirmation platforms, and establishing seamless connectivity – will take longer than most anticipate.

Testing internal systems and affirmation platform connectivity with FCMs and CCPs is critical. Firms must evaluate trade capture, affirmation, initial margining, allocations, margin calls and end-of-day processing to ensure that workflow changes operate smoothly and are fully integrated with external systems. They must extensively “test the pipes” with multiple live trades to validate system readiness. Live trade testing must be conducted across each product, asset class, region, account, executing broker, FCM and CCP in order to validate counterparty mapping across the myriad of potential trading scenarios. Many asset managers and hedge funds have identified problems with trade affirmation, account mapping and data integration through live production tests that were not apparent in UAT trials. Firms need to be actively clearing on a daily basis to truly test their systems. This cannot be over-stressed.

The capabilities put in place today will dictate how well organizations are able to adapt to change and exploit opportunities in the future.

There is No Time to Waste

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