COOConnect: Criteria for Fund Managers to consider when selecting an OTC derivatives CCP

The transition to mandatory clearing of OTC derivatives in Europe begins in the spring of 2016. With limited transparency into the differences between the operating models of the various CCPs, it is difficult for fund managers to make informed choices. At a COO Connect event in London on 20 October, Jaki Walsh (managing director of Derivati Consulting) and Phil Simons (head of clearing sales and relationship management at Eurex Clearing) explored the factors they think fund managers should take into account when choosing a CCP.

Over the course of the next three weeks, we will publish a series of articles covering Jaki Walsh’ CCP selection process that emphasizes three principal factors for choosing a CCP: margin management, collateral movement & holding and default management – as having the largest potential impact.

Part 1 - Margin management
Part 2 - Collateral movement and holding
Part 3 - Default management
(see downloads below)

A poll of fund managers conducted by COO Connect in the early autumn of 2015 found that two out of three respondents had yet to choose a counterparty clearing house (CCP) through which to clear their European OTC derivative business. Yet time is running out.

The European Securities and Markets Authority (ESMA) published the final regulatory technical standards (RTS) under the European Market Infrastructure Regulation (EMIR), following approval of the measures by the European Commission, in August this year. These govern the timetable by which European counterparties must comply with their obligation under EMIR to clear their interest rate swaps (IRS).

Clearing members (the so-called category one counterparties) will enter clearing in May 2016. Although non-clearing members (the so-called category two counterparties, which include the overwhelming majority of fund managers) are not obliged to enter clearing until the fourth quarter of 2016, the coming into force of the final RTS means that buy-side firms affected will have to front-load all derivatives trades transacted since the first CCP was approved by ESMA on 18 March 2014. That obligation, to ensure all affected transactions are captured well ahead of the start of the clearing obligation proper, begins in April 2016.

"If you have €8 billion average three month exposure in derivatives, time is running out before you need to have the plumbing in place to be able to clear," explains Jaki Walsh, managing director of Derivati Consulting. In this context, plumbing means the selection of not only of a clearing member but of one or more CCPs. If only one manager in three has so far chosen a CCP, a large proportion of the buy-side will have to act quickly. Yet the choice is far from straightforward. CCP operating models, account structures, risk waterfalls and margin and default management processes vary considerably.

“Depending on the products a fund manager trades, there are subtle but important differences between CCPs that will determine the financial gains and losses incurred not just by clearing members but by end-users of their services,” explains Jaki Walsh. “In the cleared environment, fund managers need to apply the same counterparty risk and approval process to CCPs as they applied to their choice of executing and clearing brokers in the bi-lateral environment.”

Her own template for that CCP selection process emphasizes three principal factors - margin management, collateral holding and movement default management – as having the largest potential impact.