Searching for your clearing broker used to be much like strolling down a long stretch of restaurants in your favourite holiday destination. Everyone desperately wants you to come in and dine with them, meaning you weigh each option up carefully before gracing the most appealing with your business.
Those days are now over for many buy-side firms, thanks to a new set of regulations targeting the balance sheets of banks. The process has now become more like trying to gain membership to an exclusive and very selective club, and even once you have secured that coveted entry you may yet be kicked back out again in the near future.
Many of the largest brokers and futures commission merchants (FCMs) – as they are referred to in the US – are now cherry picking their clients in light of the stringent regulations they now face. It’s not a decision they are happily making, it is a result of new rules such as the leverage ratio and other ways global watchdogs are looking at reducing systemic risk in the banking system.
Even though these regulations target banks, the knock-on effect on the brokerage finance models has hit the buy-side. The leverage ratio reduces available balance sheet commitments for client business, making it hard for them to take on too much risk from clients.
This pressure has forced them to look more precisely at the fit of each buy-side firm’s risk profile and how it will impact their own balance sheet.
Every buy-side firm is different in this case, depending on its size and derivatives appetite, but with clearing mandates on the horizon, many are looking for a clearing broker, whether it be their first, second or third.
What you need to be looking for
So in light of these wholesale changes and the on-going window shopping, what do the buy-side need to look for in their provider when aiming to find the perfect match?
Well to begin with there are some essentials as ensuring there are robust systems in place, the right business commitment and of course the price they are charging. Considering the severity of new regulations there are also many questions around risk and collateral that the buy-side will have for their potential suitors.
Hannah Meakin, partner in the financial services team at Norton Rose Fulbright, says that the clearing brokers should also be able to explain clearly the choice of accounts and the different levels of risk involved.
“We are surprised by the number of asset managers who still don’t really understand this,” adds Meakin.
“Also they need flexibility and commitment regarding collateral and commitment, in that the clearing broker will not limit the types of collateral they will accept or the terms and haircuts on which they will accept it, at least not without sufficient notice. Some asset managers and funds may need the ability to post a wider range of assets or a service whereby the clearing broker can convert whatever assets they have into more liquid collateral.”
A handful of sell-side institutions – namely BNY Mellon, RBS and Nomura – have pulled away from offering client clearing, forcing their clients to begin their search again.
A trend of ‘unboarding’ has also sprung up whereby clients are being cut-off by their clearing providers. This has made it a concerning time for medium to small-sized asset managers either maintaining existing relationships or searching for new ones.
Commitment needed
“They [clients] need to know people will be there for them,” said Jamie Gavin, head of EMEA OTC clearing sales at Societe Generale. “We know some clients who were with RBS and then moved to BNY Mellon, it is terrible for them. They want to know if they are going to have to do this for a third time.
“People are now starting to get very nervous that some clients are getting unboarded and some are getting re-priced and they want to know that their clearing broker is going to be there for them.
“That is the whole point of clearing right? You are a safe harbour in a storm for them and if they have concerns that you are not going to be there for them then that is a worry.”
Gavin believes that with the amount of clearing brokers and FCMs pulling away from the space, the worst case for the buy-side is having to start onboarding with another new broker and going through the whole selection and due diligence process.
One large European asset manager – who preferred not to be named – said ‘unboarding clients is an issue for smaller asset managers’. The danger of unboarding and brokers pulling away from the space could affect all types of buy-side firms according to Gavin.
“It is not just smaller clients getting ‘unboraded’ out it is larger ones as well, which you wouldn’t expect,” he adds.
“We are seeing institutions who took a while to select their first clearing broker and go live, now looking to fill their second and third spots. Finally, we are seeing clients who have not chosen anybody yet.
“It is quite surprising because you would have thought it would be some of the less sophisticated clients, but we have seen quite a few large asset managers come forward recently and are only just kicking off their RFI rounds now. It is quite a mixture.”
The other concern surrounding the termination of the deal with a clearing broker is the notice period, according to Sebastian Reger, partner at law firm Sackers.
It will never happen to me
He agrees that the biggest risk is whether the brokers will continue with client clearing and says that for buy-side firms the termination period could be as short as a month.
“Clearing members reserve the right to essentially terminate the services on a relatively short notice,” says Reger.
“The other risk is that clearing members can reduce the credit line they give you. They reserve the freedom to cut credit lines and they may make you reduce existing transactions.
“From a buy-side risk point of view, that members can pull out of the business, or don’t like your credit profile or cut the transactions they can do for you is a big concern.”
Reger also highlighted that moving clearing broker isn’t always a straightforward process.
“If you move clearing brokers, we don’t tell our clients that they can definitely move 100% of their transactions across,” he adds.
Mandatory clearing is set to come into force towards the end of 2016, meaning the time for buy-side firms to act is now. Though some have begun clearing early, others are biding their time. The same goes for clearing broker selection. Many have one clearing broker in place, but that is often not enough, especially with the uncertainty surrounding the clearing space.
Decision time
At Norton Rose Fulbright, Meakin represents both buy-side firms and clearing brokers and says the agreements between the two should pick up now that there is certainty around the start date.
“Many haven’t started negotiating agreements yet but we hope they may start to do so more actively now that they can see the first clearing obligation coming into effect.”
Meakin adds that only the biggest asset managers have begun clearing at present and the others are still putting arrangements in place.
“Various reasons for this including a desire to get a feel for what different clearing brokers will accept, such as what terms will really become market standard, and the need to get so many different internal stakeholders engaged and to sign off.”
Stefan Schmidt, derivatives trader at Frankfurt-based asset manager Union Investment, explained that they looked for one local and one foreign broker among other requirements when making their decision.
“Our criteria was finding two experienced fixed-income-brokers with extraordinary skills in trading and clearing OTC derivatives, one local and one foreign,” he explained.
“Since our EMIR project began in 2013 we have started trading bilateral collateralised and of course we started trading interest rate swaps centrally cleared. Credit default swaps will follow in the next three months.”
Schmidt added that the decisions were not made in line with any pre-existing deals with their two clearing brokers, and that the firm wanted access to clearing houses LCH.Clearnet and Eurex Clearing.
“People are looking for regional experts,” says Steve Woodyatt, CEO of tech vendor ObjectTrading. “Where there is a regional specialism there is an advantage.”
Woodyatt added that the services the buy-side receive are changing. He believes that fees may not have fluctuated much in recent years, however the services the buy-side receive may be diminishing.
“Fees are not going down or up much, but value is being removed from the packages so people are getting less for their money,” he says. “Suddenly some of these sell-side firms don’t offer market data in the package, for example.”
The clock is ticking and as mandatory central clearing for the buy-side draws closer, firms will have to start securing their clearing broker relationships and that could mean a lot of research and tick boxes in order to find the perfect match.