We thought a recent article “How to avoid massive escalation in swap clearing costs” by Dominic Hobson on COOConnect was interesting and worth a post. It is part of a broader theme we are seeing a lot about: banks are getting savvier about allocating capital and liquidity costs and passing those costs along.
From the article:
“…How does a fund manager make sure it matters to an investment bank? Before the crisis, the trick was to maximise the revenue generated through execution, stock borrowing, financing, clearing of futures, bi-lateral clearing of swaps. It helped to maximise the internalisation of transactions by parking entire portfolios in custody with the prime broker, and leaving ample excess collateral with the clearing arm of the same investment bank…What matters now is rather different: it is the proportion of the balance sheet eaten by the fund manager that counts. With the cost of capital to a bank running at, say, 12 per cent, an investment bank needs to make a return of at least 15 percent on risk- weighted capital to keep its shareholders engaged. An alarmingly high proportion of the business hedge fund managers transact with investment banks falls well short of that threshold…”
“…The terms of clearing agreements were generous to fund managers, chiefly because clearing brokers expected clearing to generate additional revenues from collateral transformation trades, foreign exchange and other ancillary business. Above all, clearing brokers were fearful of losing their exchange-traded and swap execution business if they did not add a swap clearing service to their repertoire…”
The author estimates that swaps clearing returns on the order of 1.5% and 3% to the banks. It may not be a loss maker, but it can’t be making management very happy. Netting was relied on to minimize balance sheet usage, but it isn’t as effective as it once was.
The business model was “one stop shopping” to capture P&L from execution. But that has changed as a result of mandatory central clearing.
“…mandatory clearing has encouraged fund managers to appoint multiple clearing brokers to cover the risk of a counterparty default. As a result, far from protecting their existing execution franchises, mandatory clearing has cost clearing brokers execution business, while forcing them to maintain a swap clearing capability…With electronic swap trading platforms already available to the buy-side in the United States, and scheduled to open for business in Europe in 2017, the execution business of fund managers is increasingly likely to bypass execution brokers and go direct…”
It has gotten expensive.
“…while clearing through a CCP is attractive to indirect members such as fund managers, Basel III imposes a triple capital burden on clearing brokers who intermediate their business with CCPs. They have to contribute to the default management fund; allocate capital to the exposure of their clients to the CCPs; and indemnify clients against any losses incurred from using a CCP…”
How much more?
“…For fund managers with swap portfolios, those fees will be non-trivial. One clearing broker told a Bloomberg webinar recently that he expected to increase his clearing fees eight-fold this year. Estimates of the possible increase in fees for clearing exchange-traded derivatives range even higher, at up to 20 times their current level. An eight-fold increase in clearing fees for a hedge fund with a large portfolio of interest rate swaps paying $4 million a year today is looking at up to $40 million…”
The article suggests that multi-lateral portfolio compression would soften the blow. It has been used by the sell side with tremendous success. But for the buy side to benefit, it has to be a portfolio with trades that will offset. Certainly investment managers with lots of in and out activity will see advantages, but for those who are predominately one-way, it has less promise.
We’ve been reading more and more that banks are getting a better handle on capital and liquidity costs and how to allocate them. This effort is broadly known as KVA, a parallel effort to CVA, FVA, etc. No institution does it the same way. This was always a highly political process. Who really wanted to know the answer since the result was going to mean pushing down costs and risk alienating their clients with higher charges? Being the first mover was thankless or worse. But that ship has sailed: it is going to become a lot more expensive to manage money. How much will these frictional costs hurt returns? It is hard to say, but it is not going to be pretty.