Risk Awards 2016
Wherever you looked in 2015, client clearing for over-the-counter derivatives appeared to be a business in retreat. Facing the added pressure of the leverage ratio, futures commission merchants (FCMs) pleaded for change, hiked costs for customers, offboarded unprofitable clients, or shut up shop altogether.
Citi was not immune to those pressures, but a brave change to the way it runs the business gave the bank and its clients some insulation.
"The business model that's been in place for futures and OTC clearing for the past two decades has to evolve," says Jerome Kemp, global head of futures, clearing and collateral at Citi in London. "We have seen tremendous changes in the cost structure of FCMs. The revenue streams that supported this business in the past will look very different in the future."
Traditionally, FCMs have relied on the interest earned on the cash initial margin posted by clients to supplement their clearing fees. Retained interest income was a cash cow for clearing firms, accounting for 20–30% of profits at some FCMs.
It also created some perverse incentives. FCMs slashed clearing fees to attract more clients and boost the amount of interest-earning cash initial margin on their books. Over time, interest earned on client cash – rather than clearing fees – became the main driver of profit growth for the industry.
The Basel III leverage ratio – and the US supplementary leverage ratio (SLR) – threw a spanner in the works. Cash margin posted by clients forms part of the FCM's leverage exposure and must be supported with equity capital.
We have seen the impact the leverage ratio has had on the clearing business. Some FCMs have dramatically increased fees, others have left the business
Jerome Kemp, Citi
The change has been hard on the industry. FCMs have hiked fees to cover the extra cost of holding cash margin on their balance sheets, while continuing to pocket the interest earned on those assets. Still, most are struggling to turn a profit. Some are offloading unprofitable clients, while others have exited the OTC clearing business entirely.
Citi's response is bolder. Its clearing business is relinquishing the interest earned on cash margin – passing it through to clients instead – in an effort to minimise balance sheet usage. The move has kept a lid on fees and freed up balance sheet capacity to take on more clients, or support initiatives such as the push to clear more single-name credit default swaps (CDSs).
"We have seen the impact the leverage ratio has had on the clearing business. Some FCMs have dramatically increased fees, others have left the business," says Kemp. "We're very focused on making this new reality work. As part of that process, we have reconsidered the revenue components that make for a healthy business in light of these new regulations – not just with respect to the bottom line, but also in terms of the return on assets (ROA) and return on equity that we need to generate as a business."
Leverage ratio or not, holding billions of dollars of cash margin on the balance sheet to earn a few basis points has always been inefficient from an ROA perspective, Kemp argues. "I'm able to earn 15–20bp by keeping client cash on the balance sheet and taking a haircut on the interest earned," he says. "That simply doesn't make sense when the industry's ROA hurdle is generally estimated to be in the 100bp range. There is just no way to earn a sufficient return on that cash to meet our return targets."
The firm began exploring ways to remove clients' cash margin from its balance sheet in early 2013, months before the clearing mandate for end-users in the US came into force. "Our thinking was that, since this cash is essentially client property and segregated from Citi's assets, it should – in theory – be possible to derecognise it from the balance sheet," says Christopher Perkins (pictured), global head of OTC clearing at Citi in New York.
Citi worked with its accountants, lawyers and regulators to put theory into practice. Ultimately, it was able to secure an opinion from its accountancy firm confirming that client cash posted for the sole purpose of margining exposures at a CCP was not part of the firm's assets and liabilities – paving the way to derecognise it from the balance sheet. Clients' cash margin was separated from the bank's estate to make it bankruptcy-remote and the firm began passing through interest income to clients.
To date, Citi has removed almost $4 billion of cash margin posted with its OTC clearing business in the US from its balance sheet. The group is working towards applying the same model in its US futures clearing unit in 2016, while cash margin posted with the bank's UK futures and OTC clearing businesses is also earmarked for asset derecognition.
This has made the economics of the OTC clearing business far more palatable. "Without this programme, it would be very difficult to meet our ROA target. With the programme, it's more manageable," says Perkins.
Kemp is more emphatic. "It's the difference between making the hurdle, or not," he says.
Losing retained interest income from the revenue line has forced Citi to think carefully about its pricing model. The firm introduced a capital utilisation charge in 2013 to supplement its per-ticket clearing fees, but clients say pricing has remained stable over the past year, with no notable fee hikes.
"We haven't had to pay more in fees. Our margin levels haven't gone up," says the head of derivatives operations at an asset management firm in London that uses Citi for OTC clearing.
"[Citi] has kept us informed about what they're doing to alleviate some of these regulatory pressures, and we've seen no impact on fees, which I'm taking as a good thing," adds an executive in the operations group of a large hedge fund in New York.
Of course, any FCM will be able to protect favoured clients from fee hikes, should it want to. Perhaps more importantly, margin deconsolidation has created more balance sheet capacity to take on new business and expand the range of cleared products available to clients.
For instance, the number of clients clearing single-name CDSs with Citi jumped last year – the firm cleared more than a thousand such trades in 2015, compared with a handful in 2014.
Kemp expects that trend to continue in 2016. "Because of capital pressures, and with the non-cleared margin rules taking effect in September 2016, we believe the market will quickly move to a cleared model for single-name CDSs," he says.
On December 16, a group of 24 large US buy-side firms – including big asset managers such as BlackRock and Pimco and hedge funds like AQR, BlueMountain and Citadel – pledged to begin voluntarily clearing their single-name CDSs in the absence of a regulatory mandate.
Bank trading desks have hinted cleared CDSs will receive preferential pricing when the non-cleared margin rules come into force in September 2016.
If you don't have your balance sheet under control, and that becomes a constraint, you can't put more trades through the pipe
Christopher Perkins, Citi
But the question most end-users are asking is whether FCMs will be willing to clear single-name CDSs, and if so, at what price?
Credit derivatives attract punitive leverage ratio conversion factors – 5% for investment grade and 10% for high yield – that make them capital-intensive to clear. Some end-users claim clearing fees for credit derivatives have increased as much as sixfold since FCMs started factoring these capital costs into their pricing models. For some, clearing single-name CDSs is a luxury they cannot afford.
However, Kemp says Citi is able to offer single-name CDS clearing in a way that makes sense for clients, and still meet the firm's return targets.
"We have done a lot of work to prepare for this," says Kemp. "We're highly efficient in compressing notionals; we've optimised our balance sheet; we've built scalable pipes and processes; and we've built a very efficient portfolio margin model for CDS clearing. We're well positioned to make this work," he says.
Citi is also eager to bring other new products – such as buy-side repo trades, inflation swaps and swaptions – into clearing.
Perkins says these initiatives are only possible because the firm has optimised its balance sheet. "If you don't have your balance sheet under control, and that becomes a constraint, you can't put more trades through the pipe, which hurts your profitability and growth prospects. It's a downward spiral," he says.
But for all its benefits, Citi's balance sheet optimisation initiative is not without controversy. The initial concern was that regulators would see margin deconsolidation as a dodge and clamp down on the practice. Those fears have receded following a series of encouraging public statements from both prudential and markets regulators.
Loose ends remain, however. In October, the Commodity Futures Trading Commission asked FCMs to answer a series of questions relating to the impact of margin deconsolidation on client asset protection. Citi, along with a number of others, is working with a law firm to draft a response. Perkins and Kemp decline to say more for fear of jeopardising the discussions.
The American Institute of Certified Public Accountants also wants to establish some common ground on the balance sheet treatment of cash margin. Citi is working with its accountants to assist with that process.
As the dust settles, some other FCMs are following Citi's lead in deconsolidating cash margin. UBS is known to have done so, while several sources say Credit Suisse has also taken the plunge. Others, including Bank of America and JP Morgan, are said to have decided against it – at least for the time being.
Some FCMs may be hedging their bets on margin deconsolidation pending final changes to the leverage ratio. Politicians and lobbyists are continuing to push for a change to the treatment of received margin in the ratio, and prudential regulators have said the rule is under review.
In the coming weeks, the Basel Committee on Banking Supervision is also expected to consult on switching the leverage exposure calculation for OTC derivatives from the decades-old current exposure method to the standardised approach to counterparty credit risk (SA-CCR). The latter is expected to be broadly beneficial for OTC clearing, although it can also result in higher leverage exposures for certain positions, including some CDSs.
Some believe a shift to SA-CCR could obviate the need for margin deconsolidation. Kemp cautions against expecting too much. "Unfortunately, there are very few eureka moments when it comes to capital," he says. "The devil is in the detail."
Citi's clearing team is already poring over those details. "The formula is a bit complex. We're still working through how much of an offset we would realise if SA-CCR were to be admitted for the SLR for cleared derivatives," says Kemp. "100% of client collateral derecognition will not be achieved under SA-CCR."