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Picking Central Clearer No Easy Task

"Centralized clearing"-it's the phrase used to describe the requirement that financial firms clear their trades in standardized over-the-counter derivatives contracts through a clearinghouse that can guarantee completion of the transaction, rather than entering transactions directly with each other.

On the surface, it sounds like a great idea. After all, it is supposed to mitigate counterparty risk by shifting the burden of making sure each party can fulfill its financial end of the bargain. The centralized clearinghouse takes on the risks of being the counterparty in the middle to each side of the transaction. This is designed to eliminate the impact of one side going unexpectedly out of business, leaving the other party holding the bag.

It's an approach used in the equities, fixed income and futures markets.

But there is one additional operational risk, in credit default swap and other derivatives markets. The fund manager will not likely be able or want to fulfill the technological or capital requirements necessary to become a member of each clearinghouse. So it will need to select one or more clearing brokers to act as an intermediary.

The Dodd-Frank Wall Street Reform Act of 2010 requires that so-called standardized OTC contracts be cleared through clearinghouses. Still to be determined by the Commodity Futures Trading Commission, which was given greater authority to police the $600 trillion market, is whether parties can be excluded from the margin requirement as long as they keep their total credit exposure low.

"Most fund managers will not fall into the category of a dealer or major swap participant but they will remain subject to the provisions of centralized clearing. That is because they won't be considered exempt end-users," says Michael O'Brien, a partner in the Chicago office of Winston & Strawn.

"Clearinghouses will likely compete for business based on their margin requirements and product specialization while broker dealers will be competing to provide additional services to generate revenue beyond bid-offer spreads," says Rowan Douglas, chief executive of Quantifi, a Summit, N.J., derivatives modeling software firm. "Buy-side firms will have to decide the right mix of clearing broker and clearinghouses."

But there are far fewer clearinghouses to choose from than clearing brokers so the decision on which clearing broker to use will likely be a lot harder to make.

The CME Group will be competing with the InterContinental Exchange's ICE Trust clearinghouse in credit derivatives while also competing with LCH.Clearnet and the International Derivatives Clearing House in interest-rate products. Just last week, CME announced it had nabbed 10 large broker-dealers as founding members of its interest rate service, which brings together a host of buy-side firms including BlackRock, Citadel, Fannie Mae, Freddie Mac and PIMCO.

Surprisingly, the creditworthiness of the clearing broker isn't the most significant factor. That's because the collateral of the fund manager will at the very least be separated from the clearing broker's own assets. Or, in the case of a mutual fund registered under the Investment Company Act of 1940, it could end up being held at a custodian bank or the OTC derivatives clearinghouse.

"Fund managers should consider the clearing broker's cost and efficiencies to be gained from their overall business relationship with the broker dealer before looking at any product specialties," says Sean Owens, director of fixed income and derivatives for Woodbine Associates, a Stamford, Conn., capital markets research firm and author of a report released last month entitled: "OTC Derivatives Clearing in the U.S."

That cost reflects the additional margin which fund managers must use beyond what is required by the clearinghouse. "The fund manager will want a transparent view on the spread that the clearing broker charges over the clearinghouse's requirements," says Sanny Maki, a partner at Capco, a New York-based financial services consultancy.

Currently, counterparties processing OTC trades with each other negotiate their margin requirements but that's not the case in the new centralized approach.

The clearinghouse will be required to set both initial margin and variation margin requirements conservatively to the lowest common denominator and then the clearing broker will likely require an additional cushion to take into account its risk of the potential failure of the fund manager.

Add too much margin and the broker-dealer might be happy but the fund manager won't be. That could be an inefficient use of collateral.

The only way to make a meaningful cost comparison between broker-dealers is to evaluate the margin for a portfolio of trades using the respective clearinghouse models and then incorporate the additional cost incurred from the broker firm, according to Owens.

That's challenging. The fund manager would at the very least have to know the methodology-or formulas-each clearinghouse uses to come up with its margin requirements so they can replicate the answers, according to Quantifi's Douglas.