Cost of Trading and Clearing OTC Derivatives in the Wake of Margining and Other New RegulationsRecent regulations are affecting the OTC derivatives markets in complex, interrelated manners that change the way firms do business.

Executive SummaryOver-the-counter (OTC) derivatives markets continue to be impacted by regulatory changes. These changes are affecting the way financial institutions do business in multiple, interrelated ways. Rising capital requirements are impacting profitability and return on equity. Market partici-pants are now being forced to clear standard OTC trades through central counterparties (CCPs)

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and will soon face margin requirements for the remaining, nonstandard, uncleared derivatives (MRUDs). This is prompting firms to better assess and manage costs (funding, collateral, capital) in a consistent fashion at a trade, desk and business unit level. The question is how much of these costs can be passed on to clients.

These changes are not just impacting sell-side firms. Central clearing and MRUDs are also impacting buy-side firms on several dimensions: funding, risk management and, naturally, valuation and operations. This paper aims to better understand:

• The various current and future regulatory ini-tiatives – transactional and prudential.

• The actual margin valuation adjustment (MVA) and its mathematical determination through initial and variation margin adjustments, with numerical examples enriched with capital, liquidity and leverage impacts.

• The resulting market evolution from the standpoint of pricing and volumes as well as the potential outcomes for market participants.

Regulatory LandscapeFollowing the 2008 financial crisis, the banking sector witnessed a plethora of regulatory changes. While these regulatory prescriptions cover every dimension of the banking world, the OTC derivatives (OTCDs) market has borne the brunt due to the derivatives’ opaque and complex nature. While some regulations such as the Dodd-Frank Act,

2 EMIR

3 and BCBS/IOSCO

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MRUD are directly targeted at OTCDs, several others, especially the leverage ratio, also have far-reaching implications for the OTCD market. Figure 1 (next page) presents a timeline of major regulations impacting the OTCD market.

All these changes are leading to structural altera-tions in the OTCD markets, consequently placing

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significant cost pressure on OTCD trading and clearing activities. This section provides an overview of the various recent regulatory devel-

opments that dictate the cost and profitability of OTCDs (see Figure 2).

Regulatory Timeline for OTCD players

Figure 1

2011 2012 2013 2015 2016 2017 2018 2019

Final frameworkpublished

Timelines extended

Margin (IM/VM) Requirements for Non-Centrally-Cleared OTCDs: BCBS/IOSCO

Final framework applies from 1st Jan 2017 Final

frameworkpublished

Capital Requirements for Bank Exposures to CCPs – BCBS / IOSCO and SA-CCR

Final LCR rules issued

Basel III liquidity requirements – LCR & NSFR

Phase-in for LCR starts from 1st Jan 2015 till 1st Jan 2019. NSFR from 1st Jan 2018.

Final NSFRrules issued

Basel III Leverage Ratio and U.S. SLR /eSLR

Basel leveragerules issued SLR/eSLR to be complied from 1st Jan 2015

Final SLR/eSLRrules issued

Public disclosureof Basel leverage

Mandatory central clearing of standardized OTCDs

U.S. (Dodd Frank) – Cat 1: 11th Mar 2013, Cat 2: 10th Jun 2013 and Cat 3: 9th Sep 2013. EU (ESMA) – Cat 1 starts from Q3 2015.

Basel III (CVA) Implementation Revised Basel III (CVA) rules issued

Phase-in starts from 1st Sep 2016 till 1st Sep 2020

2014

Risk Components of Cost of Trading OTCDs

Figure 2

High impact

EMIR (EU) & Dodd-Frank Act (US)central clearing obligation

BCBS / IOSCO margin requirements

Uncleared Trades(MARGINED )

Uncleared Trades(UNMARGINED)

Cleared Trades

Initial Margin (IM)

• Daily, Unilateral • CCP Collateral Eligibility

• N/A • Daily, Bilateral, Segregated • Supervisory Collat. Eligibility

No or low impact Medium impact Very high impact

EMIR (EU) & Dodd-Frank Act (US) central clearing obligation

BCBS / IOSCO margin requirements

Variation Margin (VM)

• Daily, Unilateral • Mostly Cash

• Weekly (Market Practice) • Daily, Bilateral • Supervisory Collat. Eligibility

BCBS (incl. Basel III)

BCBS leverage ratio (Basel III) and U.S. SLR/eSLR

bank exposures to CCPs & ctptys

BCBS (Basel III) CVA Capital Framework

Capital (Risk-Based)

• 2% Risk Weighted Assets • No CVA

• Basel III RWA • CVA Capital Charge

• Basel III RWA • Reduced CVA

• 3% SLR + 2% (eSLR ) • 3% SLR + 2% (eSLR ) • 3% SLR + 2% (eSLR )

Capital (Leverage)

BCBS (Basel III) global liquidity standards

• LCR & NSFR

• High Quality Liquid Assets

• LCR & NSFR • High Quality Liquid Assets

• LCR & NSFR • High Quality Liquid Assets

Liquidity

‘Close-out risk’Covers the potential future

exposure to the counterparty thatbuilds up post default till close out.

‘Position risk’Covers the current exposure to the

counterparty based on the mark-to-market P&L.

‘Bankruptcy risk’Basel III standards strengthenedthe global capital framework by

enhancing the risk coverage

Model risk’Basel III (non-risk based) leverageratio supplements the risk-based

capital ratio

‘Solvency risk’Two metrics for funding liquidity –

LCR (short term, 30-day) and NSFR (longer term, 1 year)

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With an objective to incentivize central clearing and make the

residual non-cleared OTCD markets more resilient, global regulators

have issued margin requirements for uncleared derivatives (MRUDs).

Mandatory Central Clearing of Standardized OTCDs

The EMIR in the EU region and the Dodd-Frank Act for the U.S. are the major regulations covering the central clearing obligation. The implementation of mandatory central clearing for standardized OTCDs requires market participants to adhere to the CCPs’ stringent requirements including initial and variation margins (IMs and VMs). Margins, in particular IMs, which are not prevalent in bilateral deals, lead to significant funding cost for collateral. Other costs such as contributions to the default and guarantee funds of CCPs also add to the cost burden. From a broker-dealer’s self-clearing portfolio perspective, there are certain benefits accrued in terms of obviation of credit valuation adjustment (CVA) and multilateral netting.

Margin Requirements for Non-Centrally-Cleared OTCDs

Even after the full implementation of clearing mandates, there would be a portion of OTCDs that remain non-clearable (non-standardized or standard but transacted by parties not covered by regulation or in currencies that cannot be cleared). With an objective to incentivize central clearing and make the residual non-cleared OTCD markets more resilient, global regulators have issued margin requirements for uncleared deriva-tives (MRUDs). Starting September 2016,

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non-centrally-cleared OTCD transactions, large banks will be required to exchange daily IMs and VMs with counterparties. The IM requirements are particularly onerous since it is stipulated to be a gross two-way exchange with segregation requirements. The collateral eligibility conditions (for both IMs and VMs) are quite stringent and will strain firms’ liquidity. From a cost perspective, the margin requirements reduce the CVA capital charge associated with the trades but increase funding cost, represented by the margin valuation adjustment (MVA).

Prudential Regulations

Bank Exposures to CCPs

The final policy framework for the treatment of

exposures to CCPs was released in April 20146 by

BCBS in consultation with CPMI7 and IOSCO, and

will come into force from January 2017. Notably, a new 2% risk weight is applicable to the eligible clearing members for exposures to qualifying CCPs; BASEL III capital standards apply for the transactions facing clients.

8 The most prominent

regulation addressing CCP resilience was adopted by CPMI and IOSCO in April 2012 in the form of Principles for Financial Market Infrastructures (PFMIs),

9 the ‘level 3’ assessment of the imple-

mentation of which started in July 2015.10

The “skin in the game” requirements (for example, in the EU CCPs are required to contribute 25% of regulatory capital to the default waterfall) and other aspects of these regulations place sig-nificant cost pressure on CCPs which will trickle down to the clearing members and ultimately to the clients and end users.

Basel III Standards

Basel III reforms are a comprehensive set of regulatory measures from BCBS to improve banks’ resilience and strengthen their risk management and governance. They affect different aspects of banks’ balance sheet management – capital, liquidity and leverage.

• The risk coverage of capital standards was enhanced in the relation to counterparty credit risk – stressed inputs, CVA, wrong way risk (WWR), etc. CVA requirements have been of prime importance to the OTCD markets as CVA is an adjustment to the fair value (or price) of derivative instruments.

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Basel III, CVA capital charge corresponds to the capitalized risk of the future changes in CVA. CVA capital charge adds significantly to the cost of trading non-collateralized OTCDs. BCBS recently issued a consultation paper inviting comments by October 1, 2015, on proposed revisions to the CVA framework in order to better capture exposure risk and align with other regulatory and accounting practices.

• The liquidity framework was strengthened by the introduction of two ratios – liquidity coverage ratio (LCR) to promote short-term resilience and net stable funding ratio (NSFR) to address longer-term funding risk. These have increased funding costs for high quality liquid assets and accentuated the incorpora-tion of funding valuation adjustment (FVA) into the cost of trading.

• The leverage ratio requirements, especially the U.S. versions – supplementary leverage ratio

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(SLR) of 3% and the enhanced SLR (eSLR) of an additional 2% (or 3%) – pose an additional (tier 1) capital burden by including OTCD and other off-balance-sheet exposures. The inclusion of client-facing legs of cleared OTCDs and the prevention of offsetting by segregated collateral posted contribute to the total cost of trading. Being more risk-sensitive, the potential adoption of the new standardized approach for counterparty credit risk (SA-CCR) could mitigate this burden to some extent.

Finally, the uneven progress of cross-border regulatory implementation has exacerbated OTCD players’ woes. Some notable examples include uneven product coverage and availability of CCPs across various jurisdictions around the world;12 fragmentation of the liquidity pools as can be seen in the euro IRS inter-dealer market where the share of exclusive European dealers in the market has risen from an average of 73.4% in the third quarter of 2013 to 94.3% between July and October of 2014, coinciding with the introduction of U.S. swap execution facility rules in October 2013;13 margin period of risk (MPOR) of two-day net for EU CCPs versus one-day gross for U.S. CCPs; threshold differences in MRUD between the U.S. and EU, etc.

Cost of Trading OTC DerivativesMVA and Cost of Funding for Centrally-Cleared OTCDs

Margin Valuation Adjustment (MVA)

To evaluate the total cost of clearing, it is important to estimate MVA – the total cost of funding IM and VM – for the life of a portfolio of trades with a CCP. The concept is similar to the funding valuation adjustment (FVA) whose two components are the cost (funding cost adjustment, or FCA) and benefit (funding benefit adjustment, or FBA) of funding hedging strategies for non-centrally-cleared trades. MVA will also become an integral part of the funding costs for non-centrally-cleared OTCD trades when recent regulations compel the counterparties to start posting IMs.

Similar to FVA for uncollateralized trades, MVA is the sum of cost and benefit adjustments arising out of funding the margins. The following

constitute the components of MVA:

• Initial margin cost adjustment (IMCA): Total cost of funding initial margins.

• Variation margin cost adjustment (VMCA): Total cost of funding variation margins.

• Variation margin benefit adjustment (VMBA): Total benefit from the variation margins posted by the counterparty.

The total MVA, which is a cost to the bank, can accordingly be defined as:

MVA = IMCA + VMCA – VMBA

IMCA: Cost of Funding the IMs

IM is a capital charge calculated by the CCP daily and is based on the whole netting set of the client’s trades with the CCP. So, in principle a new trade could decrease the margin required to be posted. It protects the CCP against the closeout risk of a client portfolio. It was recommended by regulators that IM be evaluated as a VaR of the portfolio (e.g., with 99% confidence and a 10-day horizon). Usually it is calculated as a historical VaR based on the shifts of underlying market factors.

IMCA can be defined as the expected discounted cost of funding future initial margins, IM(t). Similar to FCA, the cost portion of FVA, IMCA is propor-tional to an institution’s “borrowing” spread S

B

which means that the institution borrows funds at risk free rate + S

B. The cost is calculated over

the life of the transaction or until either the CCP or the institution defaults, whichever occurs first.

Assuming that there is no wrong-way risk, that the CCP can’t default and that borrowing spread is non-stochastic, the expression for IMCA is:

IMCA = –T

0S

B(t) · EIM(t) · q

I(t) · p(t) · dt

VMCA = —T

0S

B(t) · NEE(t) · q

I(t) · p(t) · dt

VMBA = T

0S

L(t) · EE(t) · q

I(t) · p(t) · dt

Where EIM(t) is expected future initial margin, p(t) is expected discount, and q

I(t) is an institution’s

survival probability.

The biggest challenge in evaluating IMCA is calculating the expected future initial margin – EIM(t). Since current-day IM is calculated based on historical shifts including the most recent data, IM(t) will be based on market future shifts up to time t. Brute-force Monte Carlo simulations, which can incorporate historical data path-wise, could be used for this but it will be extremely slow since the portfolio has to be reevaluated at each time point on each path – around 1,300 times for a five-year look-back period.

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The uneven progress of cross-border regulatory

implementation has exacerbated OTCD players’ woes.

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The following simplifications could be considered:

• Assume that the EIM profile and borrowing spread are constant in time:

IMCA = SB * IM * RiskyDuration

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• Assume that EIM reduces linearly to 0 at portfolio maturity T, i.e. EIM(t) = IM * (1-t/T). Then a good approximation is:

IMC = SB * IM * RiskyDuration

I / 2

• Evaluate EIM(t) by shortening maturities of all trades by t. After maturities are shortened, one can use the same historical shifts and recalculate IM.

• Evaluate EIM(t) by setting the pricing date at time t and applying some scenarios for future curves. Then one can apply current-day historical shifts and recalculate IM. To gain more efficiency, one can calculate delta and gamma values (with pricing date set at t) and apply them to the current day’s historical shifts. Note that this methodology is consistent with market practices and with the ISDA SIMM proposal of using deltas for calculating initial margins on non-cleared trades.

Once EIM(t) is evaluated, it can substitute expected positive exposure EE(t) in the FCA calculator, to get the total cost of funding initial margins.

VMCA and VMBA: Cost and Benefit of Funding Variation Margins

Variation margin (VM) reflects a change in P&L of a client’s netting set with the CCP. VMs can be positive or negative and can be significant, depending on market movements. As is the case with IMCA, evaluation of VMCA and VMBA constitute an important aspect of the cost of OTCD trading. Cost arises when mark-to-market value is negative for the institution, as it would be required to post VMs to CCP. The institution will have to borrow money at risk free rate + S

B, and

borrowing spread SB

constitutes the cost for the institution. Similarly, benefit arises when mark-to-market is positive as VM posted to the institu-tion generates cash at lending spread, S

L, which

can be different from the borrowing spread.

To estimate VMCA and VMBA, computations similar to FVA could be used. In fact, while FCA (FBA) is a cost (benefit) of funding the hedge trade, VMCA (VMBA) will be a cost (benefit) of funding the original trade itself. Thus, VMCA (VMBA) is proportional to negative (positive) exposure. Another difference with FVA is that

netting in the case of VMCA/VMBA should be done on the portfolio of trades with each CCP. But all other computational aspects of FVA such as own default risk and WWR should be taken into account for VMCA/VMBA as well.

Under the same simplifying assumptions as above, we get for VMCA:

IMCA = –T

0S

B(t) · EIM(t) · q

I(t) · p(t) · dt

VMCA = —T

0S

B(t) · NEE(t) · q

I(t) · p(t) · dt

VMBA = T

0S

L(t) · EE(t) · q

I(t) · p(t) · dt

where NEE(t) is the expected negative exposure (assumed to be positive). And for VMBA,

IMCA = –T

0S

B(t) · EIM(t) · q

I(t) · p(t) · dt

VMCA = —T

0S

B(t) · NEE(t) · q

I(t) · p(t) · dt

VMBA = T

0S

L(t) · EE(t) · q

I(t) · p(t) · dt

where EE(t) is the expected positive exposure.

Unlike EIM(t) in the case of IMCA, NEE(t) and EE(t) are much easier to calculate, and are in fact already part of CVA, DVA and FVA evaluations.

Total Funding Cost of Clearing

To evaluate the total cost of clearing for banks, MVA, as calculated above, needs to be added to the cost of the 2% contribution to risk weighted assets (RWA). One has to be able to calculate it on an incremental basis for each new trade with the netting based on the current portfolio with the CCP. Recently implemented by U.S. regulators, the supplemental leverage ratio (SLR) increases capital cost for clearing dealers due to the inclusion of the exposure of trades they clear for clients. Some dealers pass on this cost to clients

as an extra fee proportional to the initial margin. While the contribution of this fee to total funding cost of clearing might not be that significant for a single trade, for a large portfolio it can add up to a substantial amount. Finally, the liquidity ratios introduced as part of the Basel III regulations – LCR and NSFR – add to the funding costs of the trades as they necessitate the funding of high quality liquid assets (LCR) and stable sources of capital-like funding.

Recently implemented by U.S. regulators, the supplemental leverage ratio (SLR) increases capital cost for clearing dealers due to the inclusion of the exposure of trades they clear for clients.

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Profitability Analysis for Centrally Cleared and Bilateral IR Swaps

Profitability Analysis for IR Swaps

To analyze the contribution of each cost component for centrally cleared as well as bilateral trades, we ran tests for three USD IR receive-fixed swaps, all with 10-year maturity. The following scenarios were considered:

• ATM swap coupon C = 2.7%, rates flat 2.7% (current coupon, current curve).

• ITM swap coupon C = 4.5%, rates flat 2.7% (legacy coupon, current curve).

• OTM swap coupon C = 2.7%, rates flat 4.5% (current coupon, increasing rates).

While the ATM scenario reflects costs for new trades and future rates close to the current level, ITM can be thought of as a legacy trade, and OTM is a current trade with rates increasing to the pre-crisis level. To investigate the effect of volatility, we ran two volatility scenarios: flat market vols 25% and flat stressed vols 50%. To better compare the results, each cost was converted into a positive par rate adjustment. For this conversion the following were used – DV01 of 8.74 (rates 2.7%) and DV01 of 8.03 (rates 4.5%). For calculating default probabilities, counterpar-ty credit spread of 200 bps, own spread of 100 bps, and recoveries of 40% were assumed along with the assumption that the CCP can’t default. For funding costs, FVA and MVA, a borrowing spread S

B of 1% and lending spread S

Lof 0 (i.e.,

there are no funding benefits) were assumed.

Cost of Centrally Cleared Trades

For clearing costs, MVA and a 2% RWA contribu-tion costs were calculated.

For IMCA, IM was first computed as a 10-day 99% Monte Carlo simulated VaR. Then an assumption that EIM(t) reduces linearly to 0 at portfolio maturity T was considered, leading to:

IMCA = IM * SB * T/2, where T=10 and S

B=1%

KVA and Cost of Bilateral Trades

For bilateral costs, calculated XVAs comprise BCVA (bilateral CVA, i.e., CVA-DVA, consider non-nega-tive), FVA and cost of regulatory capital (KVA).

KVA reflects the total cost of funding capital requirements defined by RWA (Basel II) and CVA VaR (Basel III). In general, it also includes capital costs for funding market risk capital charges, but in our calculations we assumed that trades are hedged and market risk is negligible.

Calculating KVA would seem similar to FCA, but there is no uniformity in the market as to which capital funding spread S

KVA is to be applied. Most

market participants cite KVA as the biggest source of pricing disparity. While standard accounting practice is to multiply the capital requirement by the return on equity, the same borrowing spread S

B could be used in order to

have consistency with FCA calculations.

As with EIM(t), it is a highly challenging task to estimate expected capital requirements at various times in the future, but one can approximate it using simplifications described in a section on IMCA.

For calculating RWA, the internal models method (IMM) was used, and CVA was subtracted from exposure at default (EAD) as recommended under Basel III regulations. Then the capital requirement was calculated as 8% of the RWA. Cost of RWA capital, KVA

RWA, was calculated at

capital funding spread SKVA

which was assumed to be 10%, using the following formula:

KVARWA = 8% * RWA * SKVA

* T / 2, where T=10 and S

KVA=10%

For evaluating KVACVA

we calculated CVA_VaR using a standardized-IMM formula assuming a counterparty rating of BBB and weight 1% and then applying the following formula:

KVACVA = CVA_VaR * SKVA

* T / 2, where T=10 and S

KVA=10%

Note that CVA VaR calculations were revised in the consultative document, Review of the Credit Valuation Adjustment Risk Framework, published by BCBS in July 2015. This document proposes replacing current standardized and advanced approaches with new methodologies that are more aligned with those set down under the Basel Fundamental Review of the Trading Book (FRTB) framework and also with accounting practices of evaluating CVA.

Costs for Bilateral Trades with Margining

As mentioned in the previous section, starting September 1, 2016, banks and large nonfinan-cial institutions will have to post to each other both IMs and VMs on non-centrally-cleared OTCD trades as well. This will lead to the reduction of counterparty risk and hence converging of funding costs for non-centrally-cleared and cen-trally-cleared trades. It is expected that there will be almost no BCVA, FVA and KVA

CVA. Instead,

even the non-centrally-cleared OTCD trade costs will include MVA.

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While VMCA and VMBA are the same as for cleared trades, IMCA will be different due to the evolving standardized initial margin methods. ISDA published a proposal for the standard initial margin model (SIMM) in December 2013 and a revised draft in June 2015.

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We used the SIMM model, which is based on weighted risk factor sensitivities, to estimate initial margin and then applied the same formula for IMCA as for cleared trades.

SLR and NSFR/LCR Funding Costs

In addition to all the valuation adjustments described above, we also calculated funding costs arising from leverage (SLR/eSLR) and liquidity ratios (LCR and NSFR).

SLR cost is computed by applying the capital funding spread of 10% over the increase in the Tier-1 capital requirement which is determined from potential future exposure (PFE, computed through the current exposure method), replace-ment costs and IMs posted in the case of cleared

trades and margined uncleared trades. For unmargined trades, the IM component is ignored.

The LCR cost is derived by applying the funding spread of 1% over the net cash outflows determined from the contractual cash flows and IM/VM exchanges. The IM exchanges were ignored for the unmargined trades. The NSFR cost considers the derivative receivable amounts net of payables (if receivables are greater than payables) on top of the IM and default fund contributions. A required stable funding (RSF) factor of 85% is applied to IM and default fund contributions in line with the BCBS guidelines. The default fund contribution factor is ignored for margined and unmargined uncleared trades. IM is additionally ignored for the latter.

The following section outlines the results with notable observations.

Comparison

1. Across all types of trading, ITM costs are much higher than OTM and ATM costs, reflecting the

Costs for Cleared OTCD Trades in B.P. Adjustments to Par Spread

Figure 3

ATM IMCA VMCA 2% RWA SLR NSFR/LCR Total

Vol 25% 1.6 2.1 0.5 3.8 4.2 12.1

Vol 50% 3.0 4.1 1.1 7.1 7.0 22.3

ITM

Vol 25% 1.4 0.5 5.5 53.2 8.0 68.6

Vol 50% 2.8 2.3 5.5 51.7 10.6 72.9

OTM

Vol 25% 2.8 8.8 0.0 2.2 8.1 22.0

Vol 50% 5.5 10.5 0.2 3.7 13.3 33.1

Costs for Non-Centrally-Cleared OTCD Trades, in B.P. Adjustments to Par Spread

Figure 4

ATM BCVA FVA KVA-RWA KVA-CVA SLRNSFR/

LCR Total

Vol 25% 1.8 1.9 4.6 10.5 3.2 1.0 23.0

Vol 50% 3.6 3.6 9.2 20.9 5.7 1.0 44.0

ITM

Vol 25% 16.0 8.3 47.8 105.3 52.6 5.2 235.1

Vol 50% 17.5 9.9 48.0 106.2 50.4 5.2 237.1

OTM

Vol 25% 0.0 0.4 0.0 0.1 0.9 2.3 3.7

Vol 50% 0.0 2.0 1.1 3.2 0.9 2.3 9.5

Results

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higher market value of legacy trades when rates were higher; OTM and ATM in most cases are comparable.

2. For ATM trade, doubling vols in general leads to doubling of all costs except for non-cleared margined case where SIMM-based IMCA and NSFR/LCR are volatility independent.

3. Since regulatory-based capital adjustments – KVA, SLR – are calculated at a 10% funding spread rather than at 1% as other funding costs, they dominate costs across all types of trading.

4. For ATM and ITM trades, clearing trades centrally would be the most profitable. For bilateral trades, the new margining regime will provide capital relief. For OTM trades, the absence of margining obviously impacts the IMCA and also brings additional transparency and the controversial NSFR impact. Finally, for ITM trades, we can see the large CVA capital

charge impact when there is no IM.

Market EvolutionRepricing

As previously seen, many pricing components have recently been added to the clearing costs equation: MVA, FVA, RWA, leverage including U.S. Enhanced SLR, and Federal Reserve extra-charge for global systematically important banks (G-SIBs). However, very few market participants are ready to fully transfer these costs to clients:

• The lower-than-expected and declining volumes (see Figure 7, next page) imply that efforts to

retain market share continue to be a priority.

• Lack of consistency on the offer side: Which components should be considered and at what level to maintain my client base and yet cover the risks?

• Changing market conditions not being applied consistently on the offer side creates uncer-tainty on the client side: Why not always go to the best price?

Some key market participants – ISDA, JPMC – have highlighted the “abnormal” costs and suggested adjustments:

• ISDA in December 2014, in response to the report on clearing incentives from the OTC Derivatives Assessment Team (DAT) of the Basel Committee, expressed the concern that certain aspects of the leverage ratio potential-ly render clearing prohibitively expensive for certain types of clients, thereby creating disin-centives for banks acting as clearing members.

• JPMC during its Investor Day late February 2015, pointed to the potential exit of key OTC clearers that are G-SIB or SLR constrained.

• One key logical regulatory evolution is the use of the SA-CCR

15 that allows firms to offset the

client exposure with their segregated, non-re-hypothecable collateral, versus the current CEM which does not.

Overall, the market is still unclear. However, a slow but significant repricing seems inevitable.

• Only one major player is said to have applied a four-fold increase to its prices, but not for all the clients.

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• The phase-in of IM/VM requirements for bilateral trades from 2016 (MRUD) should also bring some balance and increased volumes to the cleared world.

Costs for Non-Centrally-Cleared OTCD Trades with Margining

Figure 5

ATM IMCA VMCA KVA-RWA SLR NSFR/LCR Total

Vol 25% 2.3 2.1 4.6 5.0 5.5 19.4

Vol 50% 2.3 4.1 9.2 7.5 5.5 28.5

ITM

Vol 25% 2.4 0.5 47.8 54.7 9.9 115.3

Vol 50% 2.4 2.3 48.0 52.5 9.9 115.1

OTM

Vol 25% 2.1 8.8 0.0 2.7 6.1 19.7

Vol 50% 2.1 10.5 1.1 2.7 6.1 22.5

Summary Table

Figure 6

OTC type ATM ITM OTM

cleared 12.1 68.6 22.0

non-cleared 23.0 235.1 3.7

non-cleared margined 19.4 115.3 19.7

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• This is evidenced in Figure 6 (previous page) for new ATM trades with no incentive to clear and obviously less operational complexity. Hence, the research by many buy-side firms to stay under the radar of regulatory thresholds.

Exchange-Traded Derivatives (ETD):

• Owing to recent OTCD reforms, which are still ongoing for large parts in Europe and for bilateral trades globally, little attention has been given to the changing ETD environment.

• The growth of swap futures, which can be more attractive than OTCDs by virtue of their shorter close-out period (two days versus five days), has been one of the most visible events.

• However, the introduction of capital require-ments for clearing brokers, regardless of the nature of the trade (ETD or OTCD), has been a key negative event for ETD clearing, as margins are narrow with little room for integrating an additional risk buffer.

• Among other factors, the above have acceler-ated the “merger” of ETD and OTCD clearing businesses at major providers.

Market Evidence

• Decreasing volumes and stable cleared-to-uncleared ratio:

> As experienced by market participants and evidenced in Figure 7, OTCD volumes have decreased approximately 26% between January 2014 and August 2015.

> The cleared-to-uncleared volumes ratio is stable at around 60%, albeit far from the initial target of 75% to 80%, which proves the lack of regulatory incentives to clear centrally. Again, a significant evolution would materialize only after the start of the MRUD, which was recently postponed to September 2016.

• Client collateral requirements: OTCD increase and ETD stabilization.

> While client collateral requirements can vary for many reasons, including market volatility in CCP risk models, the client collateral for OTCDs have more than doubled in 20 months, despite the volume decrease (see Figure 8, next page). This confirms an ongoing repricing in parallel with significant market shares’ developments between the main futures commission merchants (FCMs).

> Meanwhile, client collateral for ETDs has only increased a little over 3% to $165 billion in August 2015, compared with $160 billion in January 2014. This highlights that there is minimal room for price improvement in a very mature market with stable market shares.

Resulting Revenue Models, Market Structure

• Business strategies – from market share acquisi-tion to profitability:

> In line with any new market, the capital-inten-sive OTCD clearing business has experienced a classical initial hunting phase, but with

Gross Notional Outstanding: IR OTCDs (in Billions of U.S. Dollars)

Source: CFTCFigure 7

Jan-14 Aug-15

0

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

Cleared Uncleared Total

v 24%

v 29%

v 26%

206,744

156,116 136,572

97,337

343,316

253,453

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some key differentiation between two groups of market participants:

» Large broker dealers entered the market to first protect their trading market shares and discounted the prices for clients that traded and cleared at the same shop.

» Securities services firms were also trying to capture market share as they were betting on their collateral management services to offset some of the costs.

> Unfortunately, the lack of volumes growth combined with increased regulatory costs have seriously hurt the initial business plans.

» Several key names have already left the market or significantly reduced their service offering – e.g., BNY Mellon, State Street, RBS, Nomura, who all had less than 1% market share in 2014.

» For other participants, it is an endurance race with limited complementary strategic options: internal and external consolida-tion, price increase and hope for some regulatory adjustments.

• Clients’ reactions and adaptation:

> One could obviously argue that clients would:

» Reduce their derivatives’ usage: this is currently the case but will remain limited given hedging requirements.

» Flight-to-cheapest FCMs: This will be temporary, as regulatory costs will need to be embedded by all FCMs sooner or later. Additionally, the largest FCMs will pose concentration risks that need to be factored in.

> The MRUD implementation will eventually force clients out of the bilateral world and into the cleared world. This will, however, take time.

• Alleviation tactics:

> Ever since the announcement of various rules, banks and other market participants have been trying to persuade regulatory authorities to attenuate the impact.

» For example, industry groups have been lobbying for a change in the treatment of client collateral in the leverage ration computation (to permit margin offset).

> In the meantime, several players are devising other ways to circumvent the problem:

» De-recognition of client margins on the balance sheets. However, this would mean legal isolation and passing on the interest earnings to clients.

» Treatment of variation margin as settlement – as opposed to collateral. This could potentially lead to signifi-cant reduction in the leverage and risk-weighted capital due to reduced effective maturity (to the settlement date) and thereby PFE. In fact, major CCPs have already sought approvals for the same. The success of such a conceptual change would require addressing concerns over things like price alignment interest that is currently paid by margin receiver on interest earned from the posted margin.

> Regulators seem to be responding to some of these concerns, instilling hope that there might be light at the end of the tunnel.

Share of Funds in Cleared Swap Segregation of a Player vs. Total Such Funds

Source: CFTCFigure 8

18%

16% 15%

11% 10% 9%

5% 4% 3% 3%

9%

20%

11% 12%

16%

7%

4%

6% 8%

2%

0%

5%

10%

15%

20%

25%

Jan-14 Aug-15

BARCLAYSCAPITAL INC

CREDITSUISSE

SECURITIES(USA) LLC

CITIGROUPGLOBAL

MARKETSINC

JP MORGANSECURITIES

LLC

MORGANSTANLEY &

CO LLC

GOLDMANSACHS & CO

DEUTSCHEBANK

SECURITIESSECURITIES

MERRILLLYNCHPIERCE

FENNER &SMITH

WELLSFARGO

SECURITIESLLC

UBSSECURITIES

LLC

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Footnotes1 Yet to start in Europe.

2 The Dodd-Frank Wall Street Reform and Consumer Protection Act (or Dodd-Frank Act) is considered the most comprehensive regulatory reform of the financial sector in the U.S. Mandatory central clear-ing of the standardized OTC derivatives formed a major constituent of the swaps marketplace reform initiatives of the Dodd-Frank Act. http://www.cftc.gov/lawregulation/doddfrankact/index.htm

3 The European Markets Infrastructure Regulation (EMIR) came into force on August 16th, 2012, introduc-ing requirements aimed at improving the transparency of OTC derivatives markets and to reduce the risks associated with those markets. It includes the obligation to centrally clear certain classes of over-the-counter (OTC) derivative contracts through CCPs or apply risk mitigation techniques when they are not centrally cleared. http://www.esma.europa.eu/page/OTC-derivatives-and-clearing-obligation

4 Basel Committee on Banking Supervision (BCBS), a standing committee of the Bank for International Settlements (BIS); IOSCO – Board of the International Organization of Securities Commissions.

5 The initial margin requirements for the covered entities is phased in based on their aggregate month-end average notional amount of non-centrally-cleared derivatives activity. As per the revised time-lines from the Basel Committee on March 18th, 2015, entities with notional greater than €3.0 trillion need to comply from Sept. 1st, 2016, followed by those greater than €2.25 trillion from Sept. 1st, 2017, €1.5 trillion from Sept. 1st, 2018, €0.75 trillion from Sept. 1st, 2019 and all covered entities starting Sept. 1st, 2020. The phase-in for variation margin requirements start from Sept. 1st, 2016, for those covered entities with greater than €3.0 trillion notional and all covered entities from March 1st, 2017. http://www.bis.org/bcbs/publ/d317.htm

6 http://www.bis.org/publ/bcbs282.htm

7 The Committee on Payments and Market Infrastructures (CPMI), a standing committee of Bank for International Settlements (BIS).

8 The clearing member’s exposure to client needs to be capitalized as per CCR standardized (SA-CCR) or internal models (IMM) approach, as applicable.

9 https://www.bis.org/cpmi/publ/d101.htm

10 http://www.bis.org/press/p150709.htm

11 http://www.bis.org/bcbs/publ/d325.pdf

12 http://www.fsb.org/wp-content/uploads/OTC-Derivatives-10th-Progress-Report.pdf

13 http://www2.isda.org/news/cross-border-fragmentation-of-global-derivatives-end-year-2014-update

14 http://www2.isda.org/functional-areas/wgmr-implementation

15 CEM: Current Exposure Method; SA-CCR: Standardized Approach for measuring Counterparty Credit Risk.

16 Risk Magazine, May 24th, 2015.

» It has been claimed that the Basel Committee will soon consult on moving from CEM to SA-CCR for leverage ratio computation. SA-CCR being more risk-sensitive is expected to result in reduced derivative exposures.

ConclusionThe fast-changing regulatory landscape increases clearing costs and therefore trading costs to an extent that had not and could not have been anticipated by the market, given some late and impactful regulatory reforms. This is evidenced

by recent market exits of major financial institu-tions, repricing which is currently taking place, leveraging and active applied research for analyzing and formalizing various costs – MVA, RWA, leverage, FVA, etc.

Once the derivatives reforms are complete, on a global level and for both uncleared and cleared derivatives, one can expect cleared volumes to pick up and market prices to adjust. Meanwhile, we can assume that a few more renowned insti-tutions will need to exit the market, leading to additional consolidation.

About the AuthorsSerge Malka is the Capital Markets and Risk Practice Co-Leader for Cognizant Business Consulting in North America. He specializes in derivatives trading and risk management. Serge has conducted many organizational, regulatory and IT projects with a strong European footprint. His recent regulatory work focused on EMIR/BIS IOSCO, DFA, Basel III, Fundamental Review of the Trading Book (FRTB), and the U.S. Fed FBO regulations. Since 2014, Serge’s work has focused on the derivatives overall costs’ evolutions, including a conference in Paris with Quantifi, Axa IM, HSBC and Vivescia. He can be reached at Serge.Malka@cognizant.com.

Dmitry Pugachevsky is Director of Research at Quantifi, responsible for managing its global research efforts. Prior to joining Quantifi in 2011, Dmitry was Managing Director and head of Counterparty Credit Modeling at JP Morgan. Before starting with JP Morgan in 2008, Dmitry was Global Head of Credit Analytics at Bear Stearns for seven years. Prior to that, he worked for eight years with analytics groups of Bankers Trust and Deutsche Bank. Dr. Pugachevsky received his Ph.D. in applied mathematics from Carnegie Mellon University. He is a frequent speaker at industry conferences and has published several papers and book chapters on modeling counterparty credit risk and pricing derivatives instruments. He can be reached at Dpugachevsky@quantifisolutions.com.

Rohan Douglas is CEO of Quantifi. He has over 25 years of experience in the global financial industry. Prior to founding Quantifi in 2002, he was a Director of Research at Salomon Brothers and Citigroup, where he worked for 10 years. He has extensive experience working in credit, interest rate derivatives, emerging markets and global fixed income. Rohan is an adjunct professor in the graduate financial engineering program at NYU Poly in New York and the Macquarie University Applied Finance Centre in Australia and Singapore. He is the editor of a book, “Credit Derivative Strategies,” published by Bloomberg Press.

Krishna Kanth Gadamsetty is a Senior Consultant within Cognizant’s Banking and Financial Services Consulting Group, working on assignments for leading investment banks in the risk-management domain. He has more than seven years of experience in credit risk management, capital markets and information technology. Krishna is a Financial Risk Manager – certified by the Global Association of Risk Profes-sionals — and has a postgraduate diploma in management from the Indian Institute of Management, Lucknow. He can be reached at KrishnaKanth.Gadamsetty@cognizant.com.

S L K Prasad Thanikella is a Senior Consultant within Cognizant’s Banking and Financial Services Consulting Group. He has more than seven years of experience in financial risk including implementa-tion of complex regulations such as regulatory capital rules under Basel III, capital adequacy, capital buffer measurement and management. He is a Financial Risk Manager certified by the Global Associa-tion of Risk Professionals (GARP), a gold standard in financial risk management. He has an M.B.A. with specialization in finance. He can be reached at Santoshlakshmikiranprasad.Thanikella@cognizant.com.

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About Quantifi

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