On 13 September, Conrad Voldstad, chief executive of the International Swap and Derivatives Association (ISDA), informally proposed an idea to his Association’s New York regional conference, “First, dealers should be required to clear trades with one another. Second, no other counterparties should be forced to clear. I hope that gets your attention.”

It did; the buy-side has long argued that applying the same central clearing obligations to traditional investment managers as were applied to the sell-side was unfair. Dealers had not shown any real support for the buy-side’s view, until now.

“The aim of central clearing is ridding the system of systemic risk,” says Jane Lowe, director, markets at buy-side trade body the Investment Management Association.

“To my knowledge that systemic risk appears to rest in the banks. I don't want to criticise ISDA, but we have been saying this right from the beginning. We have not said don't bring the buy-side into clearing entirely, but rather do so on a completely separate timeline to the dealers.”

Voldstad’s argument is that a cost-benefit analysis has not been performed to back the model of clearing proposed under the Dodd-Frank Act in the US and the European markets infrastructure regulation in Europe, and that the costs may outweigh the benefits.

These regulations will oblige all firms that trade over-the-counter derivatives to use central counterparties (CCPs) for clearing. Central clearing is rarely used by the non-hedge fund investment firms under normal circumstances.

The CCP model requires firms to post initial margin to the CCP in order mitigate the credit risk they pose as a counterparties, and variation margin to account for changes in the valuation of the contract traded, according to the previous day’s price. Trading without clearing would only require variation margin, which Voldstad said would still be needed in his conceptual plan.

He supported his idea by noting that “various studies” indicated initial margin for firms that would have to clear under the Dodd Frank Act could be between $200bn to $500bn or more.

“The ‘cost’ of this liquidity is difficult to define but we suggest, at the low end, that it could be $1bn or 0.5% times the $200bn of initial margin (IM)... At the high end, initial margin could be $5bn, or 1% times $500bn per annum,” he said. “We have seen no studies that estimate the amount of money that might be saved by such a large amount of IM.”

Under the proposal he set out, all financial firms of medium size and above should be forced to post daily variation margin on a bilateral basis; without central clearing initial margin would not be required.

Where the risk lies

This would provide relief for many buy-side firms for whom there are good reasons, other than cost, for exemption from the central clearing obligation.

“The whole idea behind clearing is to mitigate credit and counterparty risk; it seems onerous to impose these restrictions on pension funds and large money managers which aren’t posing those risks,” says Craig Pirrong, professor of finance, and director, of the Global Energy Management Institute at Bauer College of Business, University of Houston.

Lowe concurs, although she says discriminating between the types of firms obliged to clear would allow the regulation to work.

“I think central clearing is a really good development but I think the regulation was rushed,” she says. “By putting buy-side customers in right at the start, regulators have created a lot of problems for themselves; they made an assumption that if you can clear for the dealers it should work for the customers. But the issues are different.”

Dodd-Frank and EMIR were designed to fulfil the commitments made by the Group of 20 (G20) countries on September 24 2009 to reduce systemic risk in the financial markets. The G20 made a range of promises, which included central clearing for all standardised OTC derivatives contracts by the end of 2012, trading of those contracts on exchanges or platforms where appropriate and reporting of all OTC contracts to trade repositories.

Punishing costs

There are many consequences for buy-side firms from this regime. In his report ‘OTC Derivatives Clearing and the Buy Side in the US: Rough Ride Ahead’, Anshuman Jaswal, senior analyst at research firm Celent, posits that margin costs will increase as CCPs are likely to be more conservative than bilateral counterparties have traditionally been, and that operational complexity will increase as multiple credit and operational agreements are needed to cope with CCPs, brokers and other bank counterparties, losing the benefits of consolidated margining and increasing the liquidity impact of the regulation.

The assets accepted as collateral for margining on CCPs are cash for variation margin and low risk liquid assets, such as government debt, for initial margin. Getting the collateral together hurts investment funds unnecessarily says Pirrong; they do not have large amounts of cash because they invest it for better return.

“The big pension funds are forced to hold portfolios that are more cash and liquidity heavy than they are mandated to be and that means that they are not able to generate the same kinds of returns as they were,” he explains. “So there is a cost but no corresponding benefit.”

In addition to long-only asset managers, commercial firms that are using derivatives markets to hedge are also punished.

“The chief risk officer at an energy trading operation told me this will transform credit risk into liquidity risk; he would prefer credit risk any day of the week,” says Pirrong. “The surprise liquidity demands that these clearing requirements can put on firms - metronomic, day-after-day, mark-to-market collateralisation - are pretty daunting.”

With the rules still unfinalised, Lowe says that funds are also concerned about operational aspects that have yet to be clarified. She says: “When these new arrangements come into place to do with new margining, where exactly is my collateral going to be? How exactly will it have to match up to my requirements to centrally clear?”

Too little, too late

With so many reasons to object to the model that regulators have opted to impose, the buy-side welcomes the support position that ISDA has shown, albeit with some chagrin.

“We have said our piece right from the beginning of the regulatory process and we got no support from ISDA,” says Lowe. “It’s really good that they are coming out with it but it’s kind of 18 months too late.”

Voldstad acknowledged this and said that the formal proposal for the type of scheme he discussed may come in 2012 or even later; but he urged the regulators to keep an open mind when such ideas were formalised. US derivatives regulator, the Commodity Futures Trading Commission (CFTC) has voted to delay the implementation of rules based on the Dodd Frank Act until 31 December 2011 from their original July deadlines.

Nevertheless Lowe says it is not too late for regulators to adapt the existing plans to better support buy-side businesses, “Even now they could put them onto two separate streams; really focus on getting as much cleared as they can on the sell-side first and give time to bring the buy-side in. Then they really do deal with knowing what is going on at the banks, flattening the systemic risk that they perceive is sitting out there in the market.”

Pirrong is less positive, saying, “I don't think that legislators and regulators are all that cognisant of these issues. They don’t understand all the kinds of cost this will impose on a wide variety of firms and there is such a suspicion of anything that comes out of the sell-side that regulators will be very sceptical about ISDA’s comments.”