Self clearing may be the only viable option for derivatives users if FCMs step back from the business, warns Venkatesh Ramasamy of Calypso Technology – but direct CCP access comes with costs and obligations
Large global banks are falling out of love with the client-clearing business. At an investor day presentation on February 24, JP Morgan warned the economics of client clearing were “incompatible with capital rules in their current form”. Fees must rise ten-fold to meet common return-on-equity targets for global banks, clearers warn. That leaves end-users, which are required to clear standard over-the-counter products under post-crisis financial regulations, in a difficult position.
Venkatesh Ramasamy, senior vice-president at Calypso Technology, is well aware of the challenges. As global co-head of prime services at Royal Bank of Scotland, he ran the client clearing business until the firm decided to exit OTC clearing last year.
“The client clearing business model is becoming increasingly unattractive to clearing brokers. It is challenging to operate the business at the prices the industry expects,” he says.
After leaving RBS, Ramasamy, along with Richard Thompson, former head of OTC clearing at the bank, and Michael Boroughs, a prime services sales executive, decamped to Calypso, a capital markets technology firm, to explore the possibility of granting clients direct access to clearing – eliminating the need for bank intermediation.
“The market is looking for another kind of solution. We are trying to do everything a clearing broker does, but we’re not principal to the risk. We think it is better for the client to go to the clearing house directly. We can provide the infrastructure, risk management and operational backbone currently provided by clearing brokers,” he says.
Ramasamy offers a stark vision of the future, in which only four banks are able to maintain profitable client clearing businesses, with a few more offering the service as a loss-leader to preferred clients. His estimate is based on conversations with clearing heads at a number of large futures commission merchants (FCMs), he says.
The alternative is for end-users to bypass the FCMs and go directly to central counterparties (CCPs). In theory, this eliminates many of the costs associated with bank capital requirements, which FCMs will be seeking to pass through to clients, if they want to make the business profitable. The question is whether this outweighs the additional costs and responsibilities clearing members face.
“We are introducing new risks to self-clearing clients around the default fund contribution, its top-up and the default management process,” says Ramasamy. “But the default fund contributions to the clearing house when you self clear are lower risk than the initial margin posted to the clearing broker, where there is uncertainty around how much of that initial margin could be lost if your clearing broker defaults. Then you would also have the replacement cost of those positions. In self clearing, all the risk sits in the waterfall behind other forms of capital.”
End-users looking to self clear face other, more practical, challenges. The minimum default fund contributions for major CCPs, which range from €5 million at Eurex to $50 million at CME Group, are prohibitively expensive for most non-dealers. US mutual funds, meanwhile, cannot contribute directly to CCP default funds, which mutualize risk.
Ramasamy has spoken with three large CCPs about a possible solution. “A possible alternative is to move to a structure where your capital at risk in the event of a default at the clearing house is embedded in your initial margin, as opposed to having a minimum default fund contribution. Then you can avoid that base cost and enable smaller players or clients with multiple funds to get direct access,” he says.
The self-clearing model Ramasamy is developing would still entail significant operational changes for clients. Many end-users are not accustomed to intra-day margin calls or posting variation margin in the currency of the underlying instrument – a CCP requirement that is often handled by clearing banks. He says Calypso could help.
“On the real-time margin, we are well positioned to help with that,” says Ramasamy. “We already provide back-office and front-office trading technology. Major clearing houses use our technology for much of their margin calculation, clearing, settlement and collateral management processes. We can help non-dealer firms get up to speed operationally.”
So far, potential end-users have been receptive. In addition to asset managers and CCPs in Europe and the US, Ramasamy says he is in active discussions with 10 of the world’s largest hedge funds about direct clearing.
Biography – Venkatesh Ramasamy
2014–present: senior vice-president, business services and utilities, Calypso Technology
2012–2014: global co-head of prime services, RBS
2007–2012: global head of prime brokerage, RBS
2006–2007: vice-president, credit financing and collateral trading, Dresdner Kleinwort
Pre-2006: a number of management roles in technology at Dresdner Kleinwort in London and Tokyo