Regulation is driving change in capital market structure, and as highlighted in the future of investment banking, banks continue to move towards a ‘capital-lite’ business model, as they seek to ‘optimise’ use of and return on capital.
The introduction of mandatory trading and clearing for standardised swaps (SEFs in US and OTF and MTFs in Europe) has resulted in higher capital charges for OTC bilateral trades, and reduced the appetite of banks to warehouse and hold inventory which is moving more banks towards a ‘capital lite’ model.
This is the backdrop to the announcement that JP Morgan the setting up a 150 strong fixed income agency execution desk called JP Morgan Execution Services (JPMES), to run alongside its principal trading operations.
At first sight, it looks as if JP Morgan is simply hedging its bets and backing both agency and principal business models. However,
I think this is more about where the value proposition is moving to in fixed income. Value is shifting from banks providing principal based bilateral trading, to offering agency execution and cleared model with differentiation and value shifting downstream into the post trade arena, with solutions being developed around client clearing, margin & collateral portfolio optimisation and other services.
Interestingly, as banks pull back from committing risk capital, a new breed of liquidity provider steps up in the form of electronic market makers such as high frequency trading firm Virtu, who will become a swaps liquidity provider on a broker owned platform with a central limit order book (CLOB).
In Europe under European Market Infrastructure Regulation (EMIR), standardised OTC derivatives (covering rates, credits, FX, commodity and equity) will be required to be cleared through central counterparties (CCPs), and those that can’t be cleared will be subject to bilateral margining. In addition, the Capital Requirements Directive (CRD IV) and Capital Requirements Regulation (CRR) increase the capital requirements for both cleared and non-cleared OTC derivatives.
So, what exactly are the increased costs for capital requirements for non-cleared (bilateral) and cleared OTC derivatives, and who will bear those costs?
According to estimates from a study by Deloitte:
the additional annual cost of trading for the OTC derivatives market will be in the region of €15.5bn/year, with cleared transactions costing €2.5bn/year more, whilst non-cleared transactions will be far more expensive at €13.5bn/year.
The main elements of the additional costs incurred by OTC derivatives being: new margin requirements, new capital charges and compliance costs.
Table above contrasts the additional costs for cleared vs non-cleared OTC Derivative trades (Source: Deloitte)
The above comparison table shows that the extra costs associated with bilateral (non-cleared) vs cleared trades arise mainly from the higher capital charges associated with non-centrally cleared OTC Derivatives (the row in green). With non-cleared trades being at least ten times more expensive than the equivalent cleared trade. A large component of the capital charge being in the form of capital charges to protect against variations in credit value adjustment (CVA). The CVA measures the asset valuation changes related to counter-party credit risk.
According to ISDA, for a non-cleared Euro Interest Rate derivative, the average notional trade size is €85m. That equates to a cost of some €14,493 (€85 x €170.5) to trade the swap as a non-cleared trade. The same trade if cleared would only cost an additional €1,374 (€85 x €13.6), meaning the non-cleared trade is some €13,119 more expensive than the same trade if cleared.
As these costs become more explicitly charged back to the sales & trading desks, banks will have to either swallow the costs (unlikely in the case of non-cleared), or look to pass on some if not all of the higher costs of trades to clients in the form of wider spreads.
This should lead to banks providing clients with the option of cleared vs non-cleared pricing via their SDP. With tighter spreads for instruments that are designated for clearing, and much wider spreads for the same instrument designated for non-clearing, giving clients a choice, or perhaps for certain clients where credit is an issue, only offering cleared trading, which is better than having to stop trading with the client!
We will revisit this discussion when looking at new initiatives in FX around ‘client-clearing’, and look at how client-clearing model can enable banks and clients to maintain strong trading relationships, whilst mitigating both higher capital costs and counter-party credit concerns by immediately upon execution migrating (or novating) pre-designated trades from bilateral to cleared trades which would be subject to margining by the CCP.