www.catalyst.co.uk OTC IRS Portfolio Optimisation: how trade compression could save hedge funds $mlns before the 2016 European Clearing Mandate strikes 1 Catalyst helped us uncover multimillion dollar savings through their unique compression methodology, which is tailor-made for the buyside. CIO, Top 5 Hedge Fund, February 2015 Despite being among the most sophisticated operators in global financial markets, hedge funds seem a world apart. While banks struggle with endless regulation and the frustrations of managing legacy and complexity, multiplied over scale and geography, funds respond quietly and rapidly to clients and markets alike. In some areas, however, funds miss out. This is particularly true of trade compression, whose benefits have historically only been realised within banks. We believe 2015 is a year in which it s vital to take a fresh perspective. The Basel III leverage ratio has placed banks under greater pressure than ever before to optimise their capital, including the capital they use to service clients like hedge funds. At the same time, the US Clearing Mandate has come into force and the European Clearing Mandate is set to apply from early 2016. Unprofitable clearing brokers are already pulling out of the market, leaving fewer to provide services that funds must access. As the 2016 mandate approaches and the number of service providers contracts, the remaining brokers are poised to increase fees significantly we estimate by eight to tenfold - to reflect their true costs and return a profit. What s more, as brokers pursue return on capital, the cross subsidisation of execution and clearing will decline as different brokers focus on different parts of the value chain. MIFID 2 and the advent of Organised Trading Facilities will drive this divorce. The collective impact of these moves makes it critical for hedge funds to eliminate excess gross notional from their interest rate books. We have therefore devised a new approach for any hedge fund trading IRS at reasonable volume that can save tens of millions of dollars each year. This paper describes how it works and why we believe 2015 offers a crucial, but limited, opportunity to act.
Why is action urgent? We believe it s critical for hedge funds to use 2015 to implement the building blocks for efficient trading and clearing. This is why: Until now, banks who also operate as clearing brokers have largely not passed the true cost of trading on to their clients. Indeed many clearing services have been significantly under-priced, with the focus being simply to secure as many clients as possible. The time of the full service investment bank is over. Banks are increasingly focussing on where they have comparative advantage. Execution and clearing are becoming increasingly divorced and will continue to do so, meaning the opportunity for funds to benefit from relationship subsidies from execution business will decrease. Basel III regulation and in particular the leverage ratio, requires banks to optimise their use of capital. Clearing brokers who previously signed business at an economic loss have started to pull out of the market altogether, with the rest poised to renegotiate their terms. They have a powerful upper hand: the supply of services has decreased at exactly the moment demand starts to build, with the EU clearing mandate due to come into force in Q1 2016. MIFID 2 will impose Organised Trading Facilities (OTFs): electronic marketplaces designed to match buyers and sellers and replace brokers own single dealer platforms. Best execution processes will mean competition for OTC execution based purely on price, marking the end of relationship discounts for nonexecution business like clearing. Our extensive experience of working closely with futures commission merchants (FCMs) and clearing brokers (CBs) shows that they are looking to make significant clearing fee increases by the end of 2015. To date, most fees have been based on a per-ticket basis, with some Initial Margin factor. Now FCMs are starting to move to a fee structure correlated to impact on capital usage. Indeed one Tier 1 CB has already moved to this structure. In fact the client clearing market today is radically different from 2009/10 when most contracts were negotiated. It has switched from a buyer to a seller s market in just over five years: In 2009 no clearing mandate was in force. Client clearing business was seen as key to execution revenues. Larger buy-side firms were in a strong negotiating position. Every broker built some level of client clearing offering. In 2013 mandatory clearing came into force in the US. Significant business migrated to Europe to delay the need to comply. By 2014 ESMA delays had eroded the supply of clearing services and RBS, BONY, State Street all withdrew from the market. Many other brokers in effect closed to new business, by offering unacceptable contract terms. Now in 2015 the EU mandate is imminent. FCMs/CBs are constrained by the true cost of financial resources. The combination of reduced and finite supply with increasing demand leaves the sell-side in a powerful Catalyst Development Ltd 2
negotiating position. Today, FCM/CB cost of capital is over 12%, with brokers targeting a return on capital of 14-15%. Average to large hedge fund fees will need to increase eight to tenfold for clearing brokers to make a profit on capital. Any client who uses less of their bank s capital to express the same risk will bear less cost. That client will also use less of their bank s credit line, enabling more efficient access to trading and liquidity. Our capital analysis on compression and netting scenarios for client portfolios shows how you can avoid up to 80% of this cost by eliminating excess gross notional from your book. then ensuring that the pot is at the highest account level in your legal entity structure. The more complex your book structure, the greater the fee saving and the higher the trading volume. Yet typically, fewer than half all eligible trades are submitted for compression, leading to a disproportionately negative impact on the capital efficiency of resulting unwinds. In the majority of cases, trades are not submitted because they are simply not in the books that are being submitted, either because of their complexity or fund account structure or because of uncertainty over the downward risk impact of their inclusion. To achieve maximum benefit, hedge funds need to consider tools which allow intra-fund netting and compression, while keeping individual strategies flat. How can hedge funds harness compression? We have completely re-engineered netting 1 and compression 2 for the hedge fund market. We can at least double what you currently unwind and improve your broker liquidity line and fee efficiency as well as delivering significant internal operational gains. How our solution works The key to achieving high compression ratios is submitting the greatest number of trades possible into the compression pot, We can pick up all the trades per book that are currently not submitted and resolve the book structure issues that result from submitting everything as though it were one book. We employ mitigating techniques that allow you to submit those trades and we configure our Risk Balancer to match your book structure, curve methodologies and individual trader risk tolerances. Our significant expertise in front to back OTC process, hedging 1 Netting is the process of eliminating trades of exactly opposite economics. A 5 year fixed pay for $300m@3.2% against 3M libor vs. a 5 year fixed receive for $300m@3.2% against 3M libor (on the same calendar, day count etc) will net to zero. If the fixed pay is $310m, these two swaps net to a fixed pay swap of $10m, with zero risk and P&L impact. Blended coupon netting is the same as netting, but with one crucial difference: varying coupons on the fixed leg. These trades can net down with no economic impact, if we replace the netting with a replacement trade representing the coupon weighted notional of the averaging process. 2 Compression true compression is not risk neutral. Instead of matching exact economic terms, firms match against a risk profile subject to tolerances such as a DV01 ladder. Risk and the front office work together to decide how narrow tolerances should be based upon the purpose of the underlying trades. For example, IRS that hedge distinct cash flow profiles are less open to tolerance than books expressing a macro rates view or a hedge to swaptions. Catalyst Development Ltd 3
algorithms and technology modelling tool ensures your risk profiles are not changed. The bespoke configuration of our modelling tool is tested with your staff against sample results before a formal compression dress rehearsal. This process reassures traders that their trades can be safely submitted. We leverage your existing controls and processes and implement additional controls as appropriate, to ensure your traders and risk managers have comfort in the internal risk mitigating trades we propose. Our approach is unique: it does not require your counterparties to use our risk balancer bilaterally in order for you to reap the capital benefits. You achieve optimal results from our no stone left unturned approach and this method of compression helps achieve the leverage ratio target and thus reduce your gross exposure. In summary Compression is one area where hedge funds can cherry-pick the advantages of banks methodology, tailored precisely to their own context. Performing regular trade compression will save you tens of millions of dollars a year from the point at which brokers begin Return on Capital (RoC) pricing. We have completely re-engineered compression with a tailor made solution for hedge funds. This is a now issue: Basel III and the leverage ratio require banks to hold more capital. Banks are increasingly focussed on ensuring the businesses they stay in are profitable. The change in clearing broker pricing will come to a crunch this year as the 2016 European clearing mandate approaches. Clearing broker supply is dramatically more constrained than it was when brokers were actively competing for business in 2009. We expect the clearing brokers to increase and reshape their fee structure during 2015 to deliver a 14-15% return on capital. Any client who uses less of their bank s capital to express the same risk will bear less cost. The same client will have lower utilisation of their bank s credit line, enabling more efficient access to trading and liquidity. In addition, the same tools can be used to rationalise the number of trades a fund needs to enter into, as well as to roll the book forward more efficiently where necessary, leading to much lower execution costs. This typically offers further savings of $3mln a year in execution fees. How we can help Our approach is different to anything else on the market: it minimises any internal hedges required and integrates with existing processes, architecture and STP with appropriate controls. Our team is also unique, combining world-leading expertise in risk with expert understanding of front office, P&L, operational flows and STP technology as well as the dynamics of team work, leadership and collaboration across different parts of highly sophisticated funds and buy-side organisations. Catalyst Development Ltd 4
Meet our authors Tom Lodge Tom is an experienced practitioner and pioneer in compression. He is an expert in OTC with more than 18 years investment banking experience spanning trading, middle office, clearing, change management and finance. Tom has a deep understanding the OTC business and support functions and advises clients on front to back business architecture and change. tomlodge@catalyst.co.uk Stephen Loosely Stephen is a leading expert in OTC clearing. Having originally joined LCH Clearnet as an analyst, he left as Head of SwapClear s middle office, running risk and operations for $300tr of IRS swaps across 50 banks. Stephen designed SwapClear s multilateral compression process, interfacing with TriOptima and the market. He leads Catalyst s international delivery teams in specialist OTC clearing, risk and regulatory projects. stephenloosely@catalyst.co.uk Sean Coote Sean has unique practical experience covering sell side, buy side and CCP clearing operations. His derivatives expertise is based on over 25 years in senior operations and project management positions. His experience includes consulting at a major US corporate on the impact of Dodd Frank on their global operations. He has also set up clearing operations for clearing brokers covering harmonisation and implementation of both SCM and FCM models. seancoote@catalyst.co.uk About Catalyst We are experts in optimising our clients balance sheet, reducing the total cost of trading and enabling regulatory compliance. We work in joint teams with our clients, combining our experience in financial markets and programme execution to deliver results. We provide honest guidance to help you succeed. We are Catalysts for enduring excellence. Catalyst Development Ltd, 167 Fleet Street, London, EC4A 2EA T +44 (0) 870 901 4155 F +44 (0) 871 433 8876 www.catalyst.co.uk Disclaimer: Comments in this presentation on are based on Catalyst's understanding of the global regulatory landscape as of February 2015. This document is neither intended to be comprehensive, nor to provide legal or accounting advice. Catalyst Development Ltd 5