Real-Time Clearing: The New Race to Zero
While the energy market has been clearing customer trades in real-time, interest rate swaps largely have been clearing dealer-to-dealer trades at the end of each day. Rates market participants did not have the desire, nor the capability, to calculate counterparty exposures in real-time or near real-time.
But once the clearing mandate goes live in March, Derivatives Clearing Organizations (DCOs), Futures Commission Merchants (FCMs) and clearing brokers must be able to accept trades for clearing within just one minute of submission. The goal is to create a market in which clicking “execute” completes the trade entirely.
This faster clearing cycle will reduce counterparty credit exposure and lead to more efficient collateral and inventory management, freeing capital and lowering margin requirements. A more automated and real-time clearing workflow will allow the market to more accurately manage risk and, by doing so, better deploy capital. But the path to this environment will require a technology investment by swaps dealers, FCMs and the clearinghouses themselves.
While FCMs have experience managing the risk of futures; they have less experience managing the risk of swaps. The Commodities Futures Trading Commission (CFTC) wants to ensure that FCMs, which clear on behalf of customers, are subject to standards at least as stringent as those applicable to Swap Dealers (SDs) and Major Swap Participants (MSPs), which will clear for themselves. The good news is that FCMs will have flexibility in developing procedures that meet their needs. Clearing intermediation can be addressed either through simple numerical limits on order or position size, or through more complex, automated pre-trade and margin-based limits. They could include price limits that would reject orders that are too far away from the market, or limits on the number of orders that could be placed in a short time.
While DCOs may be able to clear trades in real-time, the time lag between the clearing of a trade and the actual, physical receipt of margin funds could constitute a credit risk issue. Until the DCO receives the necessary margin it is, in effect, extending a loan to the clearing agent. Such loans should be subject to the same capital requirements (as well as the right to charge interest) found in other areas of the financial marketplace. Alternatively, positions could be pre-funded.
But clearinghouses in the energy markets have successfully monitored their members’ activities and communicated with those that are approaching their limits for the better part of a decade. If a firm requests an increased limit due to the fact that it knows it is ramping up business or have significant new exposures coming through in one day, the DCO can work with the firm to determine if there is room for expansion or if it needs to post additional collateral in order to facilitate a limit expansion. For this reason, TABB Group believes the new world of real-time clearing will apply as successfully in rates and credit as it has for so many years in the energy markets.