THANK YOU FOR SUBSCRIBING
By Phil Matricardi, Manager-Business Consulting and Adam Kott, Associate Business Consultant, Sapient Global Markets
Prior to the global financial crisis, OTC derivative trading was highly profitable and allowed management to overlook manual processing and large support staffs. Now, the same banks find themselves in a very different environment, with expensive and inefficient proprietary systems entrenched within their firms’ operating models. Mergers that firms used to grow during the good years (and enacted during the crisis for both strategic reasons and at the request of regulators) have left them with a proliferation of platforms and parallel operational channels.
“The client-FCM relationship involves significant credit, capitalization and concentration checks because the FCM must guarantee the client to the clearing house”
As a result of US Commodity Futures Trading Commission (CFTC) and European Securities and Markets Authority (ESMA) regulations drastically increasing the number of swaps being cleared, and internal inefficiencies, banks face decreasing returns amidst client pressure to offer high-cost clearing services.
Small or regional non-Futures Commission Merchant (FCM) banks that have traditionally done a good business in corporate finance are very concerned that a key component of their structured finance offering is missing now that they have lost access to the swaps market (formerly conducted through introducing brokers but packaged into one product for the client) due to their inability to clear trades. The client- FCM relationship involves significant credit, capitalization and concentration checks because the FCM must guarantee the client to the clearing house. Therefore, a small bank that attempts to provide debt issuance to clients and introduces them to an FCM to hedge the interest rate component may put itself at risk for competitive poaching. These large and sophisticated competitors quickly learn all they need to know to deepen and strengthen the relationship and provide the small bank’s best clients with a more complete offering.
While the financial impact of clearing has largely been placed on buy-side participants, banks must now provide connectivity to various institutions throughout the lifecycle of a swap: middleware vendors, FCMs, clearing houses and SEFs. The costs of creating these pipelines are not insubstantial.
Becoming an FCM involves a significant up-front capital outlay: To self-clear at
As rising costs have made it more difficult to retain clients, the market has recognized that it is more important than ever to maintain a full service offering to clients. Client clearing is just one service that has proved to be a necessary expense. Banks have determined that offering client clearing services keeps clients engaged in more profitable lines of business such as bond issuance and structured financing. Firms that do not offer clearing must give up client contacts and data to their competitors and risk losing long-time customers. The high cost of this service offering puts an emphasis on the need for a rational data structure and automated back-office processing. Banks that cannot afford to offer client clearing on their own must find innovative solutions, such as establishing an industry utility, to keep up with their clients’ demands.