With the recent addition of three customers and two major European banks to its ISA Direct program this summer, Eurex Clearing has made important progress in standing up the direct membership model it first introduced in 2016.
As market regulators have pushed firms with large derivatives exposures to put their trades through a central counterparty, banking regulators have required banks to set aside more capital for the risks they take when clearing derivatives. As a result, some banks have pulled back from providing clearing services to clients.
In response to this trend, Eurex Clearing, the clearing arm of Europe's largest derivatives exchange, developed a new membership model in 2016 called ISA Direct to allow customers to become direct members. But no customers took the plunge until June, when Swiss Life Asset Managers, one of Switzerland's largest institutional investors, became a full clearing partner of Eurex Clearing.
"ISA Direct of Eurex Clearing allows us to clear our OTC derivatives directly at the clearinghouse instead of using a clearing broker as an intermediary," explained Jan Grunow, head of operations & controlling at Swiss Life Asset Managers in Zurich.
The company will not take on all the responsibilities of clearinghouse membership, however. ABN AMRO Clearing Bank will act as Swiss Life's "clearing agent." Under the ISA Direct model, the clearing agent retains some elements of the traditional clearing member role, including the responsibility for making the required default fund contribution. The agent also may offer optional services such as transaction, cash, or collateral management.
"It's kind of a hybrid set-up," explained Alexander Jacobs, head of OTC clearing for ABN AMRO. The client gets the cost savings of being a direct member, such as being able to pay its own margin calls directly instead of through a clearing broker, but still outsources the ultimate default management risk to a clearing bank.
For ABN AMRO, the new arrangement also offers some advantages as it reduces concentration risk on clearinghouses, liquidity risk, and balance sheet impact, according to Jacobs. "While post-crisis regulations mandating bilateral derivatives to be CCP-cleared is good for the clearing business in general, ABN AMRO has only one balance sheet, which is not endless," he said.
"It's kind of a hybrid set-up. Instead of being the full guarantor as a clearing broker or clearing bank, we can now reduce our commitment by being an agent only."
"It's kind of a hybrid set-up. Instead of being the full guarantor as a clearing broker or clearing bank, we can now reduce our commitment by being an agent only."
Alexander Jacobs, head of OTC clearing, ABN AMRO Clearing Bank
"Like all clearing banks, we have a maximum number of clients we can offer clearing services to, so this translates into either charging higher clearing fees or implementing innovative clearing services to serve our clients while taking on less credit and liquidity risk," he added. The ISA Direct program fit the bill. "Instead of being the full guarantor as a clearing broker or clearing bank, we can now reduce our commitment by being an agent only," he explained.
So far, the transition has gone smoothly for Swiss Life, Grunow said. "The transfer of existing interest swaps into the ISA Direct model went well, and the daily process is stabilizing." He added that Swiss Life sees a substantial cost advantage in the new arrangement. "The costs of clearing are significantly lower for us as no clearing broker has to provide balance sheet capacity for our swaps," said Grunow.
Tapping into the ISA Direct program reduces risks in other ways as well. "This direct clearing relationship reduces our dependency on clearing brokers and hence reduces as well the risk of porting open trades in case a clearing broker defaults," Grunow commented. "Our initial margin for Eurex Clearing remains in a pledged account at the tri-party collateral manager SIX SIS [the Swiss central securities depository], which reduces counterparty and collateral transfer risk substantially."
As of June 2019, Swiss Life Asset Managers had CHF 232.6 billion in assets under management. Of that amount, CHF 71.2 billion were managed for third party clients and the remainder for the company's parent, Swiss Life Group, the largest life insurance company in Switzerland and one of the leading providers of pensions and financial solutions in Europe.
Swiss Life’s derivatives contracts will continue to be traded bilaterally but the principal post-trade counterparty will now be Eurex Clearing. This will enable Swiss Life to transfer the bulk of its counterparty risk to Eurex Clearing, significantly reducing the firm’s costs while improving its clients' level of protection, according to Matthias Graulich, a member of Eurex Clearing’s executive board.
Since Swiss Life announced its participation in June, a handful of other firms have come on board. On the OTC derivatives side, Zurcher Kantonalbank, the fourth largest bank in Switzerland, has agreed to act as a clearing agent for clients interested in direct membership, and Banque Cantonale Vaudoise, a retail bank based in Lausanne that has a sizeable asset management business, has become an ISA Direct member.
Eurex Clearing also clears transactions in the repo market and offers ISA Direct for that market as well. Société Générale, another bank with a large client clearing business, has agreed to act as a clearing agent for ISA Direct members in repo clearing, and two firms—PGGM, a Dutch pension fund, and Ronin Trading Europe, a principal trading firm—have signed up this service.
Graulich said the reasons for the slow uptake are primarily due to the challenge of preparing new legal documentation, changing traditional client clearing processes, and coping with changing priorities such as new regulatory requirements and Brexit.
Swiss Life’s Grunow agreed that the legal complexities of the new system took time to address, as the ISA Direct model required the alignment of four different contractual parties. The new structure "had first to be to be fully understood by the lawyers and risk managers of the involved companies, which was time intensive," he said.
However, now that those regulatory details have been better understood and addressed by both sellside and buyside members, Graulich said he sees momentum growing for the new membership model.
He also emphasized that all ISA Direct members must meet strict admission requirements and in particular its credit standards. “Overall this membership type contributes to diversify the risk, making Eurex Clearing even more robust in crisis situations,” he said.
