Category II Clearing: Expediting Readiness

The June 10 date for Phase Two of the OTC clearing mandate is fast approaching, yet a large portion of buy-side firms are still not ready. TABB Group estimates that 500 buy-side firms will fall under the Category II mandate and that 75% of them, or 375 institutions, will fail to meet the deadline. When looking at Separately Managed Accounts (SMAs), the universe is much wider, with as many as 3,000 funds still needing to get Know-Your-Customer (KYC) documents in place before an intermediary will set them up for clearing. This failure to meet the deadline will lead to a compression in US swaps trading activity and a liquidity drain of approximately US$55 trillion in notional terms.

May 15 is the absolute cut-off date for selecting a Futures Commission Merchant (FCM). This will give a buy-side firm a week to complete legal documentation, two weeks for account opening and, if it is lucky, a day or two for testing. Those commodity pools, hedge funds, and non-swap dealer banks that fall under the Category II definition but have yet to turn their attentions to clearing face a severe risk of being locked out of the swaps market after June 10. The same problem applies to those that should have complied with the Category 1 deadline of March 10 but managed to delay, as well as to those insurance companies that are reconsidering their Category III status. In practical terms, it takes three months to complete the process – from opening up a clearing relationship to the final testing of trades (see Exhibit).

Buy-side firms have to negotiate legal documents with FCMs, middleware providers, and Derivatives Clearing Organizations (DCOs), as well as executing brokers. From an operations point of view, they have to establish connectivity to clearinghouses, set up Legal Entity Identifiers (LEIs), and upgrade their trade management and portfolio reconciliation systems. For those firms only now turning their attentions to the clearing challenge, some of the stickier negotiations around collateral haircuts and margin financing will have to be foregone in order to expedite the onboarding process.

Questions abound. Will there be a legal bottleneck as players rush to comply with regulation at the last minute? How will a clearing broker’s time and resources for onboarding be allocated? Will some market participants be temporarily locked out of the swaps market come June 10? Will they have to find alternative ways to meet their investment objectives? Will firms that have prepared for clearing face liquidity challenges as latecomers create drag in the system? What will that mean in terms of their ability to manage risk effectively? Will the new infrastructure be able to handle the sudden escalation in clearing volumes? How will buy side firms handle portfolio risk in the event of a major market disruption?

The one thing we do know: the period of procrastination is over.