Eurex to offer full segregation in March launch of OTC clearing

Eurex Clearing, the central counterparty belonging to Frankfurt-headquartered Deutsche Borse, will launch over-the-counter interest rate swap clearing for both dealers and clients at the end of March. The clearing house will be the first to offer full physical segregation, meaning client collateral is held in individual accounts, separately from the CCP member firms that handle those assets – which Eurex hopes will be an advantage in the post-MF Global environment.

“Clients have recognised in the past few months that individual segregation secures their collateral and ensures portability after a default of their clearing member. That is one of the most important aspects of the segregation offering,” says Jens Quiram, project manager for client asset protection at Eurex Clearing in Frankfurt.

The OTC offering is an extension of the CCP’s existing individual segregation model, which was made available to users of Eurex Exchange and Xetra, Deutsche Borse’s electronic securities trading system, last August, but users will have a choice of three different levels of segregation.

In the late second or early third quarter, the CCP plans to roll out a net omnibus approach, comparable to the existing futures model. Under this model, all client collateral is pooled by the clearing member, which posts the net margin requirement across the entire portfolio, to the clearing house. That should reduce margin costs, but leaves clients sharing risk with other users of the omnibus account – if one of them collapses, other members of the pool will see their collateral eaten into .

“There was special appetite in the UK market for this service, and we plan to introduce it following the client assets rules of the Financial Services Authority (FSA),” Quiram says.

The third option is known as gross omnibus segregation – analogous to the legally segregated/operationally commingled (LSOC) approach endorsed in the US by the Commodity Futures Trading Commission last month – in which client margin is passed directly from clearing member to CCP without netting across client positions. In theory, this approach provides less protection than individual segregation, but is more robust than the net omnibus model. Eurex plans to add it as an offering towards the end of 2012.

The CCP says the roll-out is in response to a surge of client interest in full physical segregation. “The demand for segregation increased in particular after the bankruptcy of MF Global,” says Matthias Graulich, the CCP’s head of clearing initiatives. As in the US, clients with a fiduciary duty to protect their assets and investments are leading the charge: “Fund managers should preferably use the individual clearing model, as the omnibus model does not offer them full protection and timely portability. In an omnibus model their assets are to a certain degree at risk if a clearing member fails, which is problematic for fund managers given their fiduciary role,” he adds.

But Basel III, which offers a rock-bottom 2% risk weight to cleared exposures under certain circumstances, has also had a hand in nudging European clients towards the highest level of segregation they can get. “Under Basel III, small and medium-size banks, for instance, can receive the preferential 2% risk weight for their cleared portfolios, even if they are clients rather than direct clearing members. They can get that preferential treatment through our individual clearing model, because full protection and portability is ensured,” says Graulich.

Attempting to provide this assurance is why Eurex is backing full physical segregation.  “In the individual clearing model, client assets are segregated in an account to which we have an entitlement, so it’s not like in the US where assets are segregated at the futures commission merchant level. This is a prerequisite to ensure timely portability. As the CCP, we have full access and clarity about client positions and the collateral attached to them, which enables us to transfer them to another clearing member without interference with the defaulting clearing member or administrators,” says Graulich.

But the CCP’s enthusiasm for full physical segregation is undercut somewhat by clearing members’ reluctance to embrace it – potentially restricting clients’ access to the model. When pushed, dealers say they will consider offering full physical segregation under a set of provisos – including a full transfer of their costs to the end client – but none seem keen.

Dealers pin this to the prohibitive cost of the full physical segregation model – the International Swaps and Derivatives Association has estimated it would be almost 10 times more expensive operationally for clearing members to offer full segregation than LSOC.

And it’s not just dealers that think greater segregation means steeper costs. “Under full physical segregation, there are additional accounts, and there are as many of those as there are clients who want to take advantage of the service,” says Kim Taylor, president and managing director of CME Group’s clearing house. “There will also be additional transactions as a result. It is likely those costs will be passed on to the client – they will have a chance to make a decision about whether or not they want to bear those costs relative to the additional protection they’re getting.”