ADVERTISEMENT

Wall Street Trading Costs to Surge as New Rules Hit Derivatives

Just 20% of buy-side firms have begun to examine the impact the new rules will have on their trading costs.

Wall Street Trading Costs to Surge as New Rules Hit Derivatives
A Wall Street sign hangs in front of American flags outside the New York Stock Exchange (NYSE) in New York, U.S. (Photographer: Victor J. Blue/Bloomberg)

(Bloomberg) -- Wall Street’s heavyweights are prepping their clients for bad news: Some trades are about to get a lot more expensive.

Firms including Citigroup Inc., Goldman Sachs Group Inc. and JPMorgan Chase & Co. are warning customers to get ready for new rules that require more collateral for certain trades. The regulations take effect for some clients in September, but the snare gets even tighter in 2020, when more than 1,000 hedge funds, asset managers and insurers will get caught for the first time.

The so-called uncleared-margin rules require banks and their clients to “exchange margin” for derivatives traded directly between participants instead of being cleared through an exchange. Citigroup is sounding one of the loudest alarms about potential fallout, saying in a recent report that, for one model it tested, fees at its foreign-exchange prime brokerage got 31 times more expensive if it passed along higher costs.

“It’s going to be really tough,” said Audrey Blater, a senior analyst at researcher Aite Group. “People are dragging their feet and kicking and screaming that they actually have to do something. Up until now, a lot of buy-side firms weren’t touched by the regulation to the degree that a bank is, so they’re not used to doing stuff like this.”

The regulations will hit the currency market particularly hard, because some foreign-exchange products are rarely, if ever, cleared through an exchange. While those products could eventually move to an exchange, transaction costs and low liquidity have held back many traders from making the change so far.

Wall Street Trading Costs to Surge as New Rules Hit Derivatives

In response to the regulations, Citigroup is proposing new fees for its prime-brokerage unit -- ones that would hit not only clients but also the brokers or banks they trade with, counterparties that until now had escaped such charges.

“All participants should share in these new costs,” Citigroup said in its report. Executing brokers “should pay their fair share.”

That idea has drawn mixed reviews. Some of Citigroup’s competitors say they won’t need to raise prices. Others, such as Societe Generale SA’s John O’Hara, say there’s no system in place to begin charging the executing banks, and those firms would pass the fee onto clients anyway.

“As far as charging the executing dealers, I don’t think that will get any traction,” O’Hara, head of prime brokerage and clearing in the Americas at Societe Generale, said in a telephone interview. Still, he acknowledged, “the costs of FXPB services are going to increase significantly.”

Cost Estimates

Just 20% of buy-side firms have begun to examine the impact the new rules will have on their trading costs, according to a June report from Greenwich Associates. Less than 40% of the firms would consider listed options for their currency trades when their firm becomes subject to the new margin rules, the study found.

“The only thing it can do is cause the cost of prime brokerage to me to go up,” said Michael O’Brien, director of global trading at Eaton Vance Corp. “I strongly believe that clearing is the primary solution for the uncleared margin rules when it comes to asset managers. There are a lot of complicated things to address, but I think you want to minimize the impact on the portfolio by minimizing the number of trades it impacts.”

Transaction fees and operational challenges were among the biggest obstacles to moving to a cleared model, based on responses to the Greenwich Associates study.

Wall Street Trading Costs to Surge as New Rules Hit Derivatives

“Our analysis suggests these hurdles are diminishing quickly and, in some cases, may be more perceived than real,” David Stryker, a principal at Greenwich Associates, said in the June report, which also noted that shifting to listed foreign-exchange options could reduce costs by as much as 70% per trade.

September 2020 is the deadline for the fifth and final phase of the new regulations, requiring firms with more than $8 billion in exposure to derivatives to begin socking away more margin, a threshold that will vastly increase the number of hedge funds and asset managers that would have to comply with the rules.

Here’s how banks and their clients are preparing:

  • First, banks have to identify which clients and trades will fall under the uncleared margin rules.
  • Then, all counterparties will have to negotiate how they’ll calculate the margin needed for each trade.
  • The uncleared-margin rules require all margin balances over $50 million to be stored at a third-party custodian. That means both parties will have to also select a custodian and get “on-boarded,” a process that can take months.
  • Market participants must set up infrastructure needed to ensure they can send collateral to the third-party custodian.

While big banks have long had large special units dedicated to managing their margin, many hedge funds and asset managers have little experience in this area. Smaller buy-side firms had at least one win this month: The U.S. Commodity Futures Trading Commission ruled that firms below the $50 million margin threshold don’t have to undergo the legal-documentation process.

“Phase 5 will have a big impact on the market because more of the buy-side will come into scope then,” said Ilene Froom, a partner in the financial-industry group at law firm Reed Smith LLP. “The documentation relief from the CFTC will be a big help.”

To contact the reporter on this story: Jenny Surane in New York at jsurane4@bloomberg.net

To contact the editors responsible for this story: Michael J. Moore at mmoore55@bloomberg.net, Steve Dickson, Daniel Taub

©2019 Bloomberg L.P.