How U.S. Treasury central clearing will reshape trading documentation

Client profiling and communication

The complexity of contracting and onboarding stems from the variation of documentation across different client profiles. Each profile may have unique regulatory, jurisdictional and operational (e.g., netting and accounting) considerations. The chosen market access model also will require documentation tailored to the client. Participants will need to be mindful of the initial decisions that are made to comply with the rule. The interconnection of the areas mentioned above will impact the type and volume of documentation that will be required. 

Client profiling should include:

• Reviewing U.S. Treasury cash and repo data to determine trading activity subject to the mandate
• Classifying clients by biographical profile (e.g., trading volumes, jurisdiction, credit risk)
• Identifying accounts (e.g., 40 Act funds, corporates) that will enter the cleared U.S. Treasury market and engaging with those clients to discuss the implications
• Determining potential market access models for each client profile

A plan should be established for executing client communications and education initiatives that clearly explain market structure changes and prepare clients for the shifts ahead. Additionally, there will likely be new entrants into the clearing space besides Fixed Income Clearing Corporation (FICC) that intend to offer centralized clearing. At the outset, market participants will need to understand the various contingencies to completing their suite of documentation, including existing and new market access models, decisions on existing clearing documentation, as well as the expected contracting timelines for the updated suite of trading agreements.

Implementing onboarding and support processes for a smooth transition also is critical in this first phase. Onboarding activities should include:

• Gathering impacted documents based on client profiles to set up clearing relationships
• Collaborating with legal teams to make the required enhancements to new and existing templates
• Determining a tracking methodology for onboarding and operational setup
• Selecting technology enablers for the management and tracking of clearing application submissions
• Implementing a process to ensure all necessary activities to establish cleared relationships are completed

Completion of this first phase will inform legal teams on how to approach legal artifact creation and negotiation in the ensuing stages.

Legal artifact creation

Though the Securities Industry and Financial Markets Association (SIFMA) has released a standard clearing agreement template, financial institutions should view this as a foundational framework with a two-step customization process. First, firms should tailor the templates to their own operational and risk needs. Then firms may need to create variations based on client profiles. Additionally, many market participants already use the clearing services provided by FICC and have the documentation in place. This documentation facilitates their relationship with FICC and with the sponsoring member, who acts as the processing agent and provides clients with access to central clearing services. This documentation may need to be amended or recreated based on the offering of new access models and clearing houses.

Additional guidance and negotiation artifacts may need to be created for the different profiles. These include:

• Applicability matrixes
• Drafting and negotiation playbooks with preferred terms and fallbacks
• Escalation matrixes
• Guidance on ERISA, tax, jurisdictional analysis, representations and warranties, and other considerations.

As the market matures, firms also should prepare for the continuous evolution of documentation standards and artifacts. Historically, templates and enablement artifacts evolve over a period of years in reaction to evolving markets, regulatory changes and specific client scenarios. However, the U.S. Treasury central clearing compliance deadline significantly compresses this timeframe into a matter of months.

Negotiation

Firms will face a balancing act as they seek to create a template with their preferred language that anticipates friction points with clients as well as a client-friendly template that aims to reduce the amount of negotiation required. As new clearing houses enter the arena, decisions will also have to be made regarding such things as cross product margining and additional or amended documents for existing clearing participants. While it’s impossible to predict which provisions will become potential areas for negotiation friction, we believe the provisions below will likely require increased attention by negotiators:

• Cross-default
• Cure periods
• Set-off and cross set-off
• Mini close-out
• Limitation of liability
• Collateral, rehypothecation and security interest
• Representations, warranties and covenants