Clearing, Collateral and Allocation of an OTC Swap
Aldergate Asset Management is an FCA-authorised investment firm managing several funds. A portfolio manager executes a £75m notional 10-year fixed-to-floating GBP interest rate swap with a non-UK bank to hedge a fund's liability. The swap is in a class subject to the UK clearing obligation. Aldergate is a financial counterparty; the bank is a third-country counterparty. The trade is initially booked bilaterally and not sent to a central counterparty because the bank says 'the trade is hedged and the fund is professional'. The following day the same trader executes two offsetting swaps for two funds at prices 3bp apart, and allocates the better price to the fund with the higher performance fee. Compliance also finds the bank's CSA has a £10m threshold and no initial margin posted. The COO asks whether the trade must be cleared, how collateral should be handled, and whether the allocation is acceptable.
1. Determine whether the swap must be cleared. Does the bank's 'hedged and professional' explanation create an exemption? What should Aldergate do if the trade should have been cleared?
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The starting point is the clearing obligation, not the bank's description. The swap is stated to be in a class subject to the UK clearing obligation and Aldergate is a financial counterparty. A fund being 'professional' and the trade being 'hedged' do not, by themselves, exempt it. The third-country bank raises a separate question: Aldergate must confirm whether the bank is in scope, whether an equivalence or exemption applies, and whether any intragroup or pension-scheme exemption is available. Absent a recognised exemption, the trade must be cleared. Bilateral booking because the bank says it is hedged is not a valid basis. If the trade should have been cleared, Aldergate should escalate to compliance and legal immediately, clear or terminate/replace the trade as soon as practicable, preserve records, assess whether the breach is reportable to the regulator, and remediate the control that allowed bilateral booking. The fund should also consider whether the delay created counterparty exposure or valuation differences.
2. Assess the collateral arrangements: the £10m CSA threshold, no initial margin, and the fact the trade was booked bilaterally. What should Aldergate require?
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If the trade is cleared, the CCP will impose initial margin and variation margin; the bilateral CSA is not a substitute. For any non-cleared covered derivatives, Aldergate must check the applicable margin rules: variation margin is typically required to be exchanged daily on a zero-threshold basis, and initial margin may apply above a regulatory threshold. A £10m CSA threshold with no initial margin is likely inconsistent with mandatory variation margin and may leave the fund undercollateralised. Aldergate should require daily valuation, daily variation margin, legally enforceable CSA/netting opinions, eligible collateral, haircuts, segregation of fund collateral, and a clear dispute process. Client money and fund assets must be segregated from Aldergate's own assets and from the bank's assets. The fund's collateral should be held with an appropriate custodian or cleared through the CCP. The COO should also investigate why no initial margin was posted and whether the bank's credit risk is within the fund's limits.
3. Evaluate the allocation of the better price to the fund with the higher performance fee. What conflicts and remediation issues arise?
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Allocating the better price to the fund with the higher performance fee is a conflict of interest and likely a breach of the duty to treat funds fairly. The 3bp difference has a real value: on £75m notional, 3bp is £22,500 per annum, and it belongs to whichever fund should have received the execution. A pre-trade allocation policy should specify how partial fills and price differences are allocated-typically pro rata, random or in accordance with a documented order of priority-and should not favour the manager's fee income. The trader's action also raises best-execution and record-keeping issues. Remediation: reverse or compensate the disadvantaged fund, disclose the error to affected clients where required, report to compliance and possibly the regulator, review the trader's conduct, and test whether similar allocations occurred. The bank's assertion that the fund is 'professional' does not cure the clearing breach or the allocation conflict.