Does negative interest rate threaten post-crisis derivatives reform?

Persistent negative interest rates in Europe, and potentially in the UK, could have serious consequences on post-crisis derivatives reforms.

Central clearing and increased margin requirements for OTC derivatives has been the cornerstone of financial reform across the globe. To guarantee trades and bring transparency to a previously opaque market, there is an emphasis on participants to post high quality collateral such as cash.

However, what we have seen over the last year is that holding cash is no longer profitable as a result of negative rates.

For clearing banks their business model traditionally relied on the interest earned on the cash initial margin posted by clients to supplement their clearing fees. When interest rates were at 6.5% in the UK before the financial crisis, this was a cash cow. Over time, the interest earned on client cash, rather than clearing fees, was the driver of profits for clearing banks.

Now it is completely different, with the interest on posting cash at record lows.

When clearing houses pay out interest on cash collateral, it is based on the overnight index. In the UK it is the daily sterling overnight index average (SONIA), while in Europe it is the euro overnight index average (EONIA).

As of 22 August, the EONIA stood at -0.34% while the SONIA stood at 0.2%.

The interest LCH’s SwapClear pays out on cash collateral, for example, is calculated by the benchmark index minus the spread (for sterling it is 5bps and euro 15bps).

Do some maths, for euros the interest is -0.34% – 0.15 = -0.49 (or negative 49bps).

So in fact for banks to post euro cash initial margin, the clearing house will charge them 49 basis points for doing so.

Whereas for sterling, 0.21%-0.05% = 0.16% or 16 bps. So while it is still slightly profitable to post sterling cash initial margin, it is nowhere near as profitable. And if the Bank of England goes down the route of negative interest rates, it could get worse.

The end result of all this is costs being passed down to the end-user, or buy-side, for complying with central clearing rules.

An example of this was seen last week when Royal Bank of Scotland decided it will charge its large UK clients for posting cash initial margin on their futures trades.

Current monetary policies by central banks are perhaps causing more harm than help. Negative interest rates, coupled with heightened capital requirements from Basel III, are putting enormous pressure on the FCM model.

With the number of FCMs in the space continuing decline and increased costs being passed down the chain, at the end of the day there will be one sucker to bear the brunt of it all: the end-user.