Storm warning

The clear skies over most of the UK yesterday gave welcome respite to those whose homes and businesses have been damaged by weather conditions not experienced in this green, pleasant and – let’s face it – wet land for decades if not centuries. Whether Sunday’s calm and sunny aspect proves to be just a momentary break in a prolonged assault, or the beginning of the end of this winter’s unprecedented levels of wind and rain, the mopping up operation will take many months in the worst affected areas. Political storms will continue to rage, in all likelihood, over the culpability of a coalition government that appears to have prioritised debt reduction over investment in flood defences, despite mounting evidence of climate change, manmade or otherwise.

Wisdom after the event is always a lot easier than thorough planning, investment and due diligence in the calm before the storm. In the financial markets of course, no one is in the mood to ignore warnings of storms ahead, given the dark clouds that have rained down on the industry with a regularity that west country farmers understand only too well. If anything, there have been so many alerts that certain financial institutions may already feel like flood-threatened householders, rapidly running out of sandbags with which to block out the rising water levels. For residents of Somerset or the Thames Valley, their damp misery is compounded by successive bands of rainclouds, for financial institutions, wave after wave of scandals, missed revenue targets and regulatory reform pile on the pressure.

In both cases, resources to handle still more problems are constrained. But that doesn’t make the problem go away. Somehow, a way must be found to cope with new rainclouds on the horizon, even as the floodwaters rise at our feet. Once such impending thunderstorm is currently menacing both asset managers and banks active in the interest rate swap markets. We all know that interest rate swaps is by far the biggest of the over-the-counter derivatives markets that are currently being migrated to central reporting and clearing, and ultimately execution on electronic trading venues. In a recent interview, a sourceestimated that as many as 7,000 banks in Europe alone have some kind of interest rate swap on their books, all of whom will need to establish the ability to centrally clear these instruments as a central clearing mandate comes into force early next year under the European market infrastructure regulation (EMIR).

But despite the size of the market, there are rising fears of capacity restrictions when it comes to firms willing to centrally clear interest rate swaps in Europe. The reason is uncertainty of the risk / return outlook for clearing swaps to Europe’s central counterparties, who are currently undergoing re-registration with the European Securities and Markets Authority, while also reshaping their risk models and service offerings in line with EMIR. At this point, therefore, it is relatively unclear whether brokers can guarantee access to the level of asset segregation their clients want at the price they want to pay, nor is their ability to eliminate transit risk entirely obvious. Interest rate swaps might be the one of the world’s biggest financial markets, but notional outstanding is very different to deal flow. While some of the many thousands of financial institutions active in the interest rate swap market may have 2,000 open positions, others may have just two. If you’re only active perhaps 20 times a month, it’s likely that clearers will only be interested in your interest rate swap business as part of a wider relationship. Perhaps 12-15 firms are offering to clear OTC derivatives business in Europe at present, for most of whom it is not a core business. This means that the most active 75-100 participants in the interest rate market will have little problem finding a willing clear, but others might find limited appetite.

Just as there are many ways of protecting yourself from bad weather, there are a number of appropriate responses to constrained clearing capacity in the interest rate market. Some might simply take a more relaxed approach to hedging their interest rate exposures, with good reason expecting major central banks to little change their policies in the next three to five years. Other means of hedging interest rate risk are available of course, including from the insurance market. Competition is driving innovation in the exchange-traded market, with interest rate futures a particular area of focus for new venues in the European market. And the supply of OTC clearing services from the sell-side may well increase as the emerging environment for trading derivatives in Europe becomes more certain. 

Estimates vary on when this storm will break, with some expecting European central clearing of interest rate swaps to be a regulatory requirement by this time next year. But asset managers are probably wise to intensify their planning now to avoid being caught in the rain in 12 months’ time.