A basis which could significantly widen the cost of clearing interest rate swaps between central counterparties (CCPs) could spread to Europe, according to industry experts.
The basis, which is the difference in price to clear between two CCPs, has become a leading topic amongst market participants.
Last year in the US, the basis between CME Clearing and LCH.Clearnet for USD interest rate swaps widened dramatically, with the price of clearing at CME increasing 17 fold for a period.
Earlier this month, a basis emerged between LCH and the Japanese Securities Clearing Corporation (JSCC), with the price of a 10-year receive-fixed swap at the Japanese clearing house increasing nearly fivefold.
According to a recent blog from ClarusFT, the causes of the basis increase could be due to changes in the initial margin at the JSCC, which caused market participants to rethink the size of their portfolios at each CCP. Another trigger could have been the approval from the Japanese regulator to allow LCH’s SwapClear to clear non-JPY interest rate swaps on behalf of local banks.
Now with activity set to take off in European clearing houses with the central clearing mandate, there are increasing concerns of a potential basis between European CCPs significantly increasing.
“You are clearly going to see widened basis spreads between clearing houses in Europe as mandatory central clearing rolls out, and it is certain you will similarly come to see a widened spread between US and European markets where the same products are traded,” says Joshua Satten, director of business consulting at Sapient Global Markets.
Satten says the issue has become very specific to both the interest rate swaps market and with LCH themselves.
“The fact that LCH SwapClear was founded with the banks and operates a clearing service that’s specifically focused on interest rate swaps and on global positioning across geographies has really placed them to offer the lower cost basis,” he adds.
LCH’s SwapClear is the dominant clearer for USD-denominated interest rate swaps; however there are new entrants in the European market that could bring increased competition to pricing.
“If you look at IDB data, you are starting to see some evidence of Eurex and LCH basis start to emerge,” says Hirander Misra, CEO of GMEX.
“As Eurex is a new offering in terms of IRS clearing, it is really too early to look at the basis between Eurex and LCH on euro-denominated interest rate swaps. A more apples with apples comparison will be possible after the advent of mandatory clearing for category two clients at the end of the year, which will likely see a pick-up of Open Interest in Eurex.
“Experience of LCH/CME suggests that such basis will likely exist over time.”
The basis is also a reflection of the increasing influence cost has on flows between clearing houses.
According to a report from TABB grouped published earlier this year, it found asset managers are beginning to realise that their choices regarding where to clear will affect overall dealer margin and settlement costs on the back end.
As a result, a potential transregional basis could appear between any two CCPs.
“This has the potential to appear between any CCPs where there is significant liquidity and where there is a structural imbalance between the CCPs’ respective positions,” adds the head of one European OTC clearer.
“The perceived market wisdom is that with big enough positions and a big enough structural imbalance basis can happen anywhere.”
If the cost of clearing continues to widen, the effect it could have on banks providing client clearing to buy-side firms will be harmful.
“As we have a widening cost basis between different clearing houses and geographies, the bank’s ability to provide good pricing to [buy-side] clients that want to trade or use them for client clearing is affected due to cost and profit pressures,” adds Satten.
“If the cost to trade the same contract is different on each exchange and clearing house in different regions, it becomes much harder to manage margin accurately versus execution and almost impossible to move trades through portability from one FCM or clearing house to another to achieve true portfolio optimisation.”
In the long-term, clearing activity between CCPs will most likely be influenced by costs. However in the short-term, CCPs will have to differentiate themselves on value-added services to retain activity such as compression services, cross-margining, and efficient default protection models.