Wednesday’s decision by LCH.Clearnet to increase the margin required for Italian bond exposure has highlighted the potential costs and liquidity problems market participants could face as a wider range of instruments are centrally cleared.
The Anglo-French clearer’s risk department took the decision to raise the amount of collateral that clearing members need to post against positions in Italian bonds based on factors relating to prevailing volatility and liquidity. LCH.Clearnet’s decision forced market participants, including institutional investors, to find suitable liquidity that could be used to cover the increased collateral requirements, a situation that could become more common as a greater number of swaps are centrally cleared.
“As more derivatives move to a central counterparty (CCP) clearing model, the margin call for Italian bonds could easily be repeated in other parts of the market if counterparty risk concerns continue,” observed Gert Raeves, research director at consultancy TowerGroup. “This isn’t just an administrative burden. It will increase the cost of capital and reduce the amount of cash available for participants to transact.”
According to Raeves, margin calls like the one made by LCH this week present an immediate cash flow challenge for traders. To meet increased margin requirements, market participants are required to post more collateral, either in the form of cash or specific instruments depending on individual clearing house rules. This could require them to liquidate assets quickly or call back securities that are on loan.
The increased margin call is believed to have had an instant impact of Italian bond yields, which jumped 0.73 percentage points to 7.48%, shortly after the LCH announcement, taking the cost of borrowing for Italy above the levels of Portugal and Ireland were forced into a bail out.
According to guidelines from LCH.Clearnet issues last year, increased margin calls can be triggered if the spread between a country’s bond yield and a basket of AAA-rated sovereign reaches 450 basis points for a specific period of time. When contacted by theTRADEnews.com, LCH emphasised that these were only guidelines and decisions on margin calls are made on a case-by-case basis.
There was also a knock-on effect on Italian equities as many investors sought to dump their holdings in Italian banks, which hold the highest proportion of Italian government debt. At the end of September, for example, Italian banking group Intesa Sanpaolo held around €63 billion of Italian debt securities across its banking and insurance businesses, according to its Q3 results. According to figures from multilateral trading facility BATS Europe, there was €3.2 billion worth of Italian blue-chips traded on Wednesday, over €1 billion higher than the previous day.
In line with the Group of 20’s commitments in 2009, US and European regulators are close to finalising rules that will require more OTC derivatives to be standardised and cleared through central counterparties. The new rules, which are due to come into force at the end of next year, are being enacted through the Dodd Frank Act in the US and the European market infrastructure regulation.