With mandatory central clearing of interest rate swaps set to take off with asset managers in Europe, it places LCH’s Daniel Maguire, global head of rates and FX derivatives, at the centre of change.
Buy-side participants at The TRADE Derivatives webinar universally agreed that the buy-side is ready for central clearing, and already have begun making changes to their operating models in order to comply with the rules.
However, according to a report from the Office of Financial Research (OFR) last month, it suggested bilateral trading could cost less than its centrally cleared equivalent despite new stringent margin requirements set to come into force.
Coupled with heightened capital costs associated with OTC client clearing for clearing brokers, it is now time for LCH’s SwapClear, the world’s largest clearing house for interest rate derivatives, to bring more to the table.
Maguire believes while it may be temporarily cheaper to trade bilaterally than through centrally cleared, the added benefits a central counterparty (CCP) will not deter the buy-side.
“It is hard to see that trading bilaterally will be cheaper than clearing in the long term. A lot of products are already subject to mandatory clearing, so trading bilaterally isn’t always a choice. That is the case in the US and increasingly in Europe too,” says Maguire.
“With central clearing, participants can benefit from services that allow portfolio optimisation through services such as portfolio margining, blended rate compression and multilateral compression.”
“If some trades in a portfolio are subject to mandatory clearing, it is likely that firms will clear as much of that portfolio as possible, in order to maximise capital, margin and operational efficiencies.”
As the initial margin requirements roll out in September for the US and Asia (and in early 2017 for Europe), Maguire believes the basis between the cleared and non-cleared derivatives markets will influence trading decisions.
“Uncleared derivatives will be subject to the forthcoming bilateral initial margin and variation margin rules, and consequently the cost of funding and margining may influence pricing on execution between multilateral cleared and bilateral uncleared trades.
“The margin requirements for uncleared derivatives may also serve as a tailwind driving up cleared volumes of some products such as FX non-deliverable forwards, which are not subject to a clearing mandate.”
Setting standards
Maguire explains that clearing houses can play a large role in bringing standardisation to the post-trade workflow such as compression and portfolio margining tools.
LCH went live with the latter in May with LCH Spider, allowing market participants to offset margin between listed derivatives positions and interest rate swaps cleared by LCH.
Currently Nasdaq NLX is the only listed derivatives exchange that is linked up to Spider, but CurveGlobal, the incoming interest rate derivatives platform from the London Stock Exchange Group (LSEG), will also go live on the service following its September launch.
Now three months on, Maguire says activity in the service is peaking with several potential users in the test-phase.
“Member onboarding is a gradual process but we have live customer participation on LCH Spider and several members testing the service. Adding further trading venues [such as CurveGlobal in September] to connect to LCH Spider could act as a catalyst to encourage more participants to use the service,” he explains.
With LCH eyeing more trading venues to connect to Spider, it could mean product expansion.
““We are currently live offering portfolio margining with short term interest rate futures [i.e. short sterling, euribor]. Subject to regulatory approval, we will look to add in the longer-term interest rates such as Bund, Bobl and Schatz, so portfolio margining is an emerging story.”
Maguire adds standardised elements in the cleared markets could also be translated to non-cleared markets, with the CCP playing an enhanced role.
“Some products may not be suitable for clearing on risk grounds. However there may be opportunities to bring some of the standardisation [such as compression] and efficiency you get in the cleared to the uncleared world.”
Clearing memberships
Yet with more activity going through CCPs, there has largely been a contraction amongst clearing brokers. As a result of heightened capital costs from Basel III, many banks that previously took on a whole range of clients have either made the cost of doing business with them higher or dropped them as clients.
Some clearing houses are exploring new ways to avoid this and to allow buy-side clients a direct path to the CCP.
Eurex have launched ISA Direct, allowing pension funds and insurance companies to establish a direct clearing relationship with the CCP.
Last year Citadel Securities, the market making arm of the Chicago-based hedge fund, shocked the industry announcing it had become a self-clearing member of SwapClear, prompting commentators to predict a rise in direct clearing for the buy-side.
However, Maguire is somewhat sceptical to this idea and does not see LCH adjusting its criteria for clearing membership.
“We continuously look at ways to safely widen access to clearing but have no immediate plans to offer a direct [buy-side] clearing model. It’s important to have the right structure in place to ensure members are able to honour their obligations and that all member interests are aligned in the event of a default,” he says.
“SwapClear has over 100 members, and we welcome any new member that meets our membership criteria. Citadel Securities were perhaps ahead of the curve in terms of non-banks joining the service.”
In addition, if global banking regulators look to revise the rules around client collateral and how they are treated under the leverage ratio rules this could make direct clearing models redundant.
“If in future, client margin is exempt from the leverage ratio, demand for buy-side direct access to clearing may diminish.”