Risk Awards 2016
Once regulators decided to make the clearing of interest rate swaps mandatory, there were plenty of people who predicted the market's sole, sleepy swaps clearer would lose out to tough, street-smart futures exchanges such as CME Group.
LCH.Clearnet's SwapClear might have had a monopoly on interdealer business up to that point, but when clients had to start clearing for the first time, the argument went that they would go elsewhere, with dealers following to preserve their netting efficiencies.
So far it has not worked out that way. In fact, dealers have started quoting certain US dollar swaps more cheaply if they are being sent to SwapClear than if the client chooses CME – a basis that emerged abruptly and widened to 2 basis points in the space of a few trading days last May. Far from sapping SwapClear's gravitational pull, competition seems to have strengthened it. On January 27, the basis between the two clearing houses was 3.9bp for 30-year US dollar trades.
"It's definitely a symptom of, and vindicates, everything we've being doing," says Daniel Maguire, global head of SwapClear and listed rates at LCH.Clearnet. "It's a good indication that what we've been doing and, let's be clear, what we'll continue to do, has led the market to represent the differences between the clearing houses through pricing."
The LCH-CME basis is a function of supply and demand. CME's client base is largely comprised of asset managers that pay fixed at the Chicago-based central counterparty clearing house (CCP). But dealers struggle to find offsetting trades at CME, and so must receive floating at LCH.Clearnet, which offers a deeper pool of interdealer liquidity.
Faced with a build-up of directional exposure – and associated margin costs – at CME, dealers began to reward clients that clear pay-fixed swaps at LCH.Clearnet with better prices in an effort to balance the books.
At a basic level, it's supply and demand. But if we were not innovating, not developing new products, not offering compression, not friendly with all participants, I'm not sure this outcome would have prevailed
Daniel Maguire, LCH.Clearnet
While LCH.Clearnet does not control the basis, Maguire insists the firm deserves credit for building a better mousetrap. "In 2010, I remember we were telling anyone that would listen to us – and various people that didn't want to listen to us – that the structure and economics of clearing means, mathematically, it could lead to differential pricing by CCP," he says.
"At a basic level, it's supply and demand. But if we were not innovating, not developing new products, not offering compression, not friendly with all participants, I'm not sure this outcome would have prevailed," he adds.
There is some truth to this. Dealers clearly value LCH.Clearnet's services, most notably its compression offering, which helped to eliminate almost $100 trillion of notional outstanding from dealers' balance sheets in 2015. But the firm's real success has been in keeping those clearing members loyal, even when it became cheaper to clear receiver swaps at CME – instead of sending more business to Chicago, dealers used their pricing power to encourage clients to pay fixed at LCH.Clearnet.
The results are plain to see. SwapClear handled 83,413 buy-side trades in June 2015 – more than double the 35,919 client-cleared trades it saw in June 2014. Its market share jumped from 68% in May 2015 to 85% in July.
Importantly, the CCP was able to take the surge in volume in its stride. "From a business sense, of course it's been a successful period," says Maguire. "But, on the one hand, you celebrate success because you've got more business, which is fantastic, but the other side is everybody across the planet [is] looking at CCP stability and resiliency. Had we taken in all this volume, and had big outages and issues, then there would be some question marks, but we've taken in a doubling of volume in a very short period of time with absolutely no notifiable issues. That for us is the big success. It feels we've demonstrated our ability and our scale - we can absorb peak flows and changes day to day, and continue to operate as a reliable, resilient CCP. We're quietly proud of that."
To date, the basis has only affected US dollar-denominated swaps. But with mandatory clearing set to kick off in Europe on June 21, 2016 – among dealers, with clients to follow in three phases from December – similar forces could be at play in the euro market. Maguire believes the CME-LCH basis is here to stay, but concedes it is too early to say how it will play out in Europe.
"We don't take the basis for granted. In Europe the features and the market structure could be different. I'd expect there will be some basis emerging in Europe, but which way it goes is an interesting one. I guess it depends on similar dynamics in terms of which venue or venues are successful, and what flows they have currently and in the future. So I wouldn't call when it happens or even the size or the direction, but I would be confident there will be some form of basis that emerges."
Standardised stress tests
Maintaining the loyalty of clients sometimes requires LCH.Clearnet to ruffle feathers. In 2015, the firm spoke out strongly in favour of standardised stress tests for CCPs – a stance that pitted it against its peers, which are mostly in favour of allowing clearing houses to design their own stress tests.
Dennis McLaughlin, chief risk officer at LCH.Clearnet Group, says clearing members support the idea. "I can't tell you the number of banks that come to me with their teams and say, ‘Here's a list of questions we'd like you to answer.' Goldman, JP Morgan, Citi – you name it, they've all been around. Another bank will come in the following day and say, ‘Guess what? We've just had our board meeting. You're our top exposure, so the board is very eager to know how you're doing this, this and this – can you please fill out this questionnaire?' So it makes sense to have one template internally to give to everybody that asks," he says.
McLaughlin goes so far as to question the motives of the CCPs opposing standardised stress tests.
There are three factors that explain pretty much everything and so you might as well just look at those three factors. It's based on the idea of a reduction of the sheer scale of the numbers you have, down to something very manageable, where you don't need all this infrastructure to drive it
Dennis McLaughlin, LCH.Clearnet
"If you get any bunch of risk managers in a room and ask them what the stressed events over the past 10 years were – for example, in the rates or the repo market – they all pretty much agree," he says. "If you have different stress tests, and you're not covering one of those severe moves you've seen in the last decade, it can be very difficult to argue. But I do know of one example of a CCP that failed and hadn't included the 1987 stock market crash. If you were disclosing that, it would raise all sorts of questions. I'm not sure all CCPs would pass that test, so obviously there's a reluctance to shine a light on it."
To make its own stress-testing regime simpler, and less demanding computationally, the CCP switched over three years ago to an approach based on principal component analysis (PCA). Instead of analysing the impact of changes at every point of the curve, PCA focuses on a handful of factors, such as the steepness of the yield curve, that play the biggest part in determining the value of a portfolio.
"There are three factors that explain pretty much everything and so you might as well just look at those three factors. It's based on the idea of a reduction of the sheer scale of the numbers you have, down to something very manageable, where you don't need all this infrastructure to drive it," says McLaughlin.
While regulators debate the merits of standardised CCP stress tests – both the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions announced a formal review in March 2015 – LCH.Clearnet plans to release the results of its own stress tests to the public this year. McLaughlin hopes this will encourage other CCPs to do the same.
The firm believes it will pass any standardised stress tests imposed by the regulators with flying colours.
LCH.Clearnet applies a 99.7% confidence level in its methodologies for calculating initial margin across all asset classes – well above the 99.5% level for over-the-counter swaps mandated by the European Market Infrastructure Regulation.
The firm has also established a policy for porting client positions in the event of a clearing member collapse, which addresses a key difference in the EU and US regimes. In Europe, CCPs have full discretion when to close out a client position in a defaulted member's portfolio, while Dodd-Frank requires clearing houses to gain permission from a bankruptcy administrator before doing so. To smooth the process, LCH.Clearnet assumes it will need seven days' worth of margin from client trades, rather than the minimum five for OTC derivatives, to cover any potential delay in porting the positions.
"It's clear we don't have an exact estimate of how long that would take. That extra time is to cover the porting of the client member in the event the member has defaulted," says McLaughlin.
LCH.Clearnet has also adopted other risk management practices, which it argues are more conservative than those of some rivals. For example, it segregated its default resources into asset-specific pools to mitigate idiosyncratic risk. Until 2012, the firm had a general default fund for all products, totalling £640 million, of which £125 million was earmarked for SwapClear. When those funds were segregated into asset-specific pools in April 2012, LCH.Clearnet's combined default resources ballooned to £4 billion. This figure now stands at £5.5 billion, with the SwapClear default fund accounting for £2.5 billion of the total.
LCH.Clearnet became the first CCP to offer clearing for inflation swaps in April 2015, following a three-year design, build and the approval process run by the European Securities and Markets Authority – the first such approval to be granted by the authority.
"We undertook what I can only describe as very exhaustive, very comprehensive risk and liquidity reviews, default management fire drills, tests for new members, [and] backtesting through war times and peace time," says Maguire. "We probably hoped it would be a little bit quicker than three years, but we're committed to safe and controlled innovation, and the pressure on that is increasing every day. I think it's right that clearing houses have a lot of oversight, and that we give a lot of visibility and transparency."
Currently, LCH.Clearnet has 32 members, including 16 end-users, who clear inflation swaps on SwapClear, with $337 billion of trades in notional terms having gone through the platform from April-December 2015.
Maguire deems the foray into inflation clearing a success, albeit one that caught him by surprise. "It has definitely surpassed any of our expectations as the take-up and the product adoption were extremely strong from the start. It's been somewhat surprising in terms of the speed at which that happened," he says.