You can't please all the people all the time, Abe Lincoln once observed. It is fair to say this year's clearing house of the year, LCH, understands this more than most.
The market shocks that followed the UK's vote to leave the European Union on June 23 – and the huge margin calls the clearing house made off the back of them – sparked anger among futures commission merchants (FCMs). Speaking at a Commodity Futures Trading Commission (CFTC) meeting on October 6, Wells Fargo said an unnamed clearing house had behaved "poorly" during the episode, while Citi also attacked procyclical margining following the vote. Those are grave charges to lay at the door of arguably the single most important institution in the global derivatives market.
Once the dust had settled, others took a more nuanced view of the episode, but were still critical, accusing the central counterparty (CCP) of everything from outmoded, overly conservative margin policies to poor collateral processing technology.
"They're just not a forward-looking, commercially orientated organisation," says one of the CCP's more polite critics, summing up the frustrations of many in the FCM community, who contrast it with the greater responsiveness they claim to receive from the major exchange groups – CME, Eurex and Ice.
The problem is, that doesn't stack up with the basic facts: by any stretch, 2016 was a stellar year for LCH. SwapClear's stranglehold on the cleared interest rate swaps market is overwhelming, and is still growing – from an average market share of around 85% in mid-2015 to around 95% by the end of last year. It has added to that a huge chunk of the cleared credit default swap (CDS) market too, and is to-date the only CCP clearing single-name financial CDSs. As the year drew to a close, it also announced ambitious plans that will see it make its swap curves available to banks and clients in the bilateral market, giving it a strong hand in shaping the future of the non-cleared market too.
Aggressive, commercially orientated rivals can only dream of LCH's numbers. Last year, SwapClear handled a record notional $665 trillion in rates business, comprising 3.8 million trades. It also eliminated $384 trillion in notional through compression. Its ForexClear unit – which will soon add functionality for Group of 10 non-deliverable forwards and, it hopes, a long-awaited solution for physically cleared foreign exchange options – handled $3.1 trillion in notional. CDSClear handled €782 billion worth of index credit default trades and €117 billion in single names.
We take our role as a systemically important institution incredibly seriously, and are somewhat less tolerant of risk-taking
Daniel Maguire, LCH
But above all its achievements last year, the CCP remains fiercely proud that it stuck to its guns during Brexit, and didn't expose itself or its members to what it sees as undue risk – for instance by extending credit to members, allowing for ad hoc netting of client margin calls, or leaving large amounts of cash on tap at commercial banks. Faced with the same situation again, the CCP would make the same calls, says Daniel Maguire, global head of rates and foreign exchange derivatives at LCH in London.
"We clear for the very biggest market participants, as well as the smallest. That's why we need to have the highest standards. We take our role as a systemically important institution incredibly seriously, and are somewhat less tolerant of risk-taking. However, we will always keep our processes under review to see if they can be improved. [But] putting 2016 into context, it was probably the first year we had a broad majority of the swaps market mandatorily clearing trades, coupled with the first real test we've seen of the post-crisis markets ecosystem. We stand here very proud that we withstood that and didn't skip a beat – and most importantly didn't change our behaviour, policies or processes," says Maguire.
The Brexit episode was certainly a test of the market's mettle. On June 24, the day after the Brexit vote, the 10-year US Treasury curve fell 29 basis points, while the UK 10-year gilt curve fell by 22bp – its sharpest intraday move for the past five years, and one of the steepest moves over the past two decades.
SwapClear's policy is to make a variation margin call to the losing side of trades – as measured by the market's move close-to-close – the morning after a move has taken place. This it duly did, making an £9.8 billion call on the morning of Monday, June 27.
But SwapClear also makes three intraday initial margin calls – dubbed market data refreshes (MDR) – requiring losing sides to top up their balances. Those calls, which totalled roughly £10 billion on June 24, caused panic among FCMs, with at least one forced to pony up as much as $1 billion within an hour of the first call being made at 3am New York time.
The call was split roughly evenly between banks' own books and their FCMs' client business, says Maguire. But the aggravating factor for the latter camp was likely the frantic conversations they were forced to have with their buy-side clients, as the cash calls continued to come in. "Every trading desk we spoke to said we did the right thing," he says.
Three large buy-side swaps users Risk.net spoke to for this article confirmed their FCMs called them on June 24 to ask for funds – a rare step, given clearing brokers are supposed to handle intraday funding needs on behalf of their clients. Some say they were happy to help out and met the call – some that they politely told their FCM where to get off.
Although we didn't instigate this with the aim of reducing intraday funding costs, it is clearly part of the solution
Bruce Kellaway, LCH
Some FCMs take a more cold-blooded view of the day's events. Everyone knows the rates sensitivity of their cleared portfolios, they argue, and should have modelled that against a likely shift in the curve in the event of a Leave vote. If FCMs had stress-tested appropriately in advance, there'd be no excuse for not knowing their potential intraday funding obligation, the argument goes.
From LCH's perspective, the equation is simple: if an FCM has 20 clients – 10 long, 10 short – there may be no need for the FCM to top up its MDR after a big move, since the longs will simply net off against the shorts. But that would assume the losers will pay the winners that day; if the FCM were to default and LCH inherited its client positions, and the payments had yet to be made, it would be short money it thought it had. At that point, the CCP would be forced to mutualise the loss and tap its default resources. So instead, LCH assumes the worst-case scenario: it calls the shorts, and holds onto the gains.
European regulations require LCH to reinvest 95% of its cash balances into the repo market, creating a lag in handing back gains to clients posting dollars, LCH acknowledges – but here, the CCP has demonstrated a willingness to make improvements reasonably swiftly where it can. One change in the aftermath of Brexit saw it bring its final MDR forward, from around 7pm London time to 5pm – midday New York time – to ensure US dollar collateral received could be reinvested in the US repo markets that night, rather than the following day.
Then on November 3, it began allowing FCMs to use excess margin held in their account to cover MDRs, provided they explicitly affirm the cash is theirs, not their clients', and hence is not subject to asset segregation rules.
The timing was thoughtful, says Maguire, with the US presidential elections approaching on November 8. With markets whipsawing on November 9 as they struggled to digest the shock of Trump's election, the six FCMs making use of the facility gained a combined credit of $500 million on election day, according to LCH. The functionality was used 66 times that month in total by seven FCMs, who gained a cumulative credit of $3 billion.
Another change that should have a significant impact on dealers' intraday funding burden is already in train. This week, LCH began formally consulting on plans that will allow buy-side clients to systematically over-collateralise above their baseline initial margin requirement, to a level they would expect to face during a stress scenario, for instance by pledging otherwise dormant assets held in segregated accounts as margin. It hopes to make the service available during the first half of this year.
The change, which has been in train for over 18 months, was designed to prevent big, directional buy-side rates users from being outsized contributors to an FCM's overall margin contributions. But given such players are also the biggest losers from any sharp, adverse change in rate expectations, such as those following Brexit or Trump's election, it will also help reduce the intraday funding burden clearing for such firms places on FCMs.
"It's really designed to target players with concentrated directional risk, which we'll probably see more of over the course of the next year, as positions in the clearing book become more mature. Some clients will be long assets, and will be very happy to pledge them. That will reduce the intraday funding burden on the FCMs, and they will presumably reflect that through pricing. But we're neutral. Although we didn't instigate this with the aim of reducing intraday funding costs, it is clearly part of the solution," says Bruce Kellaway, London-based global head of RepoClear, EquityClear and collateral at LCH.
LCH, though, sees all of its changes through the prism of its safety-first approach; it can adjust its policies to help straighten out kinks in the pipe, but it won't fundamentally reappraise them.
"We think our margin processes are replicable and predictable; people are entitled to different views, but from a systemic risk-reduction perspective, we think our approach is the right one. We're not clearing non-linear products with illiquid collateral and extending intraday credit," says Maguire.
The week on Risk.net, March 10-16 2018Receive this by email