Download Clearing house of the year

Reprinted from
RISK MANAGEMENT • DERIVATIVES • REGULATION
Risk.net January 2015
Clearing house
of the year
Clearing house of the year
LCH.Clearnet
“Right now, we are still in the foothills. But as we
move this to being a daily process and it’s embraced
by the buy side, sell side and clearing brokers, we think
this has the potential to have a seismic impact on the
market” Daniel Maguire, SwapClear
service to new owner London Stock Exchange Group in April, ending
more than a decade of industry control (www.risk.net/2344324). This was
required by the European Market Infrastructure Regulation (Emir), which
also pushed the firm to raise €320 million in capital in May. Emir
authorisation for the company’s London and French entities followed the
next month.
Last year also saw cleared notionals at SwapClear shrink for the first
time in its history – as of November, the service had $404 trillion in
cleared trades outstanding, down from $426 trillion in January. That is a
consequence of the total $250 trillion in notional that was compressed
during the year, with compression volumes climbing after the new service
came online.
Photos: Scott Williams
I
t’s easy to walk past the Mercer restaurant on London’s Threadneedle
Street without noticing it. A small sign hangs next to the door.
Framed menus sit on the wall either side, while window boxes and
iron railings obstruct the view from the street. Michael Davie, chief
operating officer of LCH.Clearnet, describes it as the ideal place for
breakfast – but not because of its unobtrusiveness: “They have paper
tablecloths that you can write all over,” he says.
This proved useful on occasions when Davie has tried to explain the
clearing house’s revamped swaps compression service. “I remember one
conversation in particular. We had been sat there for a couple of hours,
during which I had scrawled diagrams and charts all over the table to
explain how we’d remove trillions of cleared notional, when eventually he
just said ‘Ok, I’ve got it.’ Something clicked and he realised what this
meant for the industry,” says Davie.
What it means is a halving of the notional size of legacy interest rate
swap books, dealers predict, enabling banks to continue making markets
without hitting the ceiling imposed by the notional-based leverage ratio
(www.risk.net/2384166).
The launch of the new compression offering was the crowning
achievement in a big year for the clearing house. Dealers ceded much of
their power over LCH.Clearnet’s SwapClear interest rate swap clearing
Dennis McLaughlin, Daniel Maguire and Michael Davie, LCH.Clearnet
The key change has been the de-linking of trade records. Prior to
clearing becoming mandatory, there were occasions when counterparties
might have wanted to take a trade out of the CCP and re-bilateralise it. As
a result, trade records maintained a link between the original executing
counterparties, even though SwapClear was the legal counterparty to each
side of the trade. By removing these links – early in the year for clients and
in September for clearing members – it has become possible for each
participant in the system to compress its own portfolio of trades, rather
than seeking to agree tear-ups with other participants in the multilateral
exercises that had been in place since 2009.
This has paved the way for blended rate compression, enabling the
compression of trades that have different interest rates but the same
remaining cashflow dates. Unlike previous compression services, blended
rate compression can be done unilaterally and requires trades to be
de-linked so the original counterparty to each trade is not impacted by the
compression (www.risk.net/2386485). So far, SwapClear has de-linked US
dollar, euro and sterling trades. At the moment, the service is running two
cycles a week, but the CCP hopes to make blended rate compression a
daily process in the near future.
“Right now, we are still in the foothills,” says Daniel Maguire, global
head of SwapClear. “But as we move this to being a daily process and it’s
embraced by the buy side, sell side and clearing brokers, we think this has
the potential to have a seismic impact on the market.”
And not just in the way firms clear, but in the products available to
them as well. The idea is that the more standardised a trade is, the easier it
Reprinted from Risk January 2015
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is to compress. As compression increases in importance, participants may
embrace more standardisation, knowing they will also have more trading
capacity. But SwapClear believes it may be able to push this process along
a little faster than usual.
“Historically, when we look at clearing in over-the-counter derivatives
markets, we have cleared what the market observably trades. That has been
the mantra for some years, but with blended rate compression going
forward, the idea the market has to prove there is liquidity in a product
before it can be cleared will be turned on its head, and we will see some
adjustments where we may launch something that doesn’t have deep
liquidity today, but by clearing it you may improve that,” he says.
The revamped service could be a boon for dealers and the buy side alike.
For dealers, reducing gross notionals is imperative when it comes to
limiting the impact of the leverage ratio. Under the current exposure
method that is used to calculate a bank’s leverage exposure, outstanding
derivatives notional is added up with only partial benefit given to netting
– the larger the notional, the larger the capital requirement.
That cost of capital is passed through to clients on their own portfolios,
incentivising them to compress as well. Compression could also be key in
allowing non-banks, which do not clear for themselves and are reliant on
the limits provided by clearing members, to make markets in cleared OTC
derivatives. Market-makers tend to run flat books but clear large cumulative notionals of trades, so ongoing compression would help limit the
growth of those books, potentially making it easier to build a business
within the risk tolerance of clearing members.
“As you see more people coming in – non-traditional players making
markets – this is going to be a very important development for them and
there is a dialogue on that now,” says Maguire.
Compression is also beginning to change the way clearing houses talk
about market share. Historically, the principal measure of a CCP’s success
has been the open interest, or the amount of notional outstanding – now,
members are more likely to see growing notionals as a measure of failure.
“It’s something we have given a lot of thought to, because the yardstick
for the industry has been notionals outstanding,” says Maguire, who was
speaking late last year. “It’s got to the point now where we are confident
this is the first year in our history where the notional outstanding starts to
kick down. That turns things on their head. So, is the best, most efficient
clearing house the one taking in the most volumes or the one with the best
efficiency ratio?”
At SwapClear, 2014 saw an average of $484 billion notional and 1,596
trades cleared daily by buy-side market participants. This is alongside
increased activity on the dealer side, where there are now 98 clearing
members, handling an average of $2.53 trillion a day with almost 10,000
trades a day on average.
However you measure it, this has been more than enough to keep LCH.
Clearnet at the heart of the biggest debates in the industry. Recently, that
has involved questions of CCP recovery and resolution, especially around
notions of skin-in-the-game – the amount of its own capital a clearing
house should put at risk – and standardised stress tests.
LCH.Clearnet is opposing calls for CCPs to stump up more capital – a
case made most prominently in a white paper it published on December
4. That stance puts it at odds with some powerful firms, including
BlackRock and JP Morgan, and also earned a put-down from Jeffrey
Sprecher, founder and chairman of Ice, at a conference on December 10
(see page 8, www.risk.net/2386402).
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risk.net
Under European regulation, LCH.Clearnet is required to have 25% of
its own capital at risk in the default fund. In addition, pay for the clearer’s
top brass is tied to skin-in-the-game – if the CCP has to dip into its own
resources, senior management lose their bonuses – according to Dennis
McLaughlin, chief risk officer for LCH.Clearnet.
“That is a big statement for a CCP. It is making sure everyone is fully
focused on what the risk in the CCP is at any one time,” he says.
He argues that requiring CCPs to put more of their capital at risk could,
inadvertently, make clearing less safe. If a larger percentage of CCP capital
is at risk higher up the default waterfall, then the CCP may default before
even reaching the rest of the default fund.
“We are here to protect members against the default of other members by
mutualisation of resources, which ultimately comes back to whether our
“It’s got to the point now where we are confident
this is the first year in our history where the notional
outstanding starts to kick down. That turns things on
their head” Daniel Maguire, SwapClear
initial margin requirements are correctly sized, whether the default fund is
correctly sized and whether we have good protections in place. We have a
number of protections built into both quantitative and qualitative processes.
We are a financial market infrastructure provider – not a bank,” he says.
The second strand of the debate centres on whether standardised stress
tests should be deployed by all clearing houses. The European Association
of Clearing Houses is currently putting some proposals together, says
McLaughlin, but the project is in its early days. So far, there is agreement
that a set of historical scenarios for each asset class is required, before
developing a test that combines asset classes – but nothing more specific
than that – and thornier issues are waiting.
“It’s hard to do correctly, because some CCPs have a general default
fund across products, whereas we have split out products by asset class,” he
says. “So doing a stress test per asset class would be very different to doing
a stress test across all assets. It would be difficult to level that playing field
and design a stress test that does that.” R