Survey
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
* Your assessment is very important for improving the workof artificial intelligence, which forms the content of this project
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 1 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). 2 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