#### Need to know

• Banks’ compliance teams are scrutinising the use of synthetic swaps as a means of reducing initial margin requirements on non-cleared rates books.
• The trades, structured using put and call swaptions, can be used instead of clearable swaps to significantly offset initial margin.
• The original risk can then be reinstated using a new cleared swap.
• Some dealers are concerned that regulators could view the structuring of these synthetic derivatives as avoidance of swaps clearing mandates.
• Supporters of the technique say it still transfers risk from a bank’s bilateral books to a clearing house.
• Lawyers argue that if the practice reduces counterparty risk, promotes clearing and is supported by a legitimate business purpose, it should not be viewed as clearing evasion.
• One regulator agrees there is a genuine transfer of risk, but says more guidance cannot be given until it can ensure that the method genuinely reduces risk.

Back in 2012, when banks were under intense pressure to reduce the capital footprint of their swaps books, there was some buzz about a new optimisation service for non-cleared derivatives from TriOptima.

Called triBalance, the service worked by identifying webs of new overlay trades that would offset bilateral exposure within a network of banks, with the exposure then being replaced using cleared swaps. It was ingenious, but a fatal flaw meant it did not take off in the way it could have; the overlay swaps would need to be exempt from any clearing requirement, and regulators were not about to puncture their new regime with loopholes.

Five years on, some banks are applying a similar approach in a different context – cutting the initial margin payments now required of non-cleared derivatives by executing so-called synthetic swaps to offset their bilateral positions. Like triBalance, these overlays reduce the footprint of the bilateral swaps book, but they do it with trades that are not subject to a clearing mandate; again, like triBalance, the flattened exposure is then replicated with cleared swaps.

But despite the significant cost savings that synthetic swaps can deliver – up to 30% of total initial margin, according to some banks – many dealers are reluctant to use the structures because of concerns from compliance teams that regulators might view the practice as observing the letter, but not the spirit, of the mandatory clearing rules.

“It will be very difficult to have a legal or compliance opinion saying ‘yes, we can do this’ or not. It is really a grey area,” says the head of credit valuation adjustment (CVA) at one European bank.

Synthetic swaps use a combination of swaptions – which are not subject to mandatory clearing – to offset risks on existing non-cleared rates books instead of clearable swaps. The concern from compliance teams is that using swaptions to effectively mimic a cleared swap is a way to avoid mandatory clearing. But there is no clear guidance from regulators on whether the technique is in line with the spirit of the rules.

Regulators say they are aware of dealers using synthetic swaps for this purpose. One regulatory source says he wants to see precisely how they are used before making a decision on whether they should be permitted. “It is always difficult as a regulator and a supervisor to discuss hypothetical scenarios without having seen how it’s implemented in practice. And we aren’t very keen on rubber-stamping something where we have not seen the details of how it works in practice,” he says.

Four dealers have told Risk.net that a decision from internal compliance on whether they can use synthetic swaps to cut initial margin is still pending. A fifth says the technique is likely to clear compliance hurdles, but whether his firm uses it will depend on whether individual business units can get comfortable with it.

Even some optimisation service providers are avoiding the use of synthetic swaps as part of their margin reduction solutions, because not all banks believe it sticks to the rules.

“Half the banks think it’s OK and half don’t. In that case, if you are trying to build a solution for the network as a whole then it is not going to work,” says one person familiar with the matter.

### Margin minimisation

The margin rules for non-cleared derivatives, which came into force in countries including Canada, Japan and the US in September 2016 and in the European Union in February 2017, require in-scope entities to post initial margin when trading with each other. More than 20 large dealers with over $3 trillion notional in non-cleared derivatives across the group were caught by the first phase and six more banks joined them on September 1 this year. The initial margin posted by dealers has to be funded, which creates material costs as more and more counterparties come into scope. Market participants estimate that initial margin funding requirements under the non-cleared margin rules is close to$1 trillion.

Typically, a bank would hedge its non-cleared rates books using cleared swaps, which belong to a separate netting set. This means the cleared and non-cleared netting sets would not offset for initial margin calculations but would be considered directional instead.

Under the International Swaps and Derivatives Association’s standard initial margin model (Simm), which is used by the industry to calculate initial margin, the more directional a portfolio is, the more initial margin needs to be posted.

###### You have to clear swaps; you can’t create things that are non-clearable just for the purposes of circumventing margin rules. That would probably be taken badly by regulators
Head of CVA at one European bank

Estimates show that the initial margin requirement can be cut by 50–70% through the use of portfolio optimisation, which includes vendor solutions and manual reduction through bilateral trades.

On the vendor side, for instance, Quantile Technologies provides counterparty risk-reduction services through the collateral management hub AcadiaSoft – a margin utility that generates margin calls for counterparties – by running optimisation algorithms over the portfolios of dealers using the service and suggesting new risk-offsetting trades, or unwinds of old ones.

TriOptima’s TriBalance service works by running optimisation algorithms on bilateral exposures, including legacy trades, and suggesting new trades that would offset market risk on bilateral books.

But dealers have also looked to manually optimise their bilateral portfolios through the use of synthetic swaps. Under this approach, the directional risk of the bilateral portfolio is significantly offset using a long swaptions call and a short swaptions put that replicates the cleared swaps a bank would typically use to hedge the bilateral non-cleared portfolio. These swaptions are traded with the same counterparty and therefore offset the risk exposure of the bilateral netting set to reduce the initial margin required under the Simm. The original risk exposure of the portfolio is then reinstated with the help of a new cleared swap.

As a result, the risk exposure in the bilateral book is reduced significantly and moved to the cleared book. This preserves the original economics of the portfolio but simply transfers the exposure to a clearing house.

Since the technique involves the use of non-cleared swaptions to replicate a cleared swap, however, some dealers are worried the creation of these structures could be viewed as a deliberate avoidance of clearing mandates.

“Basically, you have to clear swaps; you can’t create things that are non-clearable just for the purposes of circumventing margin rules. That would probably be taken badly by regulators,” says a CVA trader at a second European bank. “We are taking advantage of clearing rules rather than circumventing them, and making sure we do clear things. But yes, you do need to be a little bit careful with what you are doing there.”

A second concern is whether the transfer of risk achieved by using these synthetic swaps will hold true over the life of the trade. “If you trade today and you are audited six months or one year from now, perhaps the trade you have done today, which is reducing risk, will in six months’ time be increasing risk. So you need to be able to prove at all points in time that… you are reducing risk. I think perhaps that is where people are not comfortable,” says the first European bank’s CVA head.

### Holistic approach

Supporters of the method argue the technique ultimately transfers risks to a central counterparty (CCP) through the final cleared swap, which was the point of the mandatory clearing rules.

“You haven’t changed your market risk at all. You’ve just reinstated your risk from the bilateral portfolio,” says the clearing expert at the first European bank. “So you could argue that you are moving more risk into the clearing house, which is in alignment with the spirit of the policy.”

Other dealers agree that the risk is effectively transferred to a CCP. “I don’t think compliance has a strong argument in this case, because economically the risk is transformed from being bilateral non-clearable into clearable through a CCP,” says a derivatives valuation adjustment (XVA) quant at a third European bank. “Sometimes compliance has different views, and not really an economic or a quantitative view. They have different considerations.”

Market participants also argue that doing offsetting trades within the same bilateral books can reduce counterparty credit risk because the directional risk is transferred from a bilateral counterparty to a CCP.

Lawyers broadly agree that the use of synthetic swaps shouldn’t be seen as a ploy to avoid mandatory clearing.

“If you focus on the non-cleared transactions that are entered into to offset the risk, the issue that arises is that they could be entered into on a cleared basis. So the question is, should you be required to enter into them on a cleared basis? In the context of certain structures we have considered, we think the process should be viewed holistically as one that promotes central clearing. On that basis, the answer to the question is that you should not be required to clear them,” says Emma Dwyer, a partner at law firm Allen & Overy.

Dwyer argues that the European Market Infrastructure Regulation’s (Emir) ultimate aim is to reduce counterparty risk, and therefore any activity that furthers that aim should not be seen as a de facto breach of the rules.

“If you look at Emir holistically, what is relevant here is to mitigate counterparty risk and promote central clearing. When looked at holistically against those benchmarks, does this arrangement amount to an evasion of Emir? And the answer would then be no,” she says.

A similar argument could be made for the US. “We believe that some of the structures we have seen employing synthetic swaps, when looked at holistically rather than as their components in isolation, actually achieve and promote clearing that would otherwise not be possible,” says Deborah North, a partner at Allen & Overy in New York.

###### When looked at holistically… does this arrangement amount to an evasion of Emir? And the answer would then be no
Emma Dwyer, Allen & Overy

Edward Ivey, a senior associate at Linklaters in New York, says that if there is a valid business purpose for a trade and the derivatives used to structure it are themselves subject to regulation, synthetic swaps should not amount to an evasion of the rules.

“For clearing, I am not sure if it should be viewed as evasion if there would appear to be a legitimate business purpose to the structure, and if the over-the-counter derivatives trade is still subject to regulations – most notably, margin requirements. If the swaption was actually subject to far less regulation, such as being exempted from margin requirements, then you have a more difficult analysis. Assuming it is just treated like any other OTC swap, such as an interest rate swap, I think the business purpose here would be one based on achieving efficient capital structures,” he says.

Ivey adds that it is important for firms to fully document the reasoning behind any decision to use a synthetic swap: “Whenever an entity is going to structure a trade and it has concerns along the lines of ‘in 20/20 hindsight, we do not want this to look like evasion,’ we have always suggested that the entity documents the reasoning and decisions being made internally – the kind of activity where a formal note or memo is produced which outlines ‘why we are doing this?’.”

### Lack of clarity

Some dealers have called for clearer guidance on whether they can use synthetic swaps to reduce their bilateral margin in order to encourage other banks to use the technique. After all, the more banks there are that are willing to do it, the more counterparties there will be to enter into offsetting trades.

“All these initiatives are bilateral in nature; you need to have another counterparty to execute savings. So if more dealers, portfolio managers and traders know about these instruments, it becomes progressively easier to do things,” says the XVA quant at the third European bank.

Regulators, however, are less keen to offer a definitive view at this stage. The regulatory source agrees that “you could certainly say” the technique moves bilateral risk to clearing and that it is therefore in line with the communiqué from the Group of 20’s Pittsburgh summit, which asked regulators to create a mandatory clearing requirement for standardised derivatives.

###### It is very difficult to give a clear answer via a regulation on whether this is acceptable or not
Regulatory source

“Now, whether that is being done in a way where it actually doesn’t take out risks in the system but just gives lower capital requirements, that is where it becomes more tricky,” says the source. “I don’t think it’s normal in these cases to give regulatory or supervisory approval on business model changes. This is something that you look at in day-to-day supervision, and you see how it is being implemented. It is very difficult to give a clear answer via a regulation on whether this is acceptable or not.

“I don’t have any problems with banks going in this direction. But if the market ends up in a different place from what was intended in terms of capital requirements and this has a large impact, then it is something that we need to look at,” he adds.

The regulatory source adds that any decision would also depend on the degree of standardisation of the initial margin calculations that dealers can achieve using the Simm model, since they need to have the same model if they are to offset bilateral risks with each other: “It would not be possible to do this if you did not have the Simm model that allows banks to have the same risk being measured the same way across two institutions.

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The week on Risk.net, September 15–21, 2017