OTC infrastructure service of the year: Capitalab

Risk Awards 2021: valiant effort to solve swaptions discounting problem wins praise from clients

David Bachelier, Capitalab co-founder

As the world grappled with the Covid-19 pandemic, Capitalab staffers were trying to solve a knotty problem afflicting the swaptions market from their kitchen tables.

Central counterparties (CCPs) would soon begin using new risk-free rates to value more than $200 trillion-equivalent of cleared interest rate swaps, a key milestone in the roadmap for phasing out Ibor benchmarks. The first of these ‘big bang’ switches occurred on July 27, when CME, Eurex and LCH began using the euro short-term rate (€STR) rather than outgoing Eonia to discount future cashflows and calculate interest paid on cash collateral – known as price alignment interest (PAI) – for cleared euro swaps. 

Although not cleared themselves, swaptions would also see their valuation impacted by any change to the cleared swaps into which they settle. There were concerns about how the market would handle this switch and Capitalab – a division of BGC Brokers – spied an opportunity to help clients.

While the final product was not quite the all-singing-all-dancing fix the vendor originally designed,  parts of it were widely adopted by the industry. Clients praise Capitalab’s solution for slashing the scale of the problem and reducing the need for thorny compensation negotiations. “They were the only player to come up with a suggestion that looked credible to reduce the size of the problem,” says a derivatives funding head at a large bank.

Capitalab has played a major role in the non-cleared swaptions market since launching its swaptions compression service in 2015. Its latest solution aimed to eliminate the uncertainty hanging over €300 billion of swaptions notional via so-called bilateral zero compression runs, which saw offsetting trades with non-specified discount rates changed to reference €STR-discounted swaps. This removed uncertainty on the newly labelled trades without any P&L impact. Around 80% of swaptions submitted to the service were labelled in this way.

David Bachelier, Capitalab’s co-founder, says nine banks participated in three runs, three weeks before the €STR switch date, using a service built just a few weeks before the actual transition. He adds: “It was a fairly complex and fast-changing environment in which different participants had different views, and we managed to be quite agile to answer client needs.”

A second part of Capitalab’s solution, designed to neutralise value transfers, was ditched because dealers and buy-side traders could not agree on whether losers in the switch should be compensated by those who gained from the fixed 8.5bp basis between Eonia and €STR.    

“Unfortunately, we didn’t get the buy-in from some of the other dealers out there,” says a second bank funding head. “Nevertheless, it was a very good idea and [Capitalab] was very helpful in putting together the logic and how it could work to actually provide compensation.”

High hopes

Some banks initially had high hopes a solution might be found for parties negatively impacted in value transfers. The official sector weighed in, with the European Central Bank and the Alternative Reference Rates Committee – the industry group tasked with prising US markets off Libor – suggesting voluntary compensation should be exchanged.

But while clearing houses imposed a compensation mechanism for cleared swaps, discount rates used in non-cleared swaps are privately negotiated between the two parties, meaning an agreement was hard to come by.

Capitalab sought consensus from banks in May on how they wanted to handle the discount switch for legacy swaptions. Some argued it was better to leave the decision to individual counterparties, while others wanted to set a compensation agreement in stone, says Bachelier.

Three banks in Germany, Switzerland and the UK pushed for a product that would enable compensation to be exchanged. Capitalab began building the algorithm, but lack of consensus meant the vendor was unable to apply it to accommodate cashflows between banks.

Gavin Jackson, co-founder of Capitalab

“We solved the technical problem of how to exchange cashflows, how to calculate it, how to constrain it where required, and so on. The bit we lacked, in the end, was the agreement from the entire market that that’s what they wanted to do,” says Gavin Jackson, co-founder of Capitalab.

Most banks were open to paying compensation, “because it was the right thing to do from an integrity perspective,” says Jackson. But some buy-side firms, such as hedge funds, took the opposing view because they had a duty to make the largest possible gains for their investors.

“Dealers were caught in the middle of that,” adds Jackson.

For the market, it may have been a missed opportunity. Without compensation, every swaptions participant ended up with either a windfall or a loss as a result of the switch. “This could have been prevented with the Capitalab solution, which was the only solution out there that was feasible,” adds the second funding head.

Far from time wasted, the technology was redeployed for the compromise solution, which ultimately eased the burden.

“Capitalab has successfully lowered the number of line items that are problematic, without changing the risk profiles,” says the second funding head.

Other banks contacted by Risk.net were appreciative of Capitalab’s efforts.

“What they were offering at the time was very relevant, given what people were thinking about how crazy that thing could go,” says the funding head at the first bank.

One worry at the time was that if the compensation issue was not resolved, arguments could re-emerge at every trade expiry following the switch. “If that were to be the case, then obviously it’s much better if you reduce the population of potentially problematic trades in your book, because otherwise you would have this kind of discussion almost every day,” says the first bank’s funding head.

Reducing exposure and ultimately the amount of money involved via the compromise solution “enabled more open discussions on the right thing to do”, he adds.

For the compression exercise, the bank came up with a list of constraints that included trade date, expiry date, delta, vega, present value and counterparty, the funding head says. Around 200 of that bank’s trades were matched, eliminating around €20 billion in notional.

Importantly, around two-thirds of the bank’s trades were paired on the larger second run. “That metric looks impressive. It shows their algorithm is pretty good despite the constraints we imposed,” says the funding head.

A third bank that did not participate in the runs says it is looking instead to take advantage of a trade stamping service also offered by Capitalab. This flags any discrepancies in the agreed discount rate attributed on a trade’s MarkitWire ticket, making it easier for dealers to negotiate with each other.

“You could have a trade that’s been novated a couple of times, compressed a couple of times and it doesn’t have a label. So it starts becoming a bit unclear as to what the trade date was and which Isda supplement it falls under,” the funding head explains

Dress rehearsal

The euro discounting event was seen by some as a dress rehearsal for a much larger switch for US dollar swaps. On October 17, clearing houses changed the discount rate on these instruments from effective federal funds to the secured overnight financing rate, or SOFR.

This time, US market participants agreed not to exchange compensation and to switch without any constraint, says Bachelier. It means the US version of the service remains a work in progress, with the first labelling cycle expected to launch in the first quarter of 2021.

Sam Bussey, Capitalab

“This is what we are currently doing in US dollar for swaptions, where we received $3 trillion of notional, thousands of trades, and a lot of that still with large remaining uncertainties around the agreed discount rate,” adds Bachelier.

Capitalab’s efforts in 2020 were not limited to the discounting switch. In June, it became the first vendor to include LCH SwapAgent-settled swaptions within its biweekly rates initial margin optimisation service. Although not cleared, these trades are governed by standard documentation. The vendor is also launching cross-currency delta optimisation, which will be integrated within its margin optimisation service.

In December, Capitalab entered into an agreement with FX market infrastructure CLS Group, meaning its multilateral compression services will benefit from FX forwards and swaps data direct from CLS in all CLS Settlement-eligible currencies.

In addition, Capitalab’s risk optimisation services include multilateral non-deliverable forward and FX forward reset risk optimisation runs – soft-launched in 2017 and run by Sam Bussey – for which several FX trader clients submitted positive reviews.

“What differentiates Capitalab from others is their client focus and a constant feedback loop – on both pricing and product – with banks to improve the offering and evolve into a better platform to clear risk,” says Abhishek Jangir, executive director at Nomura.