The open secret of European swaps clearing is that it is mostly done under US rules.
Clearing banks channel the bulk of their client business stateside, where the agency model prevails. The European riskless principal model, which swells systemic risk indicators that attract hefty capital surcharges, is largely avoided.
This preference can be seen at LCH, which revealed in 2017 that 92% of client activity it sees in interest rate swaps is cleared under the agency model, via a US futures commission merchant (FCM) – even though 36% of clients are located outside the US.
That leaves European clients – especially pension funds and insurers with large, directional portfolios – who want to follow local rules in a tough spot.
These firms have found a champion in JP Morgan. Unusually among its peers, the bank’s over-the-counter clearing business has seen stronger growth in Europe than in the US – a fact not lost on clients.
“Our whole thinking is within the European framework and we made a conscious decision to use the European model,” says a source at a large European insurance company. “They are one of the few that support that. One or two others also do it, but JP Morgan is number one for capacity.”
This is by design. Nick Rustad, JP Morgan’s global head of clearing, says the firm maintains a “very balanced” book of business, “not just across products, but across geographies”.
That comes with a strong emphasis on supporting European clients on their terms. “We’re committed to the client clearing business, and as things stand, these are the capital rules for clients to clear in Europe. Offering a European riskless principal model in addition to the US agency model is about giving our clients choice,” says Rustad. “As a well-capitalised bank, JP Morgan is able to support a European model clearing business. Our fortress balance sheet enables us to do that.”
The two models are starkly different. US FCMs act as agents, guaranteeing a client’s obligation to the clearing house, but not vice versa. In Europe, clearing firms are required to enter into equal and offsetting trades with the client and the clearing house, which leaves a larger capital footprint.
The desire to run a balanced business is evident not only in the allocation of capital and balance sheet, but also staffing and product development. Rustad and several of his top lieutenants are based in London. The client service teams in the US and Europe are equally sized, with fewer in Asia.
JP Morgan has been first-to-market with a number of services aimed at European clients, such as custodial segregation at SwapClear in London. In 2018, it became the first US bank to support client clearing of credit default swaps at LCH SA in Paris. And it is the only non-European dealer on the supervisory board of Eurex Clearing, a distinction reserved for the top-five members in the central counterparty’s profit-sharing scheme for interest rate derivatives.
Investment in the European business is now paying off in spades. The bank’s cleared OTC volumes have increased at a compound annual growth rate of 18% since 2016, and much of that growth has come from outside the US.
We haven’t moved responsibility from the second line, we’ve enhanced and built out the first lineNick Rustad, JP Morgan
In the 18 months from the start of 2017, JP Morgan almost doubled its European initial margin balances for cleared interest rate swaps.
“We’ve seen greater growth internationally than in the US this year,” says Rustad.
The firm topped Coalition’s rankings for clearing revenues across futures and OTC derivatives for the past two years running.
It wasn’t always so. When Rustad took the reins as global head of clearing in early 2016, the business was ranked a distant second in Coalition rankings. Morale in the clearing industry was at its lowest ebb. RBS and Nomura had exited the OTC client clearing business in Europe, BNY Mellon and State Street were doing the same in the US, with Deutsche Bank about to follow suit.
But as others clipped back, JP Morgan dug in. “At that time, a number of firms were questioning their commitment to the clearing business and some European banks publicly announced they were pulling out of the client clearing business,” says Rustad. “We had a lot of enthusiasm and focus within the team at JP Morgan. That enabled us to pick up new business from exiting firms and really helped advance our strategy, which was to push for growth and scale.”
The trick, Rustad says, was to grow without taking excess risk or sacrificing profitability. “Profitability comes through scale, and encouraging as many clients as possible to clear with JP Morgan, while maintaining our risk discipline.”
One of Rustad’s first moves as global head of clearing was to establish an ‘in-business’ risk team. “As we are clearing more and more risk, and as that risk becomes more complex – moving away from traditional exchange-traded products and into OTC derivatives with longer maturities – I felt we needed to bring in people who had experience of risk-managing those products,” he says.
The four-person risk team was drawn from the ranks of market and credit risk specialists within JP Morgan. They act as an additional line of defence; vetting new clients, analysing the portfolio of existing clients and providing a sanity check on product initiatives.
Some of those functions traditionally sat within the second line, and that remains the case. “We haven’t moved responsibility from the second line, we’ve enhanced and built out the first line,” says Rustad. The in-business risk acts “as a bridge” to the second line, explaining the firm’s risk limits to clients and working with them to cut positions where necessary in a way that minimises disruption.
The first-line risk managers also keep abreast of CCP margin methodologies and JP Morgan’s portfolio margin capabilities. They help clients identify margin offsets, especially when they are running basis positions across cleared and bilateral products.
“The first-line risk team has market and trading experience, so they can look at positions the same way our clients do. In the second line, we have credit specialists setting limits. It’s a good balance,” Rustad says.
Clients attest to the quality of the in-business risk team. “We use JP Morgan a lot for ad hoc queries and ‘what-ifs’, and to validate some of our in-house analytics. They are very quick to turn those numbers around,” says an operations head at a US hedge fund. “They provide a useful check-and-balance to the numbers we are producing.”
An operations manager at a US buy-side firm says JP Morgan has a confidence and swagger that is rare among clearers.
“They tell me things other counterparties won’t, and I like that,” he says. For instance, the risk team critically examines client requests. At times, it pushes back. “If I tell JP Morgan I want to do something complex, they will tell me if it’s not going to work, or if it will introduce some wrong-way risk,” says the operations manager. “They explain things and give me honest feedback. It’s hugely helpful to have someone that will tell me the truth, the unexpurgated truth.”
Saying ‘no’ to clients can be difficult, but Rustad encourages honest dialogue. “That’s something JP Morgan does differently,” he says. “Clients like it because it provides an additional level of analysis as part of their clearing relationship. If we’re having those conversations with them, we’re also having those conversations with our other clients, so they can feel confident that we’re not taking excessive risk with other clients that could be disruptive to the business.”
JP Morgan routinely warns clients about portfolio concentrations. At the start of 2018, it told some clients that their positions on CBOE’s Vix futures were too large, given the level of margin and potential for an outbreak of volatility. Shortly after, on February 5, the Vix more than doubled. The Options Clearing Corporation reported a series of outsize margin breaches in volatility futures, prompting a regulatory investigation.
The bank has also invested heavily in tools that allow clients to analyse their exposures and improve margin efficiency. Its margin analytics platform allows clients to check trade eligibility, estimate margin requirements and identify margin offsets at various clearing houses. Advanced algorithms for risky compressions allow clients to execute delta neutral packages with a dealer of their choice to reduce notional exposure. Cross-product integration to facilitate margin analysis across cleared and bilateral positions is in progress.
“We think our margin analytics tools are a differentiator for optimising portfolios at JP Morgan,” says Rustad. “The reception from clients has been overwhelmingly positive.”
The margin analytics tools will see further upgrades as part of a hefty technology investment programme, dubbed ‘OTC Clearing 2020’.
Rustad insists JP Morgan will remain at the vanguard of clearing new products as they come to market. The bank was live on day-one when swaps referencing the secured overnight financing rate began clearing in July, and was the first clearing member to support client clearing of OTC interest rate swaps at the Australian Stock Exchange.
Rustad says JP Morgan also stands ready to clear OTC foreign exchange contracts if client demand emerges.
“We have an extensive client base who use us for FX prime brokerage and we’re looking at the potential opportunities the cleared model would offer them,” he says. “There are upsides and downsides to the cleared model and clients will make their individual choices. We’re about giving clients choice and we are signed-up members of the ForexClear service at LCH, where the majority of interbank flow is going, and where we anticipate the majority of clients will go as well.”