A recent Risk.net article depicted the non-cleared derivatives market as a polluted, toxic lake. That is a bleak interpretation. Yes, the non-cleared sector faces challenges, among them a major regulatory overhaul in derivatives market structure, capital and margin rules. But these instruments remain a critical part of the risk management toolbox for end-users. The objective for the industry is to ensure this market is able to continue to function efficiently.
A number of initiatives are under way, from innovations in compression services to improve capital efficiency, to work to support the move to the mandatory margining of non-cleared derivatives. This work is critical because these instruments continue to serve a very real need. By tailoring hedges to precisely meet their exposures, end-users such as pension funds, mortgage lenders, corporate treasurers and insurance companies are able to exactly offset the risks they face, allowing them to run their businesses with greater certainty.
These users have had to adapt to significant changes in the derivatives market in recent years, both in cleared and non-cleared markets. Clearing now plays an increasingly important role – which is precisely what regulators wanted to achieve following the commitments made by the Group of 20 (G20) nations in 2009. At the time the G20 pledges were made, roughly one-third of interest rate derivatives notional outstanding was cleared. Today, that proportion has increased to close to 70%, and is expected to rise further as central counterparties (CCPs) widen the universe of products they clear and new clearing mandates are introduced.
As clearing has increased, it stands to reason the non-cleared market has declined. According to Isda research, non-cleared interest rate derivatives notional outstanding stood at $86 trillion at the end of June 2015, down from an approximate range of between $111.2 trillion and $122.3 trillion the year before – a decline of roughly 22.7%–29.7%. That figure had fallen further to an estimated $74 trillion at the end of 2015.
Much of that is a result of increased clearing activity, as derivatives users progressively shift clearable interest rate derivatives exposures to CCPs.
The non-cleared market is unlikely to disappear, for the simple reason that firms will always have tailored, bespoke risks they need to hedge
Enhanced compression activity has also contributed to a drop in cleared and non-cleared interest rate derivatives notional outstanding, as derivatives users look to improve capital efficiency. Isda estimates that total interest rate derivatives outstanding compressed volume reached $468.2 trillion at the end of 2015, versus approximately $420.1 trillion in June 2015 and $319.1 trillion in June 2014.
Some parts of the non-cleared derivatives market are not yet clearable, in some cases because CCPs are unable or unwilling to clear certain products and currencies. That might include contracts that have non-standard terms because they are customised for a particular client. Or it might be because there are technical issues in developing a valuation model or enabling the settlement of deliverable currencies. In some cases, the relatively small number of dealers active in trading a particular product means there are too few firms to participate in the CCP default process.
That part of the interest rate derivatives market has also seen a decline in notional outstanding, from approximately $79 trillion at the end of June 2014 to $64.8 trillion in June 2015, a reduction of 18%. This fell further in the most recent period, reaching $51.6 trillion at the end of 2015, according to the Depository Trust & Clearing Corporation (DTCC). These figures do not include inflation swaps, as LCH.Clearnet launched a clearing service for this product in April 2015, although the entire inflation derivatives universe is not yet clearable.
The biggest component of the non-cleared segment has historically been swaptions, although CME Group launched a clearing service for this product in April 2016, initially for US dollar-denominated interest rate swaptions with European-style exercise. According to the DTCC, there was approximately $25 trillion in swaptions notional outstanding in December 2015, compared with $26.5 trillion in June 2015 and $31.9 trillion in June 2014.
Other big components are cross-currency swaps ($14.8 trillion in December 2015, versus $25.9 trillion in June 2015 and $30.9 trillion in June 2014) and options (approximately $8.7 trillion in December 2015, compared with $8.9 trillion in June 2015 and $11.8 trillion in June 2014). While not currently clearable, compression services also exist for some of these products – for instance, TriOptima offers compression for cross-currency swaps. It is estimated that nearly $2.5 trillion in cross-currency swaps has been compressed to date.
While it appears to have declined (at least, in terms of post-compression notional outstanding), the non-cleared market is unlikely to disappear, for the simple reason that firms will always have tailored, bespoke risks they need to hedge. According to a survey of end-users conducted by Isda in April 2015, 89.8% of respondents said derivatives (both cleared and non-cleared) are important or very important to their risk management strategies. Indeed, non-clearable products are still regularly traded. According to data reported to US trade repositories and compiled by Isda SwapsInfo, approximately $7.9 trillion in swaptions notional was traded in 2015 compared with $8.5 trillion in 2014. Trading activity in cross-currency swaps totalled $4.1 trillion in 2015, versus $2.7 trillion in 2014.
Forthcoming margin requirements will require many derivatives users to post initial margin on their non-cleared trades, calculated using a 99% confidence interval and 10-day liquidity horizon
Pension funds, for instance, regularly use swaptions to reduce the volatility of their funding positions in an uncertain interest rate environment. Mortgage banks and building societies tend to use a combination of interest rate swaps, swaptions and caps and floors to hedge the interest rate and prepayment risk in their mortgage portfolios. And corporates have long used cross-currency swaps to tap into new pockets of investor demand and take advantage of pricing improvements in other markets, while ensuring they qualify for hedge accounting by eliminating mismatches in assets and liabilities. The certainty that hedging provides gives companies the confidence to invest in future growth.
Tellingly, regulators have made the point over the years that they do not believe the entire market will shift to clearing. Speaking during a meeting on proposed margin rules in September 2014, Commodity Futures Trading Commission (CFTC) chairman Timothy Massad said: "Uncleared, bilateral swap transactions will continue to be an important part of the derivatives market. This is so for a variety of reasons. Sometimes, commercial risks cannot be hedged sufficiently through clearable swap contracts. Therefore market participants must craft more tailored contracts that cannot be cleared. In addition, certain products may lack sufficient liquidity to be centrally risk managed and cleared. This may be true even for products that have been in existence for some time. And there will and always should be innovation in the market, which will lead to new products."
That's not to say the non-cleared derivatives market won't face challenges. Perhaps most significantly, forthcoming margin requirements will require many derivatives users to post initial margin on their non-cleared trades, calculated using a 99% confidence interval and 10-day liquidity horizon – much higher than the five days for cleared products. That will result in significant funding costs, on top of higher capital charges for non-cleared products. It also means firms will have to make major changes to systems, processes and documents.
The industry has invested significant time and resources to respond to these changes, reflecting the importance of the non-cleared sector. A crucial part of that has been the development of a standard initial margin model, known as the Isda Simm. This model is aimed at reducing the problems created by each firm calculating initial margin requirements using its own methodology and decreasing the potential for disputes. As such, it was based on some important criteria – among the most important were simplicity and transparency, ease of replication, cost and speed of calculation.
Ultimately, the model was based on the sensitivity based approach (SBA) introduced by the Basel Committee as part of its Fundamental review of the trading book (FRTB). That's partly because global regulators were already familiar with this approach – important, as regulatory approval is required to use the model. But it's also because the Basel Committee's FRTB rules require banks to implement the SBA for market risk capital purposes. To help ensure consistency in implementation, many of the inputs will be standardised and centrally defined.
Inevitably, trade-offs have had to be made to achieve a balance between risk sensitivity and simplicity. But back-testing has shown that initial margining computations have so far been within an acceptable tolerance. A governance committee has also been set up to monitor and assess model application and establish a process for updates and modifications.
Another big initiative has been the development of revised collateral documentation to comply with the margin rules. The first variation margin credit support document was published in April, and a protocol is being developed to allow market participants to make changes to their outstanding agreements in advance of March 2017.
The Isda protocol will set out three options, reflecting the diversity of opinion in the market. For those firms that are focused first and foremost on regulatory compliance, the protocol provides two options that amend existing credit support annexes (CSAs) to bring them in line with the new margin rules – one where the updated agreement is used for the entire portfolio, and one where a replica of the existing CSA is created and amended, and then used for new trades only. A third option enables counterparties to create a completely new CSA with simpler terms.
We believe the focus of derivatives users will change over time, and they will increasingly opt for more standardisation within their collateral agreements to reduce complexity and cost
There are good reasons for firms to choose the simpler, more standardised CSA. Legacy CSAs contain complex optionality, arising from the fact counterparties have had the ability to negotiate everything from eligible collateral to thresholds. Valuations are dependent on the terms within the CSA and the collateral that is posted. Given the CSA terms negotiated between each set of counterparties might differ, pricing for the same trade can vary from bank to bank, leading to the potential for disputes. Moving to a new CSA with more standardised terms would help eliminate much of this complexity.
For many industry participants, however, the priority was to develop a solution that would help them meet the tight time frame set by regulators, without taking on the extra burden of shifting to an entirely new agreement.
The compliance challenge increased further last month, with the revelation that European rules would not be finalised in time for a September 2016 launch. No other jurisdiction has so far changed its start date, splintering the harmonised implementation schedule that had previously been agreed by regulators. This will not only add to the complexity of trading across borders, but complicates the creation of margin-compliant documentation and the protocol.
We believe the focus of derivatives users will change over time, and they will increasingly opt for more standardisation within their collateral agreements to reduce complexity and cost. Isda encourages standardisation when there is no pressing need for non-standard terms, and we will ensure the tools and infrastructure are available for market participants to make that change when they are able to do so.
There's no doubt the derivatives markets have changed. But the non-cleared derivatives market will continue to play an important role in the risk management strategies of end-users.