#### Need to know

• Since 2016, a basis has existed between yen interest rate swaps cleared at LCH and the Japan Securities Clearing Corporation.
• The basis blew out in January this year as speculators betting on a Japanese rate hike piled into LCH, making these swaps more volatile than those at JSCC.
• Dealers responded by quoting a basis for yen swaptions as well, depending on where the resulting swaps would clear.
• A re-marking of books using this new basis would cause around $100 million in losses across the Street, some traders estimate. • Japanese broker Totan published a price on Bloomberg on March 7, but criticism from some dealers prompted it to reverse course. Some speculate traders wanted to avoid losses. • The pressure may have peaked. Expectations of a rate hike are fading and more market participants are also turning to cash-settled swaptions. Swaps users have got used to the idea of a price difference arising from their choice of clearing house. But what about a clearing house basis for non-cleared derivatives? This is the situation facing the yen swaptions market, where for the first time a basis has opened up on these non-cleared products depending on where the resulting interest rate swap will be cleared. Some dealers now talk about being long or short volatility at the two competing central counterparties (CCPs), Japan Securities Clearing Corporation and LCH. “It has created the first swaption vol basis market between two CCPs,” says one international bank’s swaptions trader. “In the US you have a CME-LCH basis on swaps – but not on the basis of the volatilities. In Japan, now we do.” Domestic players in the yen swaps market are required to use JSCC, while international players have tended to opt for LCH’s SwapClear. Dealers intermediate these flows, so end up with a book at both CCPs and initial margin costs at each. A CCP basis first appeared for yen swaps in 2016, but it blew out in January this year as international investors positioned for a Japanese rate hike by putting on pay-fixed swaps at LCH. Not only did the fixed rate quoted on LCH-cleared swaps climb away from the JSCC-cleared equivalent, but the LCH curve also became more volatile. Soon after, different swaptions premiums started appearing as well, depending on which swap would ultimately be delivered. In both products, the emergence of a basis is fraught with peril for market-makers. Each bank will have a different book of business, so some will face pressure to adjust their pricing earlier; others may not be aware of the reasons for the shift, or may resist it. But if the basis becomes established – and particularly if it widens – then dealers ultimately face a question not just about how to price new business, but how to value their existing books. Speaking in early March, swaptions traders estimated the dealer community as a whole would lose$100 million if all books were re-marked using the prevailing basis.

“Quite frankly, those people who had not being paying attention and built up large positions would have lost money,” says a swaptions trader at a US bank in London.

###### It has created the first swaption vol basis market between two CCPs
Swaptions trader at an international bank

But with no firm prices available outside the voice broker market, there was nothing to base a revaluation on. That changed in March. First, IHS Markit’s Totem service, which provides dealers with consensus pricing for illiquid instruments, started providing official quotes on JSCC- and LCH-delivered yen swaptions. Soon after, Japanese broker Totan started publishing CCP-dependent swaptions prices for the first time. This sparked a pushback from dealers, and the broker took the prices down three days later.

Two bank sources claim the screen was pulled because the published prices were not accurate enough. Others – including ex-swaptions traders and buy-side firms – suggest the protests may have been an attempt by traders to avoid having to revalue their books and take losses.

“When these bases emerge, it can be a sensitive topic. Some banks won’t be marking it – some of those will take a profit, some will take a loss – so there would be resistance from the banks,” says one London-based former swaptions trader.

The pressure may now have peaked. Traders note the demand for yen swaps and swaptions among international players has become more balanced as chances of a Japanese rate hike are deemed to be fading. In addition, more market participants are gaining access to JSCC, allowing their swaptions to deliver at the Japanese clearing house – and others have also turned to cash-settled swaptions, which do not attract the volatility basis, allowing users who are not set up at JSCC to take advantage of preferential swap rates currently available there compared to LCH.

### Birth of the basis

The volatility basis for yen swaptions grew out of the CCP basis in its underlying market, yen interest rate swaps.

The CCP basis emerged in 2016 after Japanese clients started entering receive-fixed interest rate swaps at JSCC and dealers hedged them with swaps at LCH, where two-way flow was initially more readily available, market participants say.

The move came roughly a year after similar dynamics created the market’s first CCP basis in the US dollar swaps market between CME and LCH.

Starting in late 2017, however, surging demand for pay-fixed swaps at LCH caused the 20-year CCP basis to climb from 13bp on January 8 to a high of 15.75bp by January 11, before sliding back to 8.25bp by April 27 as expectations of a Japanese rate hike eased (see figure 1). In essence, dealer books had quickly become more directional and started to consume more initial margin, so traders started quoting a far higher rate for pay-fixed LCH swaps to compensate – a so-called margin valuation adjustment.

During this period, the LCH swap rate was more volatile than that at JSCC – mainly because speculators were clearing their swaps at LCH and were unable or unwilling to use JSCC (see figure 2). US hedge funds, for instance, are barred from using JSCC, as it is not registered as a derivatives clearing organisation under Commodity Futures Trading Commission rules – meaning all their trades have to go through LCH.

“The underlying swaps at JSCC, at least in the last six months, were much less volatile than LCH-cleared swaps,” says a senior rates trader at a US bank in Tokyo.

Given the differing volatilities of the underlying interest rate swaps, traders say it was only a matter of time before this bled into the swaptions market.

“If you have an option on an underlying that is systematically more volatile than another one, then it should trade at a premium,” says the swaptions trader at an international dealer in London.

The basis is generally quoted as the number of basis points required to be paid in premium at expiry, known as the forward premium. It reflects the cost of a straddle, in which offsetting swaptions are traded, one delivering an LCH swap and the other a JSCC swap.

Because the basis initially existed in the voice-traded market, it is impossible to know how quickly it appeared and how it behaved. According to one bank, on March 1 the voice broker market was showing a 21bp forward premium difference for a one-month option on a 20-year swap (see table A). The vol basis is incorporated into client-facing prices by at least one of the major dealers.

Like the underlying swaps, recent flows in yen swaptions have been split directionally, dealers say, with Japanese users primarily selling payer swaptions to international dealers at JSCC. The international dealers then hedged those positions with US and European end-users speculating on Japanese rates, most of which would deliver LCH-cleared swaps.

“Clearly there is a domestic bias towards wanting to sell delta and sell volatility, versus an external bias to pay delta and buy volatility,” says the swaptions trader at one international bank.

This means some dealers were said to have built up a position in which they are effectively long volatility at JSCC, and short volatility at LCH – even though the swaptions themselves are not cleared. Some believe dealers hedging their short vol position at LCH made the LCH-JSCC basis widening more violent earlier this year than it otherwise would have been (see box: Gamma hedging hits the CCP basis).

### Valuation differences

Given JSCC swaptions were essentially offsetting LCH positions, the arrival of the basis could have created significant valuation differences for dealers that had books at each CCP – unless they were able to progressively re-mark existing positions as the basis emerged.

While some large banks claim to have seen the basis coming and adjusted their portfolios accordingly, they suspect others might not have been so canny.

“Did they always assume [the basis] was always going to be zero, and then suddenly realise it is not and mark it higher? Or did they always know it was higher and sell it higher,” says the US bank’s swaptions trader.

Once the basis was apparent, Totem spotted an opportunity and started providing consensus marks for the yen swaptions vol basis at the beginning of March. It is understood that around six dealers currently use the service. IHS Markit declined to comment.

One market participant that had access to the Totem prices, though, claims the basis produced by the service was roughly half the level being quoted in the broker market. Another bank also thought the marks were on the low side.

“We subscribed to it to see what the numbers were – and it was clear that some dealers were submitting a zero spread,” says a rates trader at a Japanese investment bank in Tokyo. “There was no real transparency because it is not an actively traded market and there were only a handful of dealers contributing to it.”

The US bank’s swaptions trader, however, denies the gap is that large, and claims the Totem basis has at times been higher than the broker market.

Totem operates under a ‘give-to-get’ methodology – an approach that has been criticised in the past – which means the prices aren’t available to non-contributors. So when Japanese broker Totan – a joint venture with global broker, TP Icap – published a screen on Bloomberg showing the vol basis for the first time on March 7, it would have been the first sight of an authoritative basis for some swaptions users, and possibly for some dealers.

“Once there's a certain degree of liquidity, historically Icap has chosen for transparency purposes to list their screen as their interpretation of where fair value is, which some end-users take comfort from,” says the US bank’s swaptions trader.

It didn’t last for long, though – according to a swaptions trader at a US bank, the split screens for yen swaptions were taken down three days after they first appeared. Via a TP Icap spokesperson, Totan declined to comment.

The episode has sparked widespread speculation that some traders had been slow to re-mark their books, and wanted the screens taken down so they could avoid or defer losses. That’s not the only explanation – one trader says the complaints were about the robustness of the figures, and another suggests sophisticated banks may have wanted the screens taken down in order to retain an information advantage.

###### In the absence of broker screens, [Totem] is the only thing the controllers in the banks can fall back on

An informed source claims the decision to show the prices allowed Totan to gather feedback on the new screens, and that it’s likely to reappear when there is more liquidity in the market.

However, the first guess by many sources is that some traders were worried they could be forced to recognise losses.

Banks employ price verification teams, typically within their finance function, to ensure books are being marked correctly. While policies differ between banks, valuations sources say a single broker quote usually wouldn’t be enough evidence to adjust a book; there would need to be evidence that the market was active.

The existence of Totem prices can sometimes be enough for a revaluation, says a pricing expert at a European bank, but not always. One trader says that while they haven’t yet used the Totem marks to re-value their yen swaption books, it’s more about giving comfort to auditors.

“It is really demonstrating a process to auditors… it does help us to show that we have a process around marking them,” says a Tokyo-based options trader at a second Japanese bank.

Putting a price on screen, as opposed to it just trading in the voice broker market, is seen by some as evidence that a price is visible and tradeable – and therefore could be seized upon by a verification team to re-mark.

Former swaptions traders and buy-side sources suspect some dealers did not want their valuations teams to think that because the basis was showing on-screen, it was visible enough to use to re-mark their yen swaptions books.

“In the absence of broker screens, [Totem] is the only thing the controllers in the banks can fall back on,” says the former bank swaptions trader.

The vol basis has not appeared on Bloomberg since Totan’s service was discontinued, but dealers say it continues to be quoted in the voice broker market. Traders at some of the larger dealers are disappointed that the Totan screen came down so quickly.

“I thought it was a good thing to have,” says Thomas Reich, head of G10 rates at Citi in Tokyo. “I thought it would help price-finding, make the market more liquid and also reduce risk on banks’ books because it should be more visible where it should be marked.”

A senior source at one yen swaptions broker claims his firm hasn’t published a vol basis on-screen because the levels are not material. That claim is strongly disputed by rates traders.

“I disagree with that wholeheartedly,” says the US bank’s swaptions trader. “There clearly is a difference, and if I was an end-user, I would certainly want to know. If it was so insignificant there wouldn’t have been a Totem service on it, and the limited set of dealers that were contributing wouldn’t have been contributing.”

### Downward pressure

While the vol basis has become accepted, it could become less impactful over time, according to the Tokyo-based options trader. He notes the vol positioning between the clearing houses isn’t as stark now as it was in the final quarter of last year. LCH-delivered swaptions are beginning to run off and are not being replaced by new inventory, he says, because fewer international investors have been positioning for tighter monetary policy in Japan in recent months. This is evidenced by the falling yen swap rate.

“There has been a collective throwing in of the towel over the past six months on both options and swaptions trades expressing a view that the Bank of Japan is going to raise its 10-year target in 2018,” says the options trader.

“Many of our clients have unwound positions that were taking the view something would change. Some of those positions were six to 12 months, but even the ones expressing a view of change over a longer horizon are still costly to carry,” he adds.

Investors are also becoming more amenable to cash-settled yen swaptions, where the payout is based on the cashflows the swap would have generated over time if it was delivered. Cash-settled trades avoid adding to a dealer’s stock of LCH-delivered swaps, but can be used by clients that – for regulatory reasons or a lack of client-clearing access – are unable to take delivery of a JSCC swap.

Cash-settled trades are standard in many markets, including euros and sterling.

###### It is becoming perfectly normal for our clients to ask for a JSCC underlying that is cash settled rather than physically settled

The Tokyo-based rates options trader says his desk has been encouraging clients to accept cash settlement on trades for some time. But it is only very recently, he says, that clients have begun to move from physically settled contracts to cash equivalents. The driver is a gradual decline of liquidity in LCH-cleared swaps, as non-US hedge funds sign up to JSCC to arbitrage the yen swap CCP basis.

“Six months ago, when I would visit clients overseas and tell them they might want to look at cash settling against a JSCC page because LCH liquidity is declining, they would indicate some displeasure at having to do that,” he says. “But now, with the bid-offer spreads having really expanded at LCH, it is becoming perfectly normal for our clients to ask for a JSCC underlying that is cash settled rather than physically settled.”

Reiko Tokukatsu, a relative value strategist at BNP Paribas in Tokyo, says a surge in non-US firms using physically settled payer swaptions that deliver at JSCC is also helping dealers reduce their short volatility position at LCH. She believes this trend could also put more downward pressure on the CCP basis.

“I think there is more client clearing [at JSCC], and if this continues to increase then it will support a tightening of the basis,” says Tokukatsu.

Now there is greater awareness of the different volatilities on yen swaptions, dealers will be conscious not to grow short positions at LCH again, the Tokyo-based options trader adds.

“It hasn’t gone away completely,” he says. “But the combination of positions decaying and some clients unwinding has made the positions smaller, certainly,” the trader says. “The volume on LCH has declined markedly, and dealers still have a position, but one that is smaller than before, and I think they will be very wary of letting those positions build up again.”

### Gamma hedging hits the CCP basis

With international dealers believed to be long volatility at JSCC and short at LCH, this can cause problems when the central counterparty (CCP) basis moves.

The dealer’s short volatility exposure to LCH is primarily through sold payer swaptions. It hedges these with pay-fixed swaps at LCH. But if the bank is short gamma – the rate of change of an option’s delta – at LCH and the basis moves up, as it did from 13bp on January 8 to a 15.75bp on January 11 this year, it has to enter pay-fixed swaps at LCH as a gamma hedge.

An oversupply of pay-fixed swaps at LCH was said to be a driver behind the LCH-JSCC basis widening at the start of the year. If dealers were having to enter more pay-fixed swaps as the basis widens, some traders believe this could have helped the basis widen further.

“Being short gamma might explain why the basis widened more than previously,” says a swaptions trader at an international bank in London.

However, he notes that the flows are also likely to have played a major part, as well as a lack of liquidity in JSCC-LCH switch trades – a broker-run market for package trades involving offsetting positions at two clearing houses, designed to reduce initial margin requirements.

“Given the CCP basis is relatively new, I guess it takes time before you really have an active switch market,” he says.

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