Brexit flips LCH-Eurex basis

LCH-Eurex basis has inverted on buy-side flows, hitting –1.3bp at July low


Brexit uncertainty and falling European swap rates helped push the LCH-Eurex basis into negative territory in June as more investors – especially pension funds – sought to receive fixed rates at Eurex, causing unbalanced flows.

Although the basis between the UK and European clearing houses for 10-year euro interest rate swaps has been narrowing, it remained positive moving into 2019 – sitting at around +0.7 basis points on January 2. In June, it dipped below zero for the first time, before plunging to a low of –1.3bp in early July.

In part, this reflects rate expectations. Swap rates fell following European Central Bank monetary policy meetings on June 6 and July 25, when ECB president Mario Draghi postponed a rate hike for at least a year and declined to rule out the possibility of a rate cut soon. The decision forced the 10-year German Bund yield lower and prompted market participants to move into receive-fixed, pay-floating interest rate swaps.

“What’s happened here is that rates have fallen dramatically over the past six months so there’s been more receivers – if interest rates are falling then people are receiving,” says a source at an interdealer broker.

But traders say Brexit-related uncertainties have meant these flows were not evenly shared between LCH and Eurex. LCH currently has time-limited relief from EU regulators allowing European entities to continue to clear there if the UK leaves the bloc with no deal. But given the longer-term fog, increasing numbers of European buy side firms have been clearing their swaps at Frankfurt-based Eurex.

“Brexit uncertainty caused marginal receiver flow to shift to Eurex and that’s what drove the basis,” says a euro rates head at a US dealer. “There is clearly genuine demand for a European clearing house for European products, especially for European clients.”

According to a senior euro swaps trader at a European investment bank, pension funds shifting their swaps to Eurex were a particular driver of the inverted central counterparty basis.

“Historically pension funds are receivers and if they want new swaps it makes more sense for them to trade at Eurex rather than LCH due to all the Brexit uncertainties. If you’re a mainland German, French or Dutch pension fund why would you put new positions on LCH in June or July if you’re even slightly unsure about what’s going to happen with Brexit?” the swaps trader says.

Although Brexit helped to disrupt the balance of flows between LCH and Eurex, the euro rates head at the US dealer points out that the basis between the two clearing houses generally remains volatile as less risk is held at Eurex. As a result, even marginal flows to or from Eurex can cause a major basis imbalance.

Products cleared at Eurex tend to be short-dated resets and trial runs in front-end forward rate agreements and asset swaps, the rates head says.

“So the actual risk that gets transacted on Eurex compared to LCH on euro interest rate swaps is pretty low as a proportion of the market. I would guess Eurex holds 5–15% of the market’s risk on any given day,” he says.

Eurex lacks liquidity that would enable dealers to offset trades at the clearing house. This can affect the basis as dealers are forced to hedge at LCH instead and pay margin twice, raising the cost of the trade. “If it was a more liquid two-way market then you’d probably have much more stable basis levels,” the rates head says.

While LCH has the lion’s share of volume in the euro swap market, Matthias Graulich, member of Eurex’s executive board, says euro swaps volumes and the amount of risk housed at Eurex have been continually increasing, with accumulated risk on different client accounts increasing by a factor of five in March.

One clearing source believes the basis likely stabilised back towards zero in July because increased flows at Eurex had come and gone in the market.

“There’s a natural rebounding function that would pull the basis back towards zero. That negative 1.3 basis was pretty temporary so once those specific flows were digested by the market the basis simply rebalanced,” he says.

Market participants believe Brexit continues to play a large part in whether the basis will shift again any time soon.

“I don’t anticipate the basis moving much but it’s going to be very interesting to see what happens in the case of a hard Brexit,” says the senior euro swaps trader.

However the euro rates head at the US dealer anticipates continual basis gyrations to occur, unless Eurex becomes the go-to house for euro flows.

“Whether it comes because of Brexit or something else, you need two-way interest swap flows on Eurex to avoid these basis moves. Unless that happens then this basis is just another risk that people have to manage and get used to.”

Editing by Alex Krohn

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