LCH to cut jump-to-default margin for cleared CDS

Move could bring margin for cleared CDS closer to bilateral trades, but mismatch remains


UK clearing house LCH is preparing to change the way it sets margin for jump-to-default risk in credit default swaps, a move that could shrink the margin differential between cleared and bilateral trades, and lay the ground for clearing of contracts referencing the subordinated debt of financial firms.

Jump-to-default – a measure of loss incurred on a CDS if the reference entity declares a credit event – is part of margin models at both LCH and rival clearing house Ice. The risk is not included in the International Swaps and Derivatives Association’s standard initial margin model (Simm) for non-cleared trades, however, making clearing more expensive for single contracts.

“As soon as a participant clears more than one single-name CDS, the portfolio margining framework starts to kick in as central counterparties generally charge a jump-to-default risk margin. This makes it more economic to clear,” says Frank Soussan, global head of CDSClear at LCH.

Market participants have long complained that this anomaly in margin calculation has deterred derivatives users from clearing bilateral trades. A premise of central clearing is that it should be less onerous in margin terms than non-cleared transactions.

LCH is awaiting regulatory approval for a proposed methodology change that could cut margin amounts on some CDS portfolios. The so-called short charge – the jump-to-default component of CDSClear’s margin requirement – currently applies two single-name defaults to a member’s portfolio: the largest position and the largest exposure to the three riskiest credits in the portfolio.

For narrow portfolios, this can prove costly.

For example, if a member sells $10 million notional of protection on a single reference entity, the short-charge margin alone could total $6 million, assuming a 40% recovery rate for the instrument. By contrast, a counterparty would pay no short-charge margin on an identical bilateral trade calculated under Simm.

On more diverse portfolios the impact is quickly diluted as the short charge references the two exposures regardless of the total size or breadth of names in the overall portfolio. For example, a larger portfolio of 100 names might still attract just $6 million of short-charge margin.

Under the proposed changes, the short charge would be reduced to a single credit event – representing the default only of the largest exposure. This could reduce the required margin on some portfolios, but still leave it above the zero level for Isda Simm trades. Soussan plays down any link to the discrepancy with Simm, instead describing the change as a necessary step for clearing CDS on subordinated financials, which requires a more dynamic margining regime. Clearing for single-name and index subordinated financials is scheduled to launch before year-end, at the same time as changes to the margin framework.

Under the existing default methodology, a clearing member who buys $5 million of senior CDS on a reference entity and sells $5 million of subordinated CDS on the same entity would face a loss given default of zero, assuming the same recovery rate is used. This would result in a zero short-charge margin for the position.

In reality, the recovery rate on the subordinated instrument would be lower as it absorbs losses before senior holders are hit. If, for example, recovery was 20% for the subordinated instrument and 40% for the senior, the actual loss suffered on the exposures following a credit event of the reference entity would be $1 million.

The revised jump-to-default method aims to eliminate this mismatch between risk and margin.

“If there are CDS contracts on the same reference entity referencing different tiers or seniorities within the capital structure, a central counterparty needs to ensure its margin framework is appropriately capturing the risk it faces. For example, a subordinated CDS contract will absorb losses before a senior one, thus likely ending up with a lower recovery rate,” Soussan says.

CDSClear is set to become the first CCP to offer clearing for subordinated financial single names. Ice already clears Markit’s iTraxx Europe Subordinated Financials Index, but not the underlying single names.

The methodology change would include a waterfall for determining the loss given default of a particular instrument to ensure that recovery on subordinated protection would always be lower than for the senior non-preferred, which in turn would be lower than for senior unsecured.

“We are aiming to implement a model where the jump-to-default margin depends on the seniority of the contract. We think it’s important that the margin model and scenarios reflect the capital structure of a financial company,” Soussan says.

Wages of Simm

Initial margin rules for non-cleared derivatives were intended at least in part as an incentive to clear non-mandated contracts. Central clearing for single-name CDS is voluntary; for index CDS it is mandatory.

Regulatory guidelines call for initial margin on bilateral contracts to cover a 99% loss over a 10-day margin period of risk (MPOR), compared to just three or five days for cleared instruments.

Higher bilateral margin amounts have driven a voluntary shift to clearing in the market for inflation swaps, for example. LCH SwapClear has cleared almost $5 trillion notional of the instruments so far this year.

Single-name CDS has not followed this trend. CDSClear has cleared $115 billion of single-name CDS notional in the year to date. This compares to $1.2 trillion of index notional. Yet the two markets are similar in overall size. Total notional outstanding of single-name swaps was $3.95 trillion in the second half of last year, versus $3.90 trillion for index swaps, according to the latest data from the Bank for International Settlements.

Ice is a more dominant force in CDS clearing than LCH, with open interest across index and single-name CDS at its two clearing platforms, Ice Clear Credit and Ice Clear Europe, at $1.8 trillion. The equivalent figure at CDSClear is $215 billion.

Both LCH and Ice apply jump-to-default in their CDS margin methodology.

The decision to omit a jump-to-default component from Isda Simm reflects early analysis showing that the risk factor made little difference to overall margin amounts. Some believe this stems, in part, from the dominance of balanced dealer portfolios in the analysis, with less weight given to directional client portfolios – which were more heavily impacted.

The model methodology is monitored by the Simm governance committee, convened by Isda, with input from a subcommittee of industry users. Any proposed changes must be approved by regulators.

“During the development of the Isda Simm, a number of possible risk factors were assessed for inclusion, and it was found that jump-to-default risk for CDS was not material,” says Tara Kruse, global head of infrastructure, data and non-cleared margin at Isda.

Kruse confirms that, on average, margin paid on bilaterally held CDS under the Simm model exceeded that paid on cleared instruments.

“In the last annual backtesting analysis, Isda Simm margin calculations for CDS were on average significantly higher than CCP margin calculations, and this analysis was shared with regulators globally,” Kruse says.

Many dealers include a jump-to-default component in internal CDS margin models, which pre-date Simm. There are calls for an aligned approach that would incentivise clients to clear single-name contracts as those entities are brought in scope for non-cleared margin rules during the final waves of compliance.

“Historically, jump-to-default is something regulators specifically wanted to have included in margin methodology and they actively continue to assess the adequacy of the margin methodologies of CCPs,” says a clearing official at a US dealer. “So it’s something that’s worth revisiting to see whether or not one of the methodologies needs to be supplemented, or whether one of them needs to be relaxed.

“If you think of Simm as the regulatory standard for non-cleared derivatives, it would certainly seem sensible to at least be able to explain why it’s required in one place and not the other.”

Stan Ivanov, president of Ice Clear Credit, says Simm should be amended to bring it in line with clearing house practices.

“Ideally, the two modelling regimes, cleared and uncleared, should be very similar and, arguably, Simm should incorporate such a jump-to-default component,” Ivanov says.

LCH has approached Isda to discuss the current mismatch, though no formal talks have taken place.

Dealers can adapt Simm to include additional components, including jump-to-default, subject to regulatory approval. It’s a change some dealers are already considering, though early analysis suggests the majority of bilateral CDS portfolios would already benefit from a portfolio effect from moving to central clearing.

For example, a client may trade CDS with 10 different bilateral counterparties but directly offsetting positions held with two different counterparties cannot be netted down. By putting trades into a clearing house, clients may benefit from higher netting opportunity.

“When you move trades into clearing you consolidate that exposure into one portfolio and it seems like there is a benefit from centralising CDS trades versus having bilateral exposure. Unless you have a very directional portfolio, you are going to get portfolio benefits from clearing,” says the clearing official.

Playing catch-up with its larger rival, CDSClear’s expansion into subordinated financials is part of a wider product push by the firm. It aims to offer all single names underlying key CDS indexes, enabling clients to trade and clear basis packages which include opposing positions on an index and its constituents.

“In most cases, where we clear an index, we clear all the single-name constituents of that index. We are also aiming to add more index families,” says Michael Amakye, head of CDS sales at LCH. “Many market participants want to trade index basis packages so we’re focused on creating the most efficient margining by submitting all those trades as a package for clearing.”

Since late 2017, the CCP has offered clearing of credit options on iTraxx Main and Crossover indexes and aims to expand the service to CDX investment grade and high yield indexes in the coming months. Five banks are currently signed up to the credit options service, which includes an electronic exercise platform.

Editing by Alex Krohn

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