Member revolt forces SwapClear to revamp margin model


LCH.Clearnet is overhauling the margin model used by SwapClear, its interest rate swap clearing service, after members protested it was not generating big enough collateral calls – resulting in the risk being covered by member contributions to the default fund instead. That is a problem because losses that eat through a defaulting member's initial margin and default fund contribution are shared among the other contributors to the fund – less initial margin means more mutualised risk.

"The financial resources of SwapClear are made up predominantly of the initial margin and default fund, and we are of the opinion that the person introducing the risk to the clearing house should bear the risk of loss, and that should be reflected in the initial margin numbers. Currently, SwapClear's model does not make that possible, and clearing members will end up bearing more risk than they should," says one risk manager at a European bank. Default fund contributions also attract a separate capital charge.

A new model has been drawn up by the central counterparty (CCP). It is being reviewed by the UK's Financial Services Authority (FSA) but may not be signed off until March – SwapClear members say the clearer proposed an interim solution as a quick fix, but the regulator insisted on a complete model review.

SwapClear's chief executive, Michael Davie, says the clearer will change the balance between initial margin and default fund contributions, and confirms a new model is with the FSA for validation. He would not confirm or deny that an initial fix was rejected by the regulator. The FSA also refused to comment.

A year ago, the margin imbalance might not have mattered too much – SwapClear had handled a total of $359 billion in client interest rate swap volumes – but client clearing has rocketed this year. Volumes hit $2.9 trillion by the end of August. That gives rise to another headache for clearing members – because they are responsible for managing the risk of one of their clients defaulting, charging a client SwapClear's margin numbers alone could leave them exposed in the event of a customer default.

We alerted LCH.Clearnet instantly and asked them to fix their models immediately because the deficiency leaves us exposed to higher mutualised losses

"We now face awkward conversations with our clients, trying to explain to them that the CCP margins aren't enough, and we have to call for excess margin over and above the CCP minimum to cover the potential risk. That is not an easy conversation to have," says a clearing expert at a US bank.

There can be a significant gap between SwapClear's actual margin requirements and the level member firms want to see. It arises because SwapClear's value-at-risk model works out collateral based on historical market moves recorded in relative, rather than absolute, terms. When those relative moves are applied to today's low interest rate environment, the model spits out low margin numbers.

"We became aware of the issue about six months ago and we recognised the model had issues because it was based on relative moves, not absolute moves. In a protracted low interest rate environment, this means positions could be under-collateralised by as much as 40% at the 10-year point, for example. Once we discovered this, we alerted LCH.Clearnet instantly and asked them to fix their models immediately because the deficiency leaves us exposed to higher mutualised losses," says a clearing specialist at a second US bank. He says conversations with SwapClear on the subject were difficult.

SwapClear has responded to these concerns, but Davie rejects the idea that the current model is wrong or that users of the service are under-protected.

"We have a relative bias in parts of the model and as rates stay low for a prolonged period of time, the model doesn't work as well, but I certainly wouldn't characterise it as being wrong, and I certainly wouldn't characterise it as under-margining. Those are both fairly grave charges for a CCP," he says.

"What we are doing is looking to rebalance the model between what is mutualised by all the members and what is paid by the individual introducers of risk – and to have a model that will work well in low-rate environments and indeed when rates go back up. Once we have settled on a sufficient balance between the mutualised risk and margin contributions, we want to have a model that will preserve that balance in a variety of rate environments," Davie adds.

When the new model is validated, the default fund should fall in size but not necessarily on a dollar-for-dollar basis, says Davie.

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