Central clearing has had a dramatically beneficial effect on the over‑the‑counter derivatives market, reducing risk, standardising processes and generating new capital and operational efficiencies. But for some products – such as cross-currency swaps and swaptions – the road to a cleared model has not been as smooth.
A recent survey by Risk.net and LCH SwapAgent revealed that the capital, operational and margin costs of the non-cleared market have increased, while liquidity has decreased. If this is the case, what can be done to reduce costs and make the bilateral market more efficient?
- Nathan Ondyak, global head of LCH SwapAgent, LCH
- Tobias Becker, global markets – global macro products, Credit Suisse
- Michael Pollak, director, Barclays
- Mike Curtis, managing director, business resource management, Nomura International
- Moderator: Joel Clark, Risk.net
What are the greatest challenges facing the non-cleared market, and how serious are these issues?
Tobias Becker, Credit Suisse: At the heart of all the challenges for the uncleared market is the fact that it essentially looks no different today than it did 30 years ago – just much bigger. Thirty years ago a handful of banks began trading with each other under their own terms, facing each other directly. That is still very much the case – but dealers now typically face tens of thousands of clients on derivatives under the same type of infrastructure. However, since around 2009 the Basel Committee on Banking Supervision has said it wants to reward centralisation of risk and trading in central counterparty clearing houses (CCPs), meaning there will be a regulatory penalty for fragmenting risk away from CCPs.
Michael Pollak, Barclays: One of the greatest challenges is market liquidity – we are seeing less liquidity and fewer participants in these markets than three to five years ago. The balance-sheet impact for uncleared derivatives is large from a cost and regulatory perspective, and a lack of standardisation underlying the uncleared derivatives market is fundamental and poses problems.
Nathan Ondyak, LCH: LCH is certainly still learning, but one thing that has become very clear is the community has often said these things will go away as everything is going to be cleared. We’ve come to the conclusion that the non‑cleared market is not going away. We hope more clearing will take place, but it is definitely here to stay, and I think the question then becomes – how do we come together to build a more efficient non-cleared market to reduce fragmentation and help market liquidity and capital costs?
Mike Curtis, Nomura International: Clearing has been a great help in the derivatives markets. It’s made trading far easier, less inefficient and has huge benefits. Can we get some of the benefits of clearing into the uncleared market? We are all trying to work out how to do this. One benefit of clearing that could be moved across to the uncleared market is the standard credit support annex (CSA), which banks have thought about and tried two or three times, but it hasn’t taken off. The clearing world uses standard CSAs – if there is any way we can get that across, it will open up big improvements in novation, compression, risk reduction and backloading, and will take away a lot of cross-gamma problems for the traders. Having a consistent revaluation curve for variation margin calls may be very helpful to customers. Another item is settlement netting – if there is a way to get some efficiencies of clearing to make all settlements net into one payment per currency, it will be a great help.
Which products in the non-cleared market are most heavily affected, and what is the net effect on liquidity?
Tobias Becker: For decreasing liquidity in the uncleared market, an example outside the derivatives arena is the US Treasury market. People always think US Treasuries are the most liquid instrument traded in fixed income. Even there you have a situation where, of about 400 Treasury bonds, only two dozen are on-the-run, and some of those off-the-run often don’t trade in an entire month or quarter on some trading platforms. That means every bond trader really becomes a part-time capital and balance‑sheet trader.
Michael Pollak: About three or four years ago, the capital allocation from trading books came down to the desk level, or at least you were able to see an allocation. It was large, almost frighteningly so for some of these numbers. As this permeated the industry, liquidity reduced. We are currently dealing with the same participants over and over, which leads to one-way directional risk with counterparties, and then [we get] ‘gappy’ price action when markets move or somebody wants to trade.
How challenging and potentially unsustainable are these issues? If cross-currency swaps are fundamental to the real economy, companies rely on them, how critical is the need for some sort of solution?
Michael Pollak: I think it is hugely needed – we spend lots of time doing the same repetitive tasks. They are iterative, and we look at how some trades can be large and some small, and we are talking fractions – basis points – that can have real impacts to the bottom line.
Tobias Becker: It does feel like cross-currency swaps are unfairly penalised by regulation. If you dust off very old Basel I regulation, a product that sticks out that was already penalised by capital rules was cross-currency swaps. At the same time, they are the instrument that probably has the most fundamental context to the real economy in terms of financing international trade, project finance, and so on.
The lack of standardised CSAs for the non-cleared market is a benefit that could be brought by clearing. What is the potential effect of having a standardised CSA for this market, and why is this becoming more of an issue?
Nathan Ondyak: I think optimising – especially in the interbank market – with that sort of complexity is a real challenge. When you are looking to do risk or compression optimisation, and you need to overlay risk or move risk around, the product is just not fungible. Any time you try to bring risk across counterparties, you just introduce more friction. Then, when you bring the CCP into the mix, you have a whole other set of CSA terms.
Tobias Becker: On the CSA point: they are the most complex of all derivatives, and obviously were not intended to be so. If you look at the variety of CSA terms, they often make any kind of optimisation impossible. The complexity in CSAs is really a self-inflicted wound by the industry – no regulator told us to change CSA terms between different counterparties and use these kinds of fragmented terms.
If the industry brought fragmentation on itself, perhaps it could now bring standardisation on itself – what kind of optimisation solutions might help address the issues we are seeing in the non‑cleared market?
Tobias Becker: Traditionally, the largest optimisation is trade compression. Compression is a great thing – it brings operational and capital relief but is very much based on the notion that derivatives notional is bad. Anybody who deals with derivatives knows notional is a very different concept from risk, so the more recent optimisations would be rebalancings or triangulations where, for example, you are long a risk against one counterparty but short a risk against another, and you try to find offsetting trades on a multilateral basis. That’s a very exciting area, but is very much challenged by the lack of a central platform to execute on.
There are serious issues that must be tackled – liquidity, fragmentation, lack of standardisation, the difficulty of effectively carrying out optimisation such as compression. Why not just clear these products?
Nathan Ondyak: In time, there will be clearing in these products – likely at LCH – but clearing them doesn’t quite make as much sense as one might think. Cross-currencies are a perfect example – we ran quite a big programme to explore bringing the product into clearing. When we looked at the economics and the total cost of clearing the product from the margin and settlement liquidity perspectives, the efficiencies were not as straightforward as we thought.
Mike Curtis: On cross-currency swaps, we had a good look at it, and it was going to be a difficult thing to clear because of the daily settlement limit problem at the clearing house – clearing houses don’t have the sort of liquidity reserves that a banking operation would have.
Tobias Becker: Ultimately, as an industry, we will clear cross-currency swaps, but the traditional central clearing setup is not really suited – from a settlement risk perspective – for dealing with large cashflows or present values suddenly dropping off. The other thing that traditional CCPs are not quite geared towards is discontinuous counterparty risk. For example, in a swaption expiry into a cash settlement, your counterparty risk drops off overnight. It could be a very substantial swaption expiry in the money or a cross-currency swap maturing with a significant mark-to-market. That’s very different from traditional clearing products. For these discontinuous counterparty risks and the ‘Herstatt’ settlement risk, the traditional instrument that CCPs hold – the initial margin – is not a great mitigant..
At desk level, how closely do you look at potential solutions?
Michael Pollak: We have spent a lot of time thinking about the impact of initial margin – the impact of breaching settlement limits and on various different multipliers on the pricing of our existing businesses and trades. What led us down this path was that market bid offers will have to widen if we’re going to have to bear these sorts of margin costs – which would take the market back a step or two. This would have added further fragmentation to what we’re seeing in the uncleared space.
Have you considered clearing forward-starting cross-currency basis swaps with cash settlement before they start?
Nathan Ondyak: Yes – as a method to address some of this risk, there were a number of product ideas thrown up. There were also a number of participants wanting to trade a cash-settled cross-currency basis swap without ever bringing anything to delivery. There is some trading in that product on a one-off basis, but we’re trying to increase the liquidity of the product, and to do that you need a broad-based buy‑in. Cross‑currency is about actually exchanging the currencies – and there are a lot of participants that want to keep the product the same as they’ve been using it for a long time.
Michael Pollak: I remember when Nathan brought the financially settled product to us. While we thought it was a really interesting idea, we took a step back and said “wait a minute, we need the cash” – we need these initial exchanges of principle to rebalance the foreign exchange risks in the book. This is a real-world product – it is the major switching point outside of a two-year forex forward for changing currencies for corporates and asset managers. If you have to make the payment out and you are not getting it back, you’re going to spend a lot of time in the short-dated forex market trying to fund your book.
Tobias Becker: The last thing we need is product fragmentation, and typically for cross-currency swaps there is one group that predominantly trades the basis spread – the discounting risk community – but it would be wrong to separate the products into a real‑world product with real principal cashflows, and a risk management product that only trades from a basis-spread risk perspective.
Tell us about the realisation that clearing wasn’t going to be the optimal solution and the subsequent lead-up to the launch of SwapAgent.
Nathan Ondyak: When we sat down with the community and were specifically running through leverage, net stable funding requirements, compression and optimisation challenges, and redundant payments, we found a lot of nice bits in clearing that aren’t necessarily relating to centralisation of counterparty risk
We said: “Is there a way for us to take the clearing platform and the standardised documentation, the elimination of disputes, the outsourcing of valuation, the compression and the risk optimisation side of it, and bring that to the non-cleared market without necessarily having to novate to a CCP?” So we developed SwapAgent in conjunction with the industry.
How long will SwapAgent take to be fully operational, and what challenges might arise in migrating market participants onto the platform?
Nathan Ondyak: These things take time – you’ve got to put the product out there and work with the community to bring things on. However, it’s not necessarily the right answer for every customer, and I’m sure there are some that are very sensitive to their CSAs. There is a lot we can do to simplify the product set so that we can bring down costs, ultimately affecting the market and the liquidity end-users are experiencing.
What will be the tipping point to make cross-currency swaps clear? Do you see this as a stepping stone to an interim solution or something that will operate alongside it?
Nathan Ondyak: When you say something will clear these days, it is an all-or-none proposition. But from 1999 until not too long ago, clearing was optional, and the communities selectively cleared when it was efficient with their counterparties or within the wholesale market to bring down risk in an efficient and managed way. So I think in the forex and cross-currency markets that’s the role clearing will play.
What should end-users and market participants consider doing differently?
Mike Curtis: There are market participants with a desire to have a very particular CSA – if they can fit with everybody else in their bilateral space, a CSA that many other banks would have with each other, as well as with other counterparties, their experience of trading in the bilateral space would then be easier. Obviously, the ultimate solution would be a standardised CSA, such as SwapAgent has, but SwapAgent is only likely to offer certain products in the short term, so it should try to be as standardised as possible.
Tobias Becker: The advice I would give to the client base is to look at what is going on in the dealer community – because this is where client risk is ultimately being hedged between, for example, the institutions here at the table and the many other dealer banks out there – and try to align your trading as closely as possible to that. Then you’ll benefit from liquidity and the other features and advantages we’ve discussed.
Michael Pollak: Embrace standardisation – if they embrace standardisation, they will benefit from the economies of scale.
What is the approximate timing for clearing cross-currency swaps?
Nathan Ondyak: We don’t have a current active programme to clear cross-currency swaps. It makes sense for us to do that at some point in the future, but it’s not something coming down the pipe any time soon.
How many banks have signed up for SwapAgent and when do you expect the market to adopt the product?
Nathan Ondyak: We’ve signed up 14 major dealers to SwapAgent, so there is commitment from the main liquidity providers to support the platform. We recently rolled out cross‑currency swaps and processed the first trades in late November. I don’t think we’re going to see a major change in the cross-currency market by the end of the first quarter, but by the time we get to the second quarter we could start seeing material take‑up in the product.
How can clients receive an overview of how SwapAgent works, and how the variation margin is collected and distributed?
Nathan Ondyak: We are actively educating clients on the product now, and a comprehensive overview of the operational model is available for anyone interested.
Listen to the full webinar, Clearing conundrum – Forging a solution for the bilateral market