CCP basis and the future of cleared swap pricing

The lifecycle of a trade is often split into two hemispheres. There are things that happen prior to the trade being executed – quote requests, the communication of bids and offers, credit checks and so on – and things that happen afterwards.

Clearing is one of the many things that belong in this post-trade world, so an outsider looking in at the swap market might find it odd that an otherwise-identical transaction would vary in price depending on a customer's choice of clearing venue. The pre-trade and post-trade worlds are somehow bleeding into each other, they might think – the walls between them twisting into a Möbius strip.

To an insider, there's nothing strange about this. It might make sense to think about pre- and post-trade separately from an operational or regulatory point of view, but in terms of the economics, the choice of clearing house will determine how much margin the bank has to stump up and what kind of collateral is acceptable. That should be reflected in the price.

Traders learned these lessons in 2009 and 2010, when collateral agreements on bilateral trades first started to determine the swap discount rate, and introduced the market to a brand new form of arbitrage (Risk June 2013). They were reinforced in 2012 and 2013, when banks started to upfront the funding costs arising when an uncollateralised trade is hedged with a collateralised one, in the form of the funding valuation adjustment (FVA).

So it shouldn't be a surprise that – if a product can be cleared at two central counterparties (CCPs), and one of them has a directional book of trades - dealers would seek compensation for the margin costs associated with new risk-additive trades. In fact, it's more surprising that the basis between CME Group and LCH.Clearnet was not being priced in far earlier – if that had been the case, its eventual surge in May would not have been so dramatic.

For any given trade that could clear at more than one CCP, a dealer will have a preferred choice

The more divisive question is how far to take it. For any given trade that could clear at more than one CCP, a dealer will have a preferred choice – the one at which the trade will be most risk-reducing, least risk-additive, or cheapest for that specific bank to fund. In theory, the price might be shaded to reflect that. The basis, then, might not be a single figure that applies across the Street to all trades of a given type. It might be dealer- rather than CCP-specific.

This kind of development is hinted at by two traders in this month's lead stories. One says banks will have to deal with CCP basis by pricing some trades "in a more granular way relative to what we have currently". The second warns a basis could pop up for any product cleared at two different CCPs, then adds: "There should be one in theory, because no-one will ever have the same position between two clearing houses."

In other words, cleared swap trades might not be immune to the kind of pricing diversity that now afflicts the bilateral market.