Swaptions CCP basis arrival raises wider valuation questions

Halting rollout of new prices highlights potential weak points in valuing illiquid products

Dealers get the jitters when a spread appears for products that are meant to be fungible: it could mean the valuations in their books are wrong. But for price verification teams to re-mark those books, they need to see a functioning, tradeable market. 

For relatively illiquid products such as swaptions, pricing is difficult at the best of times. But it becomes a lot harder if you are trying to find accurate values for something as esoteric as the basis between yen swaptions depending on where the underlying interest rate swap clears.

While this basis has traded in the voice broker market for a while, such quotes may not be solid enough to re-mark books. 

IHS Markit’s Totem consensus pricing service started providing marks for the basis to around six participating banks in March. Pricing experts say this can be enough to re-mark books, depending on the number and size of the banks involved, and the perceived accuracy of the marks. 

For non-Totem users, though, verification teams might prefer to see a price on Bloomberg before revaluing existing positions. That’s exactly what they got on March 7, when Japanese broker Totan began publishing differing quotes on Japan Securities Clearing Corporation and LCH-delivered yen swaptions. 

It didn’t last long – following criticism from dealers, the broker took the screen down after just three days. Some believe it was due to the inaccuracy of the prices, while one informed source says Totan was just gathering feedback. But former swaptions traders and buy-side sources speculate dealers wanted to avoid re-marking their books, fearing losses that could add up to $100 million across the Street.

While it’s difficult to know what happened behind the scenes, the episode highlights potential conflicts of interest in the valuation of illiquid trading positions. The Totem marks for the basis, which are submitted by banks themselves, were said by some to be around half the size of the ones trading in the broker market at the time – though bank sources say this isn’t always the case. 

While it didn’t necessarily occur in this instance, it shows a potential motive for banks to lowball Totem submissions, which could allow them to dampen the losses they might otherwise have had to show. The interaction between banks and brokers is another area in which conflicts could arise: it’s possible to imagine dealers pressuring a broker not to broadcast pricing if they were sitting on losses.

In the case of the yen swaptions basis, pressure on the market is said to be easing as strong international demand for Japanese rates exposure wanes. However, it’s unlikely to be the end of the story – one broker points out that you can’t keep a lid on a basis – and there may well be other attempts to put the price difference on screen at a later date. But the significance of the story goes far beyond the yen swaptions market. 

Editing by Lukas Becker