Clear warning on escape hatch for optimisation trades

CCPs fear Emir clearing mandate carve-out for portfolio rebalancing could be abused

  • European lawmakers have allowed post-trade risk reduction runs to be exempted from the clearing obligation as part of Emir 3.0.
  • Some clearing houses fret that this could create a loophole for cleared trades to be moved back into the non-cleared space without justification.
  • But other market participants say there are good reasons to think this hypothetical risk will never materialise.
  • Eurex, which previously opposed the exemption, has now become favourable, possibly because the PTRR relief may facilitate the transfer of cleared trades from the UK to the EU.

When a trade is labelled risk-reducing, it seems natural to assume that’s what it does. Yet some clearing houses are claiming new legislation in the European Union might permit the label to be used for a more nefarious purpose: to extract derivatives trades from central clearing altogether.

Other market participants – including some central counterparties (CCPs) – are sceptical about the claim. They point out there are few incentives to employ portfolio optimisation trades as a way to evade the clearing mandate, and indeed some strong disincentives. But as EU regulators are currently drafting the technical standards that will implement the new rules, they may well be wary to avoid creating any loophole that might increase systemic risk.

When the European Market Infrastructure Regulation (Emir) was first drafted in 2012, portfolio compression was already established as a way to reduce total derivatives exposure across the financial sector. Consequently, lawmakers were comfortable that compression cycles could be carved out of the clearing mandate while fulfilling the objective of creating a safer financial system, agreed at the 2009 Pittsburgh Group of Twenty summit.

It was only later that post-trade risk reduction (PTRR) exercises began to catch on. Banks argued that the clearing mandate for vanilla interest rate swaps (IRS) made it difficult to engage in PTRR for non-cleared instruments. They were forced to use swaptions to avoid triggering the clearing obligation, but these exotic instruments are too sophisticated for smaller clients to trade frequently.

In November 2020, the European Securities and Markets Authority recommended exempting rebalancing trades from the clearing mandate. The regulator believed PTRR could genuinely help curb the systemic risk of legacy derivatives trades, and that facilitating the use of vanilla swaps rather than swaptions would also reduce complexity in the system.

The European Commission initially declined to follow Esma’s advice when it proposed amendments to Emir – dubbed Emir 3.0 – in December 2022. However, bank lobbying evidently paid off, as both the European Parliament and Council of the EU included the clearing exemption for PTRR in their own drafts of Emir 3.0.

Roger Cogan
Roger Cogan, Isda

“As the text moved through Parliament, the European Commission backed an idea that support was building for anyway,” says Roger Cogan, head of European public policy at the International Swaps and Derivatives Association.

The relief was included in Article 4aa of the final version of Emir 3.0, agreed in February 2024. It will apply to over-the-counter derivatives contracts that are initiated and concluded as the result of an eligible PTRR exercise. According to one clearing house source, this is an “unfortunate” outcome.

“It would be a mistake if the EU strayed from the G20 commitments, but they seem to have done it anyway,” says the source.

The head of regulatory policy at a major clearing house says that central clearing has “greatly contributed to the safety of the financial system”, and providing any route for exempting plain vanilla swaps from the clearing mandate is “questionable”.

Even some clearing members – who are supposed to benefit from the relief – are anxious. A former head of clearing at a large bank thinks the exemption is “definitely a loophole that can and will be exploited”.

If all main global regulators were on board, it could result in up to a thousand or so non-cleared IRS optimisation trades in each rates optimisation cycle
Gavin Jackson, Capitalab

Needless to say, those who lobbied for the exemption take a very different view. “This is something that we’ve really been pushing in earnest for six years or so,” says Cogan.

Isda’s latest margin survey shows bilateral trades were collateralised with $325.7 billion of initial margin (IM) in 2023, not far behind the $384.4 billion in IM posted for cleared trades.

“There’s obviously a huge amount of exposure where it’s probably going to be very attractive to do these kinds of exercises,” predicts the first clearing house source.

The case for

Post-trade vendors providing PTRR services certainly interpret the potential uses of the new clearing exemption narrowly, consistent with lawmakers’ intentions.

“A targeted exemption would enable a simpler and more effective process for market participants to reduce risk, especially in their uncleared portfolios,” says Andrew Williams, head of London Stock Exchange Group’s post-trade solutions, and chief executive of Quantile, the compression provider that LSEG acquired in 2021.

Gavin Jackson, founder of Capitalab, says the carve-out could be helpful to increase the notional efficiency of rates optimisation exercises in a comparatively straightforward way.

It would be a mistake if the EU strayed from the G20 commitments, but they seem to have done it anyway
Source at a clearing house

“We could then use non-cleared interest rate swaps (IRS) for tackling delta risk optimisation, whilst saving options only for the vega and gamma elements,” he says.

However, Jackson is hoping regulators in the US, UK and Japan will follow the EU’s lead, because an exemption for intra-EU trades only would restrict the potential for risk reduction.

“If all main global regulators were on board, it could result in up to a thousand or so non-cleared IRS optimisation trades in each rates optimisation cycle,” he explains.

The US and Japan don’t have an exemption from the clearing obligation for risk rebalancing services. Nor does the UK, but the Financial Services and Markets Act 2023 empowers the Financial Conduct Authority to make rules exempting certain PTRR activities, services or providers from the derivatives trading obligation. Market participants are waiting to see if the Bank of England – which regulates central clearing – may also provide a parallel exemption from the derivatives clearing obligation.

The case against

Esma’s view is that the reduction in net risk and complexity from portfolio rebalancing outweighs any resulting increase in gross risk in non-cleared netting sets.

However, the European Systemic Risk Board was never a fan of the clearing exemption for portfolio PTRR. Twice in the past four years – in 2020 and 2022 – the ESRB has expressly criticised the idea. The watchdog warned that a carve-out could “create a loophole for circumventing the clearing obligation and reversing centrally cleared trades”.

A spokesperson for the ESRB says its official view is unchanged: “Our original position would stand.”

The first clearing house source explains how the alleged loophole might work. A bank and a hedge fund could agree a term sheet equivalent to the whole DV01 profile of the bank’s IRS exposures at the clearing house across all currencies, and execute a single new trade that is the equal and opposite of these cleared positions. This bespoke swap would obviously not be covered under the clearing obligation.

A targeted exemption would enable a simpler and more effective process for market participants to reduce risk, especially in their uncleared portfolios
Andrew Williams, LSEG and Quantile

“Then they run this PTRR cycle, as they are euphemistically calling it, and it tells you that since you can’t clear the swap done with the hedge fund, you should extract all your trades out of LCH and put them into the same netting set with the hedge fund,” says the clearing source. “And then they rip up the original contract – they’ve just extracted all of their trades out of the CCP in one fell swoop.”

A former US federal regulator is inclined to agree. They make the point that exempting more trades from clearing has the potential to obscure the transparency of the total number of outstanding derivatives contracts for an asset.

“If you create a mechanism by which you can essentially compress a buy against a sell, not in the marketplace, then it corrupts the integrity of what the open interest is,” says the former US regulator.

“I can see why the Isda membership would absolutely support a way to trade off-exchange, and I can easily see why the CCPs don’t like the idea.”

Never going to happen

The senior clearing house source concedes their example is hypothetical, and of course no market exists currently for a total return swap version of everything a bank clears at SwapClear.

“But the simple example shows it’s very easy to quickly construct versions of trades where you can essentially decide what you’d like to have in which netting sets,” says the clearing source.

The source also acknowledges that end-clients such as pension funds would not want to directly face a hedge fund using a bilateral Isda master agreement. But he argues that the bank can easily sit in between.

“The point is that if a bank is facing its clients, which are a mix of hedge funds, pension funds and what have you, if they wanted to, they could create bilateral trades in such a way to also bring out the normal cleared trades [from CCPs].”

However, other market participants seriously question why any bank or hedge fund would want to participate in some kind of fake PTRR exercise. Bill Stenning, head of public affairs, UK, at Societe Generale, argues there are protections in the drafting specifically designed to ensure risk is genuinely reduced, rather than just being moved from the cleared to the non-cleared ecosystem. The trades must be market risk-neutral, accepted in full, and not contribute to price formation.

Bill Stenning
Bill Stenning, Societe Generale

Most importantly, the rule requires that the risk in each bilateral portfolio that is part of a PTRR run must be reduced to qualify for the exemption. A trader cannot simply claim that a trade is risk-reducing to obtain the relief.

“This is not just an exemption from the clearing obligation,” says Stenning.

The senior clearing source disagrees. He thinks the trade he describes could still comply with Article 4aa, because it is not price-forming and could include all the safeguards required to qualify for the exemption.

This is “an example of the size of error that the Europeans made when they passed this”, says the senior clearing house source: “If somebody wants to exploit this, there’s no control over it.”

However, Stenning also points out that non-cleared margin rules mean the liquidity benefits of removing trades from clearing houses will be minimal. Conversely, the capital charge for counterparty credit risk on a bilateral trade with a hedge fund would be many multiples larger than on the same exposures cleared at a CCP, which would be a strong disincentive for any bank to enter into such an arrangement. The first clearing source accepts there are potential capital implications.

Two sources also think hedge funds would be reluctant to participate in a phoney rebalancing exercise. Anyone wanting to provide PTRR services must register as an investment firm authorised under the Markets in Financial Instruments Directive (Mifid), and demonstrate that it is independent from the counterparties to the OTC derivatives included in the optimisation run.

Esma will need to define how hedge funds demonstrate independence – it could mean avoiding prime brokerage relationships with any of the banks involved in a PTRR run. And for hedge funds currently regulated under the Alternative Investment Fund Managers Directive, switching to a more onerous Mifid licence could be unattractive.

Brexit transfers

Of course, CCPs have a vested interest in objecting to anything that might reduce the volume of cleared trades. But at least one clearing house now seems to be coming round to the exemption for PTRR runs. Eurex Clearing last year told it would not support an exemption, and didn’t see how it could increase the appeal of clearing in the EU.

Yet, in an about-face, a spokesperson for Eurex now says PTRR is “an additional tool in managing risks for major market participants”.

If somebody wants to exploit this, there’s no control over it
Senior source at a clearing house

“We believe that in general, the defined conditions and the monitoring mechanisms adequately support the general clearing obligation,” they say.

A former risk manager at another CCP suggests a possible reason for the change of heart at Eurex. The PTRR exemption might be used as a way to extract IRS exposures from LCH and transfer them to Eurex, without the burden of unnetted double margin requirements at the two houses while the transfer process is ongoing. Being able to shift the trades into the non-cleared space and then move them across to Eurex in bulk when ready could also avoid the risk of having to operate in an inadequate liquidity pool at either CCP.

“Having a temporary way to avoid this obstacle might enable volumes to pass out of the UK,” says the former CCP risk manager.

EU clearing participants are now under pressure from European regulators to demonstrate they are trying to move more of their volumes onshore, rather than leaving them in UK CCPs post-Brexit. If lawmakers deem that the shift from the UK to the EU is inadequate, they may introduce quantitative minimum thresholds for clearing derivatives onshore, which market participants are keen to avoid.

Still to play for?

The senior clearing source is pessimistic there is much that can be done now that the exemption is included in Emir 3.0. However, the relief will not come into force until Esma has written regulatory technical standards setting out the detailed obligations for PTRR providers.

“It should be noted that the Emir 3.0 legislative text is currently going through the legislative process, and thus Esma will await its finalisation, the publication in the Official Journal and the entry into force of Emir 3.0 before developing these technical standards on post-trade risk reduction services,” says a spokesperson for Esma.

The legislative text requires that, in advance of the investment firm providing PTRR services, its national regulator must notify Esma of the firm’s name and provide its assessment of how the firm will satisfy the requirements for conducting PTRR services. The national EU regulator will be responsible for monitoring ongoing compliance with these requirements. Esma will annually publish a list of PTRR service providers.

Among the obligations on the investment firm undertaking the PTRR exercise, it must monitor the resulting transactions to ensure they do not result in any misuse or circumvention of the clearing obligation. The Esma regulatory technical standards on these obligations could therefore provide a route to close any loopholes, but the senior clearing source says it won’t be easy.

“This requires monitoring, somebody who needs to look through trade repository data and check,” they say. “It’s just very cumbersome and difficult, because now you have to really check.”

Correction, May 13, 2024: This article was amended to correct data on the volume of initial margin posted in cleared and non-cleared markets.

Editing by Philip Alexander

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