When it comes to clearing and settlement today, the name of the game is capital efficiency.
With a host of regulations hitting the market, particularly with bank capital requirements under Basel III, exchanges and clearing houses are moving quickly to find ways for banks and clearing FCMs to lower the amount of cash they need to hold onto in the name of lower systemic risk.
It is an interesting time to be in the clearing space, as clearing firms offer a number of new services and some oldies aimed at clearing FCMs. Portfolio margining, which has been done more or less in a fragmented way by individual clearing houses in recent years but with limited success, may be finally finding an audience in today’s market environment. Clearing houses such as CME Clearing, LCH.Clearnet, Eurex Clearing, ICE Clear, OCC and others have all offered some form of portfolio margining services in recent months or years. LCH.Clearnet is attempting to push that concept further with its so-called “open access” on clearing, which essentially allows customers to choose where they would like to clear transactions with the markets it services. A London Stock Exchange-Deutsche Boerse merger could help, or depending on the German approach, alter the concept.
Sunil Cutinho, the president of CME Clearing, said the top priority for clearing house customers is finding that capital relief.
“In 2013-2014 the focus was meeting clearing mandates. Now it has shifted and is more heightened given the new rules such as uncleared margin rules, which came down in September,” Cutinho said. “The rules are increasing capital costs for market participants, banks and non – bank affiliated organizations.”
CME Clearing has been seeking capital reduction synergies through its portfolio margining service and via new contracts. The exchange is set to launch clearing on April 11 of interest rate swaptions, which it claims could create margin offsets of up to 91 percent with cleared interest rate swaps, Eurodollar, and deliverable swap futures.
When the CME launches cleared swaptions, Cutinho said participants will be able to “selectively choose the swaptions that go along with the swaps to be cleared at the CME, so they can get 90 percent of the portfolio benefits. Their swaptions will be compressed, because if you have a long and a short position, they cancel out and you have a zero net position.”
And Cutinho is not alone in looking for efficiencies. John Horkan, executive director of SwapClear US, said that LCH Spider, its new automated service designed to offset OTC and listed interest rate positions. The large pool of swaps that could be offset with futures positions could be well timed for the current and upcoming capital requirements.
And like several other clearing houses, LCH.Clearnet continues to plug away with its compression services, in partnership with TriOptima. In 2015, for example, LCH.Clearnet’s SwapClear service compressed $323 trillion in trades with a net notional reduction of $107 trillion on instruments such as forward rate agreements, and overnight index swaps.
Eurex, too, has joined the clearing house innovation game. Yesterday, Eurex Clearing announced a new service that allows buy side participants – pensions, endowments, fund companies and other institutional investors – to become direct clearing members. The new membership class (called “ISA Direct”), will initially be available for interest rate swaps and repo transactions, and later be expanded to include securities lending and listed derivatives. This could help alleviate some of the balance sheet concerns that have contributed to the decline in the number of bank FCMs.
LCH.Clearnet and CME Clearing also provide for blended compression, which expands the pool of securities available for compression, by including trades with compatible cash flow dates but with different rates or coupons. Blended compression essentially replaces a basket of similar securities with one that exactly replicates the cash flow characteristics, thereby reducing net notional value, as well as the number of line items, outstanding. According to Cutinho, CME Clearing has compressed over $10 trillion in notional value. Both CCPs offer multilateral compression through TriOptima’s triReduce service.
“With netting and coupon blending, we’ve given participants an independent way to bring down their notional outstanding. Because Basel capital rules are anchored on notional and line items, they get substantial benefits,” Cutinho said.
Whether this combination of margin offsets and various forms of compression will be enough to free up enough capital in the system is still a key question. Some global clearing firms believe that the agreement between the EU regulators and Commodity Futures Trading Commission, granting equivalent rules on clearing between US and EU clearing houses in February, is one positive step. What Basel III’s capital ratio and risk requirements all entail and perhaps the so-called Basel IV focus on risk weighted asset standards will push clearing houses and firms even further to come up with solutions.
In the meantime, clearing houses are focused on the current offerings while keeping an eye on the next solutions that will provide relief.