In September 2021, CME Group published a paper that discussed the history of the USD central clearing counterparty (CCP) basis market. Additionally, the paper analyzed the advantages of clearing invoice swap spreads at CME Group using portfolio margining, which based on historical data, have been demonstrated in case studies to outweigh the average cost associated with managing the CCP basis. CME Group has received positive feedback on the thesis. However, many firms have mentioned that implementing this strategy is challenging given the various netting sets that exist across all relevant CCPs.

The goal of this paper is to discuss a potential solution that is designed to address these challenges; a strategy whereby individual traders’ activity at each CCP will remain unchanged and the Treasury Departments of these firms will look to optimize initial margin requirements across CCPs via overlay trades. This overlay strategy provides an effective solution in circumstances where the initial margin savings are greater than the expected corresponding costs of managing the CCP basis for a given period of time.

It is important to acknowledge the constraints that currently obstruct firms from achieving the most optimal capital efficiency results.

Based on observations across the marketplace, firms historically tend to gravitate towards operational ease and individual portfolio managers’ CCP preferences. Although it is common for traders within the same firm to implement multiple strategies across various IRS currencies, listed futures, and CCPs, it might not be efficient to have these individual traders managing the resulting CCP basis risk.

Additionally, many firms utilize different FCMs for listed products and cleared swaps. This structure limits the firms ability to achieve the savings available via portfolio margining.

Based on these constraints, an overlay strategy could be utilized to achieve optimal margin results at the firm level across CCPs.

This rule-based strategy would involve a firm entering a series of overlay trades when the resulting margin savings available outweigh the predicted cost of managing the CCP basis for a given period of time. This would allow the Treasury Department of the firm to take advantage of margin savings without disrupting individual trader activity.

For example, assume a simple scenario where a firm has three portfolio managers trading unique strategies across USD IRS and EUR IRS (Non-CME Group) and listed futures (CME Group) at the 5-year point on the curve:

Trader 1: Receives fixed in USD IRS vs. equivalent short treasury futures position

Trader 2: Pays fixed in USD IRS vs. receives fixed in equivalent EUR IRS position

Trader 3: Receives fixed in USD IRS vs. a non-cleared fixed income instrument

Note that the sum of the traders’ initial margin requirements do not match the firm total. For the avoidance of doubt, the goal of the overlay strategy is to maximize the firm’s savings through portfolio margining offsets with their listed futures positions at CME Group.

In this example, as shown in Table 2, the following overlay strategy could be implemented:

• Enter into a 5-year CCP basis trade of approximately $75,000 of DV01 that pays fixed at the non-CME Group CCP, while receiving fixed at CME Group.

By shifting a portion of its USD swap risk into CME Group, this strategy allows the firm to achieve significant savings through portfolio margining offsets with its listed futures position. In this example, this firm’s margin requirements would decrease by $3,602,294 or just under 40%.

Given the recent Federal Reserve rate hikes, we can reasonably assume an initial margin funding cost of 3.5%. At this funding level, the firm would save approximately $350 in funding costs per day via portfolio margining in this example (($3,602,294 x 3.5%) x (1/360)).

Based on dealer conversations, CME Group understands that participants can reasonably expect to see a two-way CCP basis price that is 0.1 bps wide for a trade of this size. From a cost perspective, this implies the cost of executing this overlay trade is 0.05 bps from mid on average, or $3,750 ($75,000 x 0.05).

In summary, if the firm’s current exposures are held for greater than ten days, the margin funding savings outweigh the cost of executing the overlay strategy ($3,750 ÷ $350 = 10.7 days).

Implementing this swap overlay strategy would allow market participants to realize two key advantages:

• Allows individual portfolio managers to continue trading independently across various IRS currencies, listed futures, and CCPs.
• Enables the Treasury Department within a firm to reduce margin requirements across CCPs and listed futures when the savings exceed the predicted cost of managing the CCP basis.

There are a few implementation challenges to consider in relation to this strategy:

As stated earlier, many firms use different clearing members for their cleared swap and listed futures activity. To fully take advantage of the potential savings available via portfolio margining, it will be critical that the CME Group side of the CCP basis strategy is cleared at the same clearing member where the listed future activity is held. Likewise, the non-CME Group side of the CCP basis trade will need to be cleared through the same clearing member where the existing cleared swap activity resides.

In order for firms to implement this overlay strategy and effectively monitor the corresponding cost and savings, the Treasury Department will need to operate as a profit center. This would require the establishment of risk limits and the ability to execute CCP basis trades. Additionally, it is essential for the firm to have a means to account for the margin savings generated, specifically:

• Overlay trades will need to be marked-to-market (MTM) daily, which will capture the cost of execution and any potential gains or losses associated with moves in the CCP basis.
• Any CCP or clearing member fees associated with clearing the overlay trades should be taken into account.
• The account will need to be credited for any reduction in initial margin funding costs across CCPs, as well as any FCM fees related to initial margin requirements.

Lastly, the Treasury Department must be able to estimate the average holding periods of positions and identify overlay opportunities.

Note, given the assumptions embedded in this strategy, the margin savings of a particular overlay trade may not outweigh the cost of executing the overlay strategy in particular circumstances. Therefore, the application of the strategy would need to be considered by a firm on a case-by-case basis. The Treasury Department’s risk limits should be aligned with the firm’s overall comfort level and ability to design and implement an overlay strategy that could deliver benefits that are expected to outweigh the costs over time.

CME Group consistently aims to provide solutions that help alleviate capital efficiency challenges faced by market participants. In addition to acknowledging the constraints related to cross-CCP margin optimization, this paper outlines a strategy involving the implementation of swap overlay trades that unlock potential margin savings by having the Treasury Department centrally manage the CCP basis risk. The goal of this paper is to serve as a reference for firms exploring avenues for achieving optimal margins across CCPs without altering their portfolio managers behavior. If you would like to discuss this topic further or provide feedback, please reach out to your CME Group representative or email the Interest Rate Product Team at interestrate@cmegroup.com.

Opportunity costs have traditionally been difficult to calculate, track, and act upon without specialized analytics that reflect customers live positions.

However, there is a growing recognition across the industry for the need to evaluate cost benefits at alternative trading and clearing venues as a fiduciary responsibility to investors. The need is clear, but the real challenge remains how to carry out the required analysis without stressing internal resources.

The change in the recent approach can be explained by three important external factors:

1. Market volatility over the last two years has resulted in significant increases in the initial margin requirements being called by CCPs across all asset classes.
2. Central banks raising rates in an effort to curb inflationary pressures has translated into an increased cost of funding.
3. Regulation – Uncleared Margin Rules (UMR) has tied up more collateral, causing liquidity pressures for highly leveraged and fully invested strategies.

The combined net effect of these structural market changes has accelerated the need for a new generation of funding, liquidity, and optimization solutions.

To help our clients better assess the potential cost efficiencies associated with cross-CCP optimization, CME Group has partnered with OpenGamma, a technology firm that specializes in pre- and post-trade margin and collateral analytics with coverage across cleared and bilateral derivatives.

For clients interested in achieving cross-CCP optimization, OpenGamma will provide access to margin analytics and daily USD interest rate swap CCP basis trade recommendations. This collaboration offers clients the ability to view, quantify, and track the cost benefits of optimizing positions and margins across CCPs. OpenGamma’s available analytics will bolster the decision making process and cost benefit analyses required within firms in order to identify beneficial opportunities to enter any potential overlay trades.

Please reach out to your CME Group or OpenGamma representative for additional information on ways to access the service.