Clearing at the right place, at the right time

Clearing of OTC derivatives continues to grow, with approximately 89% of traded interest rate swap notional currently being cleared1. For large financial institutions across the sell and buy-side the question is no longer if and what to clear, but where.

Mandates aside, the clearing of bilateral trades or switching to futures usually makes sense for large financial entities for several reasons, including the capital, counterparty risk and margin efficiency benefits that are achieved by using a central counterparty (CCP).

One major driver of voluntary clearing over the past two years has been the uncleared margining rules (UMR), which began a phased implementation in September of 2016. As at Q1 2019, financial counterparties with non-cleared gross notional of more than €1.5 trillion in qualifying OTC derivative contracts must calculate and post 2-way initial margin in accordance with the UMR requirements. This qualifying threshold will fall to €8 billion by September 2020, sweeping in a large pool of smaller financial institutions, including many buy-side firms.2

The widespread adoption of central clearing for interest rate derivatives combined with the impact of UMR has led to a renewed interest in running total cost analysis on bilateral and CCP portfolios to understand and deliver optimal efficiencies.

Clearing with a CCP typically enables three headline benefits for clients to consider:

1. More consistent and potentially tighter pricing at point of trade
As the swaps market has bifurcated between cleared and non-cleared swaps, pricing has often become differentiated between the two camps, with dealers potentially quoting tighter and more consistent spreads for cleared trades. Such pricing benefits are underpinned by the fact that in the cleared environment, dealers don’t need to price in counterparty credit risk by adding a credit valuation adjustment (CVA) and cleared positions attract more favourable capital treatment (KVA).

In addition to CVA and KVA, the cost of trading is also likely to be impacted by margin valuation adjustments (MVA). Dealers now need to consider the funding cost of any new trade which is driven by the IM requirements of the UMR, both on the interdealer leg and potentially directly on the client as well. The industry standard for calculating this IM is the ISDA SIMM model which is based upon a 10-day margin period of risk (MPOR). Clearing provides the ability for entities to not only net all their exposures against one counterpart but also to use the CCP margin model (e.g. 5-day MPOR at CME) and additional services such as portfolio margining of OTC cleared swaps versus Exchange Traded Derivatives (Futures). These netting and model benefits should assist dealers in optimising their overall IM funding costs and so reduce or even remove the impact of MVA when pricing client trades.

2. Enhanced liquidity
Clearing brings a significant reduction in the documentation required to onboard new liquidity providers, with a concise cleared derivatives execution agreement (CDEA) rather than the extensive and complex ISDA Master Agreement. Furthermore, clearing removes counterparty risk between the two trading counterparts. Once a trade is executed, the CCP becomes the counterpart to both original entities.

This combination of less cumbersome legal documentation combined with the mitigation of counterparty risk makes it far easier for buy-side customers to onboard and trade with a broader range of liquidity providers, including local onshore entities and non-bank entities which may have previously been less accessible.

3. Counterparty netting
One of the most celebrated benefits of clearing is that it allows market participants to replace multiple bilateral partners with a single CCP relationship. Rather than having bilateral trades outstanding with multiple individual dealers, firms can net their positions with the CCP.

Having all open positions netted with a single CCP creates significant benefits, including: all correlated risk positions netted together for one margin call, one counterparty for all reconciliations and payments, optimal opportunities for trade compression and also freeing up credit lines against the original executing dealer.

Choosing the right CCP

Whilst the headline benefits above could, to a large degree, be achieved by clearing at either of the global qualifying CCPs (QCCP) more sell and buy-side firms are re-visiting analysis on where and how they are clearing their activity in order to ensure they are not leaving money on the table by missing optimisation opportunities. Buy-side firms place a great deal of care on selecting the right liquidity providers and trading platforms to suit their business, and given the growing importance of clearing, it is just as important to choose the right CCP. While certain elements of clearing have now become standardised across clearing houses, there are important differences in the breadth and scope of their offering.

1. Product scope - which products can your CCP clear?
Like other CCPs, CME offers clearing in interest rate and foreign exchange derivatives, with 24 currencies, ranging from the majors such as USD, EUR and JPY and frontier markets including the Brazilian real, Chilean peso and Colombian peso.

As financial markets transition to new interest rate benchmarks, CME is also seeing growing demand for swaps referencing new ‘Risk Free Rates’ (RFR) such as the Secured Overnight Financing Rate (SOFR) in the USD market. Based on strong client demand, SOFR swaps at CME are unique in that they are discounted and have collateral remunerated using the SOFR rate.

2. Portfolio margining - enhanced margin efficiencies
Many swap market participants have existing relationships with CME through its industry leading interest rate futures market that trades over 6 million contracts a day. The corollary of this interest rate futures activity is that many large financial entities are already connected to CME and are already posting IM for this trading. By choosing CME for the clearing of OTC traded swaps customers can achieve both further operational efficiencies and more importantly potential cost savings by having one combined IM requirement across Swaps and Futures rather than two bifurcated calculations.

This service of portfolio margining interest rate swaps and Futures together was launched by CME in 2012 and it enables all 24 currencies of IRS to be margined versus MAC Swap Futures, Treasury Futures, Fed Fund Futures and Eurodollar futures. Fifteen clearing members support this service and it is used every day by c. 700 client accounts, who achieve total risk reduction of $2.9 billion in initial margin in Q1 2019.

3. Process:
As a global CCP operator, CME offers two compelling benefits when it comes to the clearing process. Firstly, it operates real-time clearing on a 24-hour basis to all market participants, without being confined to a time zone. Secondly, rather than requiring margin at the point of trade, CME will calculate margin at the end of the day and allow it to be posted the following day3. This makes the funding process more efficient for both clearing members and the end user clients.

4. Jurisdictional coverage
In order to service a global customer base a CCP must have the necessary regulatory and jurisdictional approvals in place in order to allow customers to meet their local legal requirements. CME has worked to achieve regulatory standing in multiple jurisdictions around the globe, including the US, Mexico, Europe, Australia, Hong Kong, Japan and Singapore. This has enabled CME to support a truly global footprint, with an active ecosystem of over 500 dealers and buy-side users in North America, Latin America, Europe, the Middle East and Africa, and Asia-Pacific.

Making the informed choice

In such a complex and evolving market, it is evident that ongoing analysis must be carried out to ensure that the right choices are made to deliver optimal results. The benefits of this analysis and exploring the detail of ‘where and how’ to clear both IRS and FX products can enable firms to achieve far greater risk reductions on their portfolio and so reduce the cost of capital and/or margin that they may incur either directly or indirectly.  


1 ISDA SwapsInfo as of January 25, 2019
2 There has been active industry advocacy to raise the final threshold from €8 billion to €100 billion to reduce the number of smaller entities that would be brought within scope. A letter from industry bodies to regulators in September 2018 sets out the case in more detail: https://www.isda.org/a/5evEE/Initial-Margin-Phase-In-Implementation-Joint-Trade-Association-Comments.pdf
3 Intraday calls maybe made in certain circumstances.