The Great Migration: hedge funds and the move into central clearing
Buy-side interest rate swap clearing volumes have grown rapidly during the first half of 2012 as hedge funds and other asset managers have raced to begin central clearing ahead of the imposition of Dodd-Frank. HedgeWeek looks at developments in store for the rates clearing space in the coming six months ahead of the anticipated go-live date for the Dodd-Frank clearing mandate in the US.
After years of false starts and disappointed expectations, buy-side central clearing of interest rate swaps has finally and quite suddenly roared into life.
Last month LCH Clearnet announced that its SwapClear platform has cleared more than USD1 trillion notional in end user interest rate swaps much of which has cleared since the December 2011 re-launch of its client clearing service into a more futures commission merchant (FCM) focused service. Impressively, SwapClear’s notional outstanding has increased by 274% since January 1, reaching a notional outstanding of USD 717 bn by the end of June. A third of that activity was recorded in May alone, coming off of large spikes in buy-side clearing volumes in both March and April, evincing real momentum developing in the until-now nascent market.
The Chicago Mercantile Exchange’s (CME’s) interest rate swaps clearing platform has also enjoyed meaningful growth in the first half of 2012, with open interest soaring from USD139 billion in notional swaps value on December 30, 2011 to USD260 billion as of 4 May, 2012.
The cleared volumes are astonishing, not only in that the notional values outstanding have ramped up so swiftly, but also because the swap end user community is so feverishly embracing central clearing ahead of looming regulatory mandates on both sides of the Atlantic.
In the US specifically, the Commodity Futures Trading Commission (CFTC) has already passed several major elements of its final Dodd-Frank Act rules on clearing, including core principles for derivatives clearing organisations that set the minimum capital requirement for institutions seeking to become direct clearing members of a central counterparty (CCP) at just USD50 million.
Given that obligatory clearing for vanilla and highly liquid interest rate swaps is likely just months away in the US, increasing numbers of buy-side firms are electing to clear ahead of the imposition of the mandate.
“If I were to give any advice to hedge funds considering submitting their interest rate portfolio for clearing, my message would be: do it now. Some of the largest buy-side clients are already on board and increasingly we are seeing hedge funds taking advantage of uniform CCP pricing and credit terms that clearing provides,” Michael Davie (pictured), CEO of SwapClear tells HedgeWeek.
So why should fund managers move into clearing now? Hedge funds are generally much more nimble than other buy-side participants. Their typically smaller corporate structure allows them to move faster than more traditional investment managers and they have a much greater degree of autonomy in making strategic decisions.
That ability to move swiftly will prove to be a significant advantage. The large influx of asset managers and other buy-side firms that will wait until the last minute to migrate into clearing will mean that the resources, time and attention of FCMs will almost certainly be constrained by the glut of firms seeking to establish clearing relationships once the hard deadline for the imposition of the mandate is announced.
“Currently the FCMs and CCPs have the resources and expertise ready and waiting to load buy-side clients into clearing. Six months from now when the majority of buy-side participants move to get agreements in place with FCMs and set up their clearing arrangements, they may find that they do not receive the same attention as they would now,” says Davie.
A key feature of some CCPs is a requirement that variation margin can only be posted in cash and in the same currency that the underlying interest rate swap is denominated in: only Euros can be posted as collateral against a Euro interest rate swap, for example.
Typically, the credit support annexes (CSAs) that govern margin procedures between hedge funds and their dealer counterparties do not include the same restriction, allowing managers to post US Dollar, Sterling or Yen against a Euro swap. The cross-currency basis risk inherent in posting collateral in a currency different to the denomination of the trade should be reflected in the trade valuation and may result in a different price for the swap relative to that where collateral is posted in the swap denomination currency. This adds further time and complexity to swap valuation and makes a less transparent valuation process.
When a fund backloads its interest rate swap portfolio into a CPP, the requirement that margin is denominated in the same reference currency as the swap means that this pricing differential is eliminated, resulting in a simpler and more transparent valuation and margin process. This transparent and independent valuation, contrasted with the relatively subjective and opaque methodology used to value interest rate swap variation margin in the bi-lateral world, has proved hugely popular with fund managers that have already back-loaded their rates portfolios into CCPs.
“That’s one of the reasons why some hedge fund managers are moving early into centralised clearing. They see clearing as re-imposing standards in place of unhelpful variability. We bring increased transparency and discipline to the market,” says Davie.
Collateral management will be a challenge for the hedge fund industry as this migration takes place, with the most obvious concern being how funds will locate enough eligible collateral to post as margin.
The major dealers have posted over USD50 billion in margin with clearing houses as of 2012, according to the most recent margin survey conducted by the International Swaps and Derivatives Association, and the aggregate figure for collateral posted by all buy-side participants when mandated clearing commences in earnest will undoubtedly swell to be several tens of billions larger still.
CCPs are in the process of expanding the eligible collateral that they will accept from clearing members, away from traditional margin instruments like cash and government bonds, to include a broader array of assets. Clearing houses are also exploring options to further alleviate pressure on collateral assets by investigating the feasibility of extending cross-margining services across different asset types to include interest rate swap portfolios for the first time.
In March, LCH Clearnet announced it was exploring plans to join NYPC’s existing “one-pot” cross-margining arrangement. The agreement would provide cross margining capabilities across NYSE Liffe-traded interest rate futures contracts cleared at New York Portfolio Clearing with fixed income cash and repo trades cleared by the Depository Trust & Clearing Corporation’s Fixed Income Clearing Corporation (FICC) and interest rate swaps cleared by SwapClear into a single portfolio for purposes of margin netting and offsetting.
By comingling the different contracts in a single cross-margined pot, clients clearing at all three CCPs would be able to net positions off against one another, dramatically improving collateral efficiency and optimising margin requirements.
“Some say there won’t be enough eligible collateral but the derivatives market has long been populated by people who are able to bring an engineering mindset to solving complex problems. One potential solution we’re seeing is a growing relationship between custodial providers and derivatives desks to allow asset managers to do intra-day collateral substitutions and other collateral-related services. There’s going to be an interesting choreography between the CCPs, clearing members, executing brokers, end-user clients and custodians going forward,” concludes Davie.
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