Video: The Big Squeeze – Margin Compression in Interest Rate Derivatives


Six industry experts discuss the cost pressures on interest rate swaps from regulatory reform and the steps required of buy-side firms to assess their hedging options, with Mike O’Hara of The Realization Group.


Robert de Roeck, Standard Life Investments
Laurent Louvrier, MSCI
Nick Green, Crédit Agricole CIB
Hirander Misra, GMEX
David Bullen, Bullen Management
Liam Huxley, Cassini Systems

Mike O’Hara: Hello and welcome to Financial Markets Insights. Today, we speak with six industry experts about the impact of central clearing on the interest rate derivatives markets.

The G20 reforms that were introduced to address systemic risk following the global financial crisis are now well under way. As part of these reforms, category 1 firms, banks, clearing members and so on, have to centrally clear OTC derivatives by late June 2016. With the deadline for category 2, buy-side and investment firms, just six months later.

So, what are the key challenges for the buy-side under this new regime?

Robert de Roeck: I think the short answer is collateral. There are probably two elements to that: the ability to source it on a BAU basis and probably more importantly, how do you get hold of the necessary collateral in a stressed market environment?

The second element from a fund management point of view is how are you going to account for the requirement to hold even more collateral in terms of drag of performance. The regulation has meant that a given mandate won’t necessarily have to hold initial margin for some of the cleared instruments. That initial margin can only really come for return-seeking assets, which in turn, would lead to a performance drag.

And what will need to happen is fund managers will need to understand how they account for that and whether it’s accepted by the client or whether fund managers and asset managers come to the fore with ways to improve upon that, or mitigate the effect of performance drag.

Mike O’Hara: And what are some of the second order effects for the market, particularly from a cost perspective?

Nick Green: If you have more than one central clearing house, central counterparty, you end up with different open positions in the different clearing houses and those affect the underlying participants differently. And so, you can end up with different risk positions for the dealers in different CCPs.

And that means that the cost of hedging into one or the other can get out of line. And we have this at the moment where the two main clearing houses for interest rate swaps are LCH and CME. And there is a basis between them.

And so, any client that wants to trade, if you like, the wrong way around for the market is going to face higher costs to trade into CME than they would if they were trading into another CCP or into LCH or if they were trading on the other side of the trade.

Laurent Louvrier: And if you, on top of that, add some, I guess, second holder effect is just simply the cost of compliance attached to those new regulations. The reorganisation that needs to happen, new boundaries between banking and trading groups, for example, just the assessment whether some businesses are operative or not, plus the cost of simply implementing all the changes from the system and technology point of view. That’s a fairly significant cost for banks. That has an impact on the cost side and cost income ratio as well.

Hirander Misra: Even though the buy-side firms may primarily be using a clearing member to clear their trades, those clearing members are obviously passing those capital costs upstream, whereas in the past, those costs weren’t necessarily passed on to the buy-side. This is therefore increasing the cost for those buy-side firms as they have to also find more capital.

And certainly, the sell-side are getting rid of what they call bad business that’s very capital intensive, versus that return on investment. This is forcing some of those buy-side firms to look at less margin-intensive alternatives because, obviously, centrally cleared standardised swaps have clearing of anything between five and seven-day VaR.

And if you look at OTC derivatives versus exchange-traded derivatives, exchange-traded derivatives have a two-day VaR of clearing.

Mike O’Hara: Exchange-traded instruments might be more cost effective from a margin point of view, but for asset managers looking to migrate from OTCs to these new instruments, what other factors will they need to consider?

Laurent Louvrier: Well, I would say that most of this one is liquidity. I mean, whether you are like a highly-levelled hedge firm doing like a relative value strategy where you need to be able to get in and out of a position quickly, you need to know that you can trade in size at any point in time without any restriction.

David Bullen: In my mind, there are three things. One is a lack of a supplier pool, so the investment consultant, actuary environment is less well educated. You find, where you explain a problem to yourself is one thing, but being able to explain it to your customers is another. So, that’s a lack of a drag from the supplier side.

I think the fragmentation of being able to pick a winner is a problem. That is stopping people making those decisions and the mandate to clear is still not forcing there to be a clear winner to be coming out.

And I guess, lastly, is an absence of independent advice that they can get. Often, that advice used to come from the bank community. They’re less incentivised to provide that advice and, therefore, really, those are kind of the challenge they’re facing.

Laurent Louvrier: The products need to be compelling, as well. It’s not to say that swap issues are not… I think it’s a very good idea, but the cost benefit for clients needs to be obvious and compelling.

Mike O’Hara: In order to perform a true cost benefit analysis of trading one type of instrument versus another, what do firms need to do?

Liam Huxley: So, the important thing from the buy-side, really, is to understand, for any trade that’s being put on to understand the true all-in cost of that trade. And this sort of plays into MiFID and best execution requirements, as well. So, if I’m putting on an OTC swap and I see some quotes being offered to me, I need to understand my all-in costs of executing a trade and clearing it through each particular clearing channel.

So, that means, as a buy-side, I need to be able to determine at pre-trade time the full fee cost of holding that trade over the lifetime of the trade and the full cost of supporting and financing the collateral over the lifetime of the trade.

And it’s not as simple as it may sound because, obviously, if you’re holding the trade for a period of time, the initial margin will start to decrease over time, as the trade moves towards maturity.

So, you need to able to calculate and derive how that will play down and sort of decay over time and how the related fees will decay over time. And you will find that in some situations, the OTC swap will be more cost efficient and in others, the swap future will be more efficient.

So, again, that plays into having an automated solution that can compare all of those alternatives and factor in all the lifetime elements of the trade to tell you at execution time, the best option available.

Mike O’Hara: So, is innovation in new technology and new products the answer to addressing some of these challenges?

David Bullen: I think market forces are driving innovators into this space. Look no further than the contributors to this blog and to the articles that we put out. Plus, there are some interesting collateral exchange offerings starting to pop up, which I guess, shows that innovation as well as coming, whether it be the analytic space, administrative space or whatever.

And also, forward-looking asset managers are beginning to realise they have an advantage, especially in the liability-driven investment, LDI market space, that if they do this right, they all could take a larger share of that market. So, that innovation and that drive is what’s dealing with these challenges.

Hirander Misra: In terms of the buy-side need, obviously, there will be a number of exchange-traded alternatives out there, some existing. And we’d like to think we’re one of those with GMEX constant maturity features offering, but certainly as well.

And collectively, I think it’s all about using a range of tools because, in some cases, OTC interest rate swaps may be suitable to hedge your portfolios. In other cases, swap futures, like those offered by us will be suitable as well. But it’s all about sort of using a balance of instruments to meet your needs and become more efficient.

Mike O’Hara: As we’ve seen, central clearing will have a significant impact on both the buy-side and the sell-side. But the market is adapting, and it will be interesting to see how it evolves from here.

Thanks for watching. Goodbye.