06.04.2013

Clearing Costs Climb

06.04.2013
Terry Flanagan

Mandatory central clearing of OTC derivatives transactions will prove costly to the buy side due to increased costs of margin and collateral.

A study by Sapient Global Markets demonstrates significant drag on portfolio returns in the new regulatory environment. The drop in return ranges from between 0.20% to 0.62% for cleared hedges, up to almost 1.00% for traditional uncleared bilateral over-the-counter (OTC) trades.

The study compares the overall portfolio performance of a typical fixed-income fund using four different hedging instruments over a fixed historical period: uncleared swaps subject to pre-2008 margin requirements; uncleared swaps subject to the Basel Committee on Banking Supervision (BCBS) and International Organization of Securities Commissions (Iosco) guidelines for margining (effective after 2015); swaps cleared through LCH.Clearnet SwapClear; and Eris Standard swap-futures (cleared through CME).

“Because of the significant impact on performance these results demonstrate, as well as the June 10th timeline set by regulators, it is apparent that portfolio managers must examine their own hedging strategy based on expected cost of clearing with a renewed urgency,” said Ben Larah, manager, Sapient Global Markets, “Once the post-Dodd-Frank and BCBS/Iosco recommended treatment for uncleared derivatives takes effect, using standardized and centrally cleared instruments will be the cheapest available option.”

On March 11, 2013, firms categorized as swap dealers, major swap participants and active funds were required to centrally clear several types of interest rate swaps — across four currencies — and certain credit default swap index trades.

On June 10, 2013, “Category 2 Entities,” including securitization vehicles, insurers, investment funds and non-swap dealer financial institutions must begin mandatory clearing. In order to comply with complying with regulations, firms need to make informed decisions about how to invest and where to clear.

The results of the study show that cumulative portfolio returns are highest when hedging is performed using uncleared swaps in a pre-2008 environment, and lowest when hedging is performed using uncleared swaps in a BCBS/Iosco recommended environment.

These results serve to show the significance of the impact of Dodd-Frank/BCBS legislation on clearing costs; once the BCBS/Iosco recommendations take effect the use of customized, uncleared swaps will jump from being the cheapest way to the most expensive way to hedge.

Sapient Global Markets conducted this study with support from LCH Clearnet and Eris Exchange. LCH.Clearnet SwapClear provided access to the LCH.Clearnet SMART Tool and Eris Exchange provided the Initial Margin (IM) percentages for the Eris Standard contracts. Additional models were developed using the FINCAD F3 analytics package to build an internal historical value at risk model in order to calculate IM according to the BCBS/Iosco guidelines.

LCH.Clearnet has announced the launch of a U.S.-domiciled interest rate swap clearing service. This new service expands SwapClear’s interest rate swap offering and demonstrates the importance of the U.S .to LCH.Clearnet’s geographic expansion strategy.

SwapClear’s U.S.-domiciled service is the first to be available through LCH.Clearnet and is a direct response to client demand for a domestic clearing service in the U.S.

“This launch is part of our long-term growth strategy in the US, and we will continue to seek new opportunities to expand our business in this important market,” said David Weisbrod, CEO of LCH.Clearnet. “Proven risk management, liquidity and choice are always in demand.”

Executing brokers and futures commission merchants (FCMs) from 10 major firms (Barclays, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Morgan Stanley, Nomura and UBS) have joined the U.S.-domiciled service, with further major firms expected in the coming months.

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