New Margin Rules Boost Inflation Swap Clearing

Shanny Basar

A market for cleared US dollar inflation swaps has sprung up since new regulations for the exchange of margins for uncleared swaps came into effect at the start of this month.

Daniel Maguire, global head of rates and foreign exchange derivatives at LCH, said in an email that the arrival of the first wave of uncleared margin rules may have stimulated a shift to clearing more eligible inflation swap portfolios. LCH Group is the multi-asset clearing house majority owned by the London Stock Exchange Group.

“We’ve definitely seen a significant step up in trade and notional clearing volumes of inflation swaps both across all three currencies (US dollars, sterling and euros) and also across many sellside and buyside participants, plus more participants are actively onboarding to clear inflation swaps,” Maguire added.

At the beginning of this month new regulations requiring the exchange of initial margins for uncleared swaps between the largest swap dealers, with gross exposures of more than $3 trillion, came into force in the US, Japan and Canada affecting approximately 20 global firms. The rules do not yet cover Europe but European institutions still have to post margin for uncleared swaps with US, Canadian and Japanese institutions. Only transactions between two European institutions, in which neither is a European affiliate of a US, Canadian, or Japanese firm, are excluded.

LCH currently has 39 live members globally clearing inflation swaps, and 12 clearing brokers and FCMs offering client clearing to 26 live clients. When LCH launched the clearing of inflation swaps in April 2015 there were 11 live members.

At the launch last year Nathan Ondyak, head of products and markets, SwapClear, LCH said: “After thorough risk reviews and testing, we are proud to be the first CCP to secure regulatory approval under both the Emir and US Commodity Exchange Act regulatory frameworks for inflation swaps clearing.”

Trading in inflation-linked swaps is popular among asset managers and pension funds looking to guard against rises in inflation and interest rates. Firms clearing inflation swaps through SwapClear are able to offset their margin requirements with correlating interest rate derivatives cleared at LCH.

Simon Wilkinson, head of LDI Funds at Legal & General Investment Management, said at the launch: “Risk management is a top priority for fund managers. Central clearing significantly mitigates counterparty risk and we welcome industry moves to provide clearing services for inflation swaps.”

So far this year LCH has cleared $375bn in notional in inflation swaps across all three currencies. However on 8 September, after the uncleared margin rule was implemented, almost $10bn was cleared on just that one day according to the CCP.

This month on 12 September, inflation swaps at LCH became available for solo compression, which means that all LCH products can now be compressed.

Compression is a process in which clients can “tear-up” offsetting trades in their portfolios to reduce the notional outstanding and number of line items in their portfolio while maintaining the same risk exposure. Use of compression services has increased following the introduction of stricter capital requirements, such as the Basel III leverage ratio, which has led to banks reducing their balance sheets and capital efficiency becoming increasingly important.

SwapClear has compressed a total of $137 trillion of notional swaps between August 2014 and July 2016. In the first half of this year $180 trillion of swap notional has been compressed which LCH said has resulted in an estimated $9bn of capital savings for customers.

Tod Skarecky at analytics and research firm Clarus Financial Technology, said in a blog that there was no evidence of panic September 1 as there did not seem to be any halt or reduction in swaps trading through the new mandate. Skarecky added: “Clearing of inflation swaps seems to be the success story coming from uncleared margin rules.”

He continued that Clarus data shows there are a daily average of between 50 and 70 inflation swaps in US swap data repositories, with 45 cleared trades on September 9.

“Let’s now remove the uncleared swaps and refine the analysis for cleared-only inflation swaps,” he added. “From a notional perspective, these cleared trades in September account for aggregate notional sizes of up to $2bn equivalent. There is suddenly a cleared US dollar inflation swap market.”

Since the uncleared margin rule came into force there has been an increase of between $1bn and $1.5bn per day in cleared inflation swaps in the US and between $2bn and $4bn per day globally according to Clarus data.

The uncleared margin rule has not come into effect in Europe. Timothy Massad, chairman of the US CFTC, said in a speech at the OTC Derivatives Summit North America today: “We continue to be mindful of the fact that, on March 1 of next year, a much broader scope of firms will be subject to variation margin requirements. I am hopeful that the European rules will be in place by then. We will keep an eye on this date and we will explore alternative actions that we could take to address any further consequences in the event the delay is not minimized.”

Euroclear, the central securities depository, said in a note:  “In Europe, the deadline for the start of buyside compliance with the new non-cleared rules has been pushed back several times.”

Euroclear added that once regulatory obligations become clearer, it will be difficult to segregate assets in a way that is compliant with the new rules in Europe.

“One point of contention could be the location of the segregated assets exchanged for initial margin purposes,” said Euroclear. “Under the new rules, this has to be a neutral third-party, but it might not be possible to agree on the use of a custodian that is already working for one or other party to the transaction.”

As a result asset managers may need to hold discussions with each of the custodians selected by their asset owner clients in order to put the necessary structures and processes in place to isolate and protect assets.

“The new environment for non-cleared OTC derivatives transactions may lead to a greater use of common standards and utility-type solutions to smooth collateral processes,” added Euroclear.

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