Volume of Uncleared Swaps Declines as Regulations Bite

Terry Flanagan

A reduction in the level of uncleared interest rate swaps reflects broad changes in the industry as reforms by the G20 group of nations intended to promote the central clearing of derivatives kick in.

Banks are launching services aimed at simplifying the clearing process in order to help clients avoid the associated funding costs and increased complexities.

“Over the last few years the industry has undergone a significant regulatory overhaul,” said Nigel Kneafsey, chief executive of Options IT, a technology infrastructure provider. In the U.S. alone we’ve seen in the last year several new requirements stemming from the Dodd-Frank Wall Street Reform Act of 2010. Generally, regulations increase business costs and the industry looks to minimize those costs through innovation.”

The International Swaps and Derivatives Association (ISDA), a trade body, reported that during the second half of 2011, the volume of uncleared interest rate swaps fell 15.1% to $122 trillion, and was smaller than volumes reported for all other periods except 2010.

The reduced level of uncleared swaps reflects new interest rate swap products becoming eligible for clearing at SwapClear, LCH.Clearnet’s global clearing service for interest rate swaps which currently clears more than 50% of the market, in the latter part of 2011, and very modest amounts of client clearing.

In the U.S., the Commodity Futures Trading Commission (CFTC) has proposed a rule under Dodd-Frank that would establish margin requirements for uncleared swaps for swap dealers and major swap participants that are not banks.

Under the CFTC’s proposed rules, a non-bank swap entity would be required to have credit support arrangements (CSAs) in place with all of its counterparties.

Many non-financial entities enter into agreements with multiple swap dealers so they can benefit from the transparency and pricing benefits of requiring multiple dealers to compete for their business. They would be required to renegotiate multiple agreements to add CSAs with multiple dealers.

For those that do have a CSA in place, the variation margin above the threshold is typically bilateral where either the swap dealer or the end user can post or collect collateral depending on the net position of the portfolio with respect to the threshold set in the CSA.

Consolidation within the industry has left banks with complex organizations, costly redundancies and multiple product lines across the business. Increasingly, these ad hoc infrastructures fall short of satisfying the needs of customers, shareholders, regulators and employees.

“The industry has reached a point of no return that demands a fundamental transformation of business and operating models,” said Keith Saxton, director of global banking and financial markets at computer services group IBM. “Maximizing risk adjusted returns on capital and liquidity in a way that also delivers compliance will become the new differentiator of success.”

The Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (Iosco), both regulatory bodies, have issued a consultation paper on margin requirements for non-centrally-cleared derivatives.

The BCBS and Iosco are proposing that all financial firms and systemically-important non-financial entities that engage in non-centrally-cleared derivatives must exchange initial and variation margin as appropriate to the risks posed by such transactions.

“Looking ahead, it may be difficult to make much further progress on the notional amount of uncleared interest rate swaps until client clearing begins in earnest in 2013,” said ISDA.

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