Over-the-counter derivatives are big business. The size of the portfolios traded as well as those cleared at the leading central counterparties (CCPs) has increased substantially over the years, both in terms of line items and notional outstanding. This used to be a measure of success and a method of gauging who was at the heart of the industry, but this attitude changed in the wake of the global financial crisis in 2008–09.
Now, size is a concern and reducing risks from OTC derivatives is a central part of the G-20's agenda to clean up the financial system after the crisis. A key driver of change was leverage rules imposed under Basel III. Under these rules larger notional outstanding means higher capital requirements.
"If you look at the recent history, market participants used to trade swaps and the outstanding notional was left on the shelf, until periodically a TriOptima run would be scheduled – around once a month – and this would crunch some of that outstanding notional down, however, not significantly enough to reverse the trend of overall growth in notional volumes," Martin Pluves, chief executive of LCH.Clearnet, explains. "With the addition of blended rate compression, LCH has changed the landscape somewhat."
Since 2014 SwapClear, an LCH.Clearnet platform for clearing interest rate swaps, has started making TriOptima runs weekly. It has also introduced proprietary daily solo compression runs and bi-weekly blended rate-compression runs. "We've created a more effective and more frequent means to allow for much more compression to take place," Pluves says.
At the start of 2015, LCH.Clearnet had $362 trillion in notional outstanding. By the end of November, SwapClear had compressed $304 trillion in notional, reducing the notional outstanding by $99 trillion to $263 trillion. A key part of this was the launch of blended-rate compression the year before.
Compression allows clearing members to offset their positions against each other. This means fewer line items and smaller notional outstanding. Traditionally only the portfolio of trades between two institutions could be grouped and compressed, as both counterparties retained a link to the original trade, a way of ensuring they could remove it from the CCP and ‘re-bilateralise'. With the advent of mandatory clearing for simple OTC derivatives, the initial trade records are no longer maintained.
Now, firms can offset all the trades in their portfolio against each other, regardless of the initial counterparty. "Firms can now net and blend down many more trades facing the clearing house," Pluves says. "It is a huge change in the way the industry works and, despite no let-up in traded volumes, the outstanding notional is decreasing overall."
Initially SwapClear's solo compression service required "the economics of the trades to be identical", says Daniel Maguire, global head of SwapClear. The advent of blended-rate compression, however, has "significantly expanded the number of interest rate swaps eligible for compression".
It means firms can net trades with the same cashflow dates but different fixed rates, while "making absolutely no difference to the characteristics of your portfolio", Maguire says. If there are any other dissimilarities, clients can still then turn to the risk-constrained compression operated by TriOptima, though this will impact the profile of the portfolio. These different methods add up.
"People have been decluttering the closet of all this notional that has been stored up over time," Maguire says. Notional outstanding is down to $267 trillion, but Maguire believes LCH.Clearnet can go even further. "We believe we can get that, if the industry works collectively with us, as they are, to sub-$200 trillion notional outstanding on SwapClear," he says.
Beyond interest rate swaps, LCH.Clearnet became the first CCP to offer inflation swaps clearing to its members and their clients, after gaining regulatory approval. Trading in the swaps allows firms, often asset managers and pension funds, to guard against rises in inflation – not a common concern across the globe, yet SwapClear has already cleared more than $300 billion in notional. It has 32 members actively clearing the product.
Another important development in the past 12 months saw LCH.Clearnet become the first overseas licensed CCP to maintain an exchange settlement account (ESA) with the Reserve Bank of Australia (RBA). It quickly began settling its Australian dollar payments via the account.
The use of central bank money means CCPs can access liquidity without needing to liquidate assets - reducing the risk of fire-sales and offering assurances to market participants that they will be able meet their obligations in times of stress. While the consensus appears to be that central banks should provide the ultimate source of funds for systemically-important CCPs, it is still early days, and the Federal Reserve in particular has offered limited clarity on the matter.
By contrast, the RBA announced any CCPs designated as systemically important would need to use an ESA to settle their obligations denominated in local currencies - with LCH.Clearnet the first overseas clearing house to make the leap. LCH.Clearnet also maintains a sterling and euro central bank account at the Bank of England, and a Canadian dollar account at the Bank of Canada.
LCH.Clearnet is keen to make the most of its foothold in Australia, turning its regional hub in Sydney into a "fully operational centre" with a larger team of employees. More recently, it has also established an office in Tokyo, suggesting it could see room for growth in Japan. These efforts to improve market infrastructure around the world should help to reduce the threat posed to the financial system by OTC derivatives in the years ahead.
The Central Banking awards were written by Christopher Jeffery, Tristan Carlyle, Daniel Hinge, Arvid Ahlund, Dan Hardie and Rachael King.