Concentric Circles: Central Clearing, Leverage Ratios and Concentration Risk

By Radi Khasawneh, TABB Group

Originally published on TABB Forum

A regulatory rethink of bank leverage ratios could make the clearing business more attractive, reinvigorating competition and helping redistribute concentrated clearing flows and the associated risk.

News last week that global regulators are meeting to reconsider the consequences of imposing bank leverage ratios is good news for the clearing industry. In May, the TABB Group view was that it was clear that this would have to be re-examined at some point, given the level of concern by Futures Commission Merchants (FCMs) about the effect of these changes on the economics of their business.

Nearly 90% of FCMs interviewed for TABB’s May study, “The FCM Business 2015: Overcoming Industry Adversity,” cited national regulatory leverage and capital rules (such as the enhanced Supplementary Leverage Ratio and Globally Systemically Important Bank rules in the US) as major concerns for the coming year. As currently formulated, the negative effect of the rules on the over-the-counter (OTC) swap clearing business seems far too proscriptive, leading us to the conclusion that the intermediaries will require more encouragement to provide clearing services as reform transforms the global markets. That view has been backed by members of the Futures Industry Association as well, as efforts are made to reduce the requirement to account for derivative positions on a gross basis and account for collateral received from clients on balance sheets.

In the meantime, as mandatory clearing rules, recently finalized for Europe, come into force in the two most important regions, clearing behavior has become more entrenched in familiar patterns (see Exhibits 1 and 2, below).

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So far, rather than diversify the product and client mix at CCPs, clearing houses have largely continued to dominate in their traditional areas. Take the above clearing flows as an example – looking at the clearing house breakdown, interest rate swap clearing has largely been dominated by LCH.Clearnet as the dealer clearer of choice, and the CME has remained a significant participant, maintaining its position as a buy-side clearer; meanwhile, ICE has long been the CDS clearer of choice. Market shares calculated by Clarus Financial show that this dynamic has persisted, creating a potential problem in terms of so-called concentration risk.

In addition, a material difference in quoted prices has emerged this year between LCH.Clearnet and the CME for USD IRS based on the cost of clearing. Clarus data shows that, on average, $8 billion of switch trades were enacted a week between May 18 and July 10 via interdealer brokers to take advantage of this price disparity. As a result, LCH.Clearnet has attracted up to 70% of new IRS trades, a much higher portion than its historical average against the CME, which has a much higher percentage of buy-side participants versus the more balanced dealer/buy-side mix of clearing clients at LCH.Clearnet.

The point here is not the breakdown between the clearing firms as much as the lack of growth elsewhere. These types of dynamics, which tend to concentrate risk at a clearer, have meant a necessary focus on default and resolution schemes at the clearing houses.

In the absence of meaningful dispersion of clearing flows, it is clear differences between the cost of clearing can create a redirection of flow, as already has been seen with LCH.Clearnet and the CME – in the future, this could be to a new entrant or to an expanded offering from other venues. This would be a positive for all market participants, as more options would exist, and the FCMs themselves would be more encouraged to widen access to clearing (crucially, at an affordable price point), resulting in a greater fragmentation of clearing flow and, consequently, risk.

This is a new phenomenon, and is generally a healthy sign for the market as a whole – as long as there is true competition among all clearing houses offering similar product choice. It is a good sign that market participants finally are beginning to analyze their cost of clearing on a more systematic basis and are beginning to make clearing choices on this basis. And a change in the regulatory framework could help spur further competition.

In the interim, the situation is similar to the rise of towns during the expansion of the railroads in the U.S. “old west”: People have invested significant sums in building the infrastructure necessary to attract more people to their area, but only time will tell which towns prosper and which wither away.