Managing Swap Portfolios Is About to Get Even More Complex

By Will Rhode, TABB Group

Originally published on Tabb Forum 

Already complex, swap portfolio management will become less forgiving with the implementation of the next clearing mandate in June. Buy-side firms need new technology that can help them streamline the process of trade terminations, compactions, fund rebalances and back-loading. 

As the next clearing mandate hits June 10, buy-side firms are going to need new systems to help them manage their swaps portfolios. Today’s imperfect science of swap terminations, compactions and fund rebalancing will have to be perfected, since clearinghouses will only recognize precisely coded trades for netting purposes. If there is one mistake in any one of the 85 fields required by the CME Trade Register, for example, an offsetting swap designed to terminate a pre-existing position will count as an additional line item. Rather than eliminating the problem, this will create a new problem for traders.                     

Swaps portfolio management is already an operationally complex task, with the messaging of multiple Excel files containing multiple line items, the negotiation of trade prices, collective affirmation, and the delivery of the final trade packet – mostly manually managed. That said, while a bilateral dealer may today forgive a decimal error or an incorrectly labeled line item, a clearinghouse won’t. Without a system that can communicate with the clearinghouse in order to ensure all necessary fields and coding requirements are met prior to execution, the buy side will find it impossible to manage its swaps portfolios effectively through:

Terminations of existing bilateral swaps;

Compaction, which allows traders to replace multiple swaps with different coupons; and maturity dates with a single economic equivalent position;

Fund rebalances that transfer swap positions from one fund to another;

Or, when the specific risk of the bilateral swap must be retained, back-loading the swaps into the clearinghouse.

Even as the CFTC rules stipulate that certain swaps must clear, the portfolio logic of converting all swaps is increasing. The clearing mandate, escalating bank capital charges, a new margining regime for bilateral trades, and a desire to realize portfolio margining efficiencies all play a part in driving the industry toward clearing. Even though the Dodd-Frank clearing mandate does not require ‘grandfathering’ of pre-existing swaps into clearing, once any sizable volume of swaps are centrally cleared, it will make little sense to manage both old and new swaps with different operational and margin requirements in a single portfolio. 

This is a heavy operational lift, however, since the world of bilateral trading has engendered a proliferation in line items. Now the process of rationalizing swap portfolios will need to begin, even as regulators raise the bar with a new real-time clearing requirement. Given the bottlenecks likely to occur as funds simultaneously look to comply with the clearing mandate, the need for new technology solutions that can help streamline the process of back-loading, fund rebalances, trade terminations and compactions is paramount.