Margin Compression in Interest Rate Derivatives: The Big Squeeze
By Mike O'Hara, The Realization Group
Originally published on Tabb Forum
The long-anticipated introduction of central clearing for over-the-counter interest rate swaps in parallel with the rollout of new capital, liquidity and leverage constraints for banks is bumping up the cost of hedging interest rate risk in Europe for brokers as well as their buy-side customers. What steps are required of buy-side firms to assess their hedging options?
Forewarned is forearmed; but sometimes it’s hard to use prior knowledge to your best advantage.
Take, for example, the impact of post-crisis regulatory reforms on the cost of hedging interest rate risk in Europe. The long-anticipated introduction of central clearing for over-the-counter interest rate swaps in parallel with the rollout of new capital, liquidity and leverage constraints for banks is bumping up costs for brokers as well as their buy-side customers. In the U.S., which has already implemented G20-mandated central clearing and electronic trading of interest rate and credit default swaps, the new rules have given rise to a wave of innovation, in part due to the increased costs they impose. New instruments have been launched in Europe, too, including exchange-traded swap futures, which offer market participants the opportunity to offset their risks in ways that may prove cheaper or better suited to their needs than centrally cleared interest rate swaps.
But while swap futures slowly gain momentum in the U.S., Europe stands nervously at the starting gate, ahead of a year of deadlines as the European Market Infrastructure Regulation’s (EMIR) clearing mandate finally comes into force. Some costs are already rising, but the overall cost/benefit analysis for continuing use of existing instruments, versus migration to swap futures et. al., is far from certain.
Will exchange-traded instruments provide a viable alternative as the prospect of cost hikes dampens the appeal of swaps? The buy side may need to keep its options for the foreseeable future, but it is worth examining some of those cost drivers for both the sell side and the buy side in order to further understand the motivation for using new approaches for hedging interest rate risks.
Two of the biggest policy conclusions drawn from the collapse of major financial institutions in 2008 were that the opacity of the OTC derivatives markets and the size of bank balance sheets posed unsustainable systemic risks. Thus, the G20’s 2009 summit in Pittsburgh mandated central reporting, central clearing and electronic trading for standardized OTC derivatives – enacted under national and regional legislation, such as EMIR and the U.S. Dodd-Frank Act – and imposed higher capital charges and margin requirements for non-standardizable OTC instruments, based on guidelines drawn up by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). The BCBS was also tasked with tightening up the capital rules for banks, ostensibly to hike the cost of products and services in line with their inherent risks. Known as Basel III, and subject to “gold-plating” by local regulators, the new capital framework introduces a number of measures that increase the cost of clearing, structuring and execution services in the OTC derivatives market, as well as the cost of accessing collateral. Both Basel III and EMIR involve multi-year implementations, but they must also be placed in context of other legislation, notably MiFID II, with its implications for pre-trade transparency and best execution.
Explicitly, the aim of the G20 political leaders and the Financial Stability Board – the coordinating body for implementing post-crisis reforms – is to encourage banks to find cheaper and safer ways of providing the more high-risk services to clients, not least in the derivatives markets. This takes time and causes pain, as service providers and market participants alight on new innovations. But unintended consequences are also a fact of large-scale regulatory reforms, as recognized by regular revisions by the BCBS, and the European Union’s consultation on the collective impact of post-crisis legislation. Among several pertinent examples are capital charges on client collateral held by clearing members and the negative impact of Basel III’s leverage ratio on banks’ appetite for repo market business, which in turn hampers buy-side firms looking to transform assets into eligible collateral to post as margin at central counterparties (CCPs) in support of centrally cleared interest rate swaps.
Feeling the pressure
How does regulatory change translate into industry cost? Historically, buy-side clients posted collateral for interest rate swaps according to terms agreed bilaterally with a broker in a credit support annex (CSA). With the switch to central clearing of swaps, the buy-side firm needs one or more of its brokers to serve as a clearing member at multiple CCPs in order to post initial and variation margin on its behalf, according to collateral eligibility terms and schedules dictated by the CCP. Some broker-dealers in the European swaps market were already clearing members at some, but not all, European CCPs, for the purposes of clearing futures and other exchange-traded derivatives. But few, if any, had all the necessary connections to the growing range of CCPs needed to offer clients swaps clearing choice, and none already had the necessary risk and collateral management models and processes in place.
Investing in the infrastructure needed to support a new, if complementary, service was already a challenge for banks under the shadow of Basel III. But the uncertainty of a return was multiplied by delays to EMIR’s timetable for launching central clearing, with a number of major banks deciding the risks and costs were no longer acceptable, quitting the market before it went live. As such, there is still a scramble for even large buy-side firms to sign up with clearing brokers ahead of the December deadline for mandatory clearing by non-clearing members. Moreover, the same mix of regulatory uncertainty and capital constraints means no major sell-side firm is currently supporting indirect clearing, designed by regulators for mid-tier and smaller users of interest rate swaps. This relative absence of competition has inevitable implications for pricing.
Laurent Louvrier, EMEA Head of Sell-Side and Hedge Funds, Risk Management Analytics, at MSCI, says Basel III may have an impact beyond the capital requirements imposed on execution and clearing services. “Generally, banks have to set aside more capital for certain activities, but the impact of this is combined with some very specific rules which exacerbate the impact, such as the capital treatment of collateral posted by clients for margin purposes, which is somewhat counter-intuitive and increases costs significantly,” he says. “Further, as a direct consequence of the new capital regime, some banks are retreating from specific areas of trading. Fewer offers in the market mean less competition, less liquidity and higher costs.”
New structures and processes must also be put in place for non-standardized derivatives that cannot be cleared centrally. From September, bilaterally cleared swaps will be subject to the BCBS-IOSCO risk mitigation framework, including consistent calculation methodologies for initial and variation margin and new controls for the exchange and secure holding of initial margin. As well as putting new models and processes in place, banks are factoring new costs into their pricing. “For bilateral trades, we’re starting to see pricing being impacted by XVAs, the valuation adjustment factors, due to regulatory capital requirements on the banks. Firms are no longer putting their heads in the sand and are taking a pragmatic approach, adjusting to the new environment ahead of the new rules,” says Liam Huxley, CEO of Cassini Systems, a provider of OTC cost and margin analytics.
Nick Green, Global Head of eRates Product Management at Crédit Agricole CIB, sees a number of costs stemming from the regulation-driven shift in brokers’ counterparty risk distribution. Rather than many relatively small exposures spread across multiple buy-side clients in the bilaterally cleared world, brokers now face fewer, larger risks concentrated at a handful of CCPs in the centrally cleared environment.
“Clearing and collateral costs vary across CCPs and according to the size and nature of a clearing member’s aggregate position. If underlying client positions are highly skewed in a particular direction, the dealer can quickly find itself posting a lot more margin as it triggers bigger thresholds, which result in ever steeper collateral requirements. These increased collateral costs inevitably feed back into the price to the client,” he explains.
Moreover, the proliferation of swap-clearing CCPs can also increase costs beyond mere connectivity. One variable arises if the client wishes to clear a swap at a different CCP than its dealer would choose, which is likely to be a common scenario as spreads offered by CCPs will reflect different risk implications for the buyer and the seller of the contract, informed in part by their existing positions. In the U.S. cleared swaps market, a market has developed in the spread between LCH.Clearnet’s SwapClear and CME Group for clearing the same swap tenors as participants seek to balance their exposures across the two and so minimize their clearing costs.
“Clients can often get a better price by choosing to clear at the CCP that is favorable to the side of the trade they’re on. But they must also consider the overall collateral requirements: posting collateral in two CCPs is less cost-efficient than concentrating all your positions into one,” says Green. “These differences in price will become more of a factor as a wider range of CCPs become active in the swaps-clearing market.”
Cassini’s Huxley says buy-side firms need to assess these costs independently, including the embedded costs of the broker posting collateral to the CCP, which, as Green points out, will vary based on its overall position. “Buy-side firms must understand that the price offered by the broker will vary across clearing channels. And when you build in your own operational holding costs and collateral requirements bearing in mind the nature of your portfolio, the cheapest option offered by the broker might end up costing you more over the lifetime of the trade. But whichever choice you make, you’ll need to be able to demonstrate why you’ve done that, from a MiFID II best execution perspective,” says Huxley.
Even after all these costs are factored in, we still haven’t mentioned the elephant in the room, according to Robert de Roeck, Head of Multi-asset Structuring at Standard Life Investments. For him, the critical challenge of the centrally cleared environment for interest rate swaps is mitigating the drag on performance caused by the need to post eligible collateral at CCPs. “The more of the fund one is required to hold in low-yielding eligible collateral, the greater the impact on fund performance,” says de Roeck, whose team oversees the firm’s liability-driven investment (LDI) funds.
According to de Roeck, delays and amendments to the European framework have already had “a material impact” on the ongoing development requirements for buy-side trading platforms. Access to interest rate swap markets is still considered fundamental to most LDI strategies, as the bespoke nature of OTC instruments enable managers to precisely hedge client’s long-term liabilities. (Pension funds have a temporary exemption from EMIR, but it is not clear how this will be replaced.)
“With bilaterally collateralized derivatives, the counterparty-negotiated CSA has historically allowed for the posting of assets already held within the fund, with the obvious benefits,” he explains. “Under central clearing, the assets that qualify as eligible collateral are very limited: cash or sovereign debt as initial margin, and only cash for variation margin.”
A typical pension fund liability hedging portfolio implemented on a bilaterally collateralized basis might easily require an additional 4% to 8% of the fund to be held in eligible collateral in order to meet the initial margin requirements under exchange clearing. This is before taking into account the eligible collateral requirements for variation margin. As a consequence of the more restrictive collateral posting constraints, asset managers also increasingly require access to a deep and liquid repo market in order to transform ineligible assets into eligible collateral. However, the impact of Basel III on the ability of banks to offer liquidity in repo markets is very much in question. “The ability to fully retain the fund’s exposure in funded return seeking assets and repo them out as required has, in my opinion, long since gone. Firms might end up holding 5% to 15% of the value of their funds in low-yielding eligible assets,” says de Roeck.
Exchange-traded instruments may well provide an alternative for certain funds but, he asserts, innovation will be required in order for such contacts to suit the idiosyncratic characteristics of LDI funds: “Historically, futures haven’t really cut it for LDI funds because they haven't offered the duration to meaningfully hedge pension and insurance liabilities. We are talking about durations of 20 years-plus, while the most liquid future in the sterling rates market is the 10-year gilt future.”
The swap spread effects being observed at the long end of the term structure are causing a rethink among providers and users of swaps, but de Roeck is also looking for other types of innovation, including new mechanisms for exchanging collateral assets in a repo market now hamstrung by capital regulations. “While Basel III makes repo too balance-sheet intensive for banks to participate at historic levels, there are still large pools of eligible collateral out there the owners of which are willing to lend out at a price. As such, peer-to-peer collateral transformation platforms might be the way forward, subject to agreement on the regulatory context,” he says.
Although anecdotal evidence suggests that cost pressures are beginning to make themselves felt, only the very largest buy-side firms are centrally clearing swaps in Europe, while even fewer have dipped their toes into the exchange-traded environment, despite the launch of numerous innovative contracts. This makes it hard to get a handle on future preferences. The slow growth of swap futures in the U.S. underlines the challenges of shifting liquidity in the derivatives market, but Cassini’s Huxley offers exchanges evidence for optimism, based on his platform’s analysis of the overall costs of new instruments versus cleared swaps.
“It’s a multi-dimensional picture: the cost-benefit of swap future alternatives depends on how directional or balanced your portfolio is, as well as the exact nature of the trade. But if you’re running a directional portfolio, and hedging shorter duration, then you can find that putting on swap futures instead of swaps can give cost savings of up to 55+% over the lifetime of the trade,” he says.
Despite such potential savings, asset managers face a number of challenges in assessing and migrating to new instruments, says independent consultant David Bullen. “The investment consultants who are advising their pension fund clients on how to manage interest rate risk are not yet fully aware of these complexities. Pension fund trustees do not make major decisions without their investment consultants, but these advisors, not to mention actuaries, have not got the requisite tools to understand these new interest rate products at this stage,” he says. “The world simply hasn’t caught up with today’s market reality.”
The need to educate stakeholders and the difficulties of picking a winner from the current crop of swap future offerings add to the inertia resulting from ingrained processes and the weight of open interest. “There is clearly a market need for these new instruments, but the immediate challenge is the lack of liquidity, which is providing a disincentive for major firms to go into the market and test out these alternatives,” observes MSCI’s Louvrier.
But the clock is ticking down on the EMIR deadline and the new costs of using OTC swaps will become more evident to asset managers of their clients. As such, many buy-side market participants will intensify their scrutiny of the new innovations, weighing up their fit with long-term requirements and operational realities.
“For some firms, it will make sense to leverage existing collateral pools generated by their use of exchange-traded fixed-income, but that only makes sense if the available futures instruments meet their needs and can offer liquidity over the long term. Even the perfect product needs time to build momentum,” says Hirander Misra, CEO of GMEX.
Bullen suggests that many on the buy side will have to cover all their bases, at least in the short term, securing access to OTC and exchange-traded interest rate derivatives. “To date, swap futures have mainly found favor at the shorter end of the market, with the reluctance of some exchanges to offer longer maturities, suggesting there will always be a place for OTC trades,” he observes. “The very precise hedging needs of a pension fund mandate typically favor OTC, but on the other hand we’ve seen over the last decade growing buy-side demand for instruments that can help them manage the roll risk.” Moreover, the widening cost differential between longer-dated OTC swaps and futures is now encouraging exchanges to offer 30-year contracts.
Two years ago, Deloitte estimated the cost to the industry of reforms to OTC derivatives in Europe at €15.5 billion per annum, with the burden weighted toward the bilaterally cleared sector. Those figures are likely in need of upward revision, but reflect the scale of change faced by users of interest rate swaps, by far the biggest OTC market. This offers opportunity to investors, but new business will not simply fall into their laps.
“The existing futures construct doesn’t automatically work as a replacement for OTC interest rate swaps, which is why we have come up with a futures paradigm that is more closely aligned to OTC instruments,” says Misra. “New products have to be aligned with existing processes and analytics. You need to be able to demonstrate the cost savings and hedging effectiveness over the life time of the instrument, but the more you can intertwine yourself into existing workflows, the better chance you have of succeeding.”