Swap Terminator: The Paradox of Central Clearing

By Will Rhode, TABB Group

Originally published on TABB Forum 

Though central clearing of swaps was intended to reduce counterparty risk, it comes with an unfortunate side effect: It now will take two trades to effect a termination, which threatens to increase operational complexity and risk. 

Central clearing was designed to cure the swaps market of cascading counterparty credit risk, but it comes with an unpleasant side effect: line item proliferation. If a buy-side firm wants to eliminate a swap from its portfolio, it will have to add an equal and opposite trade that the clearinghouse can recognize for netting purposes. It will no longer be able to rely on its over-the-counter (OTC) dealers to port positions to a willing substitute. Such is the paradox of trading swaps in a centrally cleared world – it takes two trades to effect a termination.

Terminations and compactions are based on a simple idea: As a buy-side firm enters into a series of swaps over time, trades can begin to be removed without impacting the interest rate profile of the overall portfolio. For example, a buy-side trader may have entered a swap for which he is receiving fixed rate cash flows for two years and two months. Suppose the same trader enters a new swap two months later for the same notional amount that pays fixed and receives floating for two years; the interest rate risk naturally offsets. The trader is paying fixed and receiving fixed on the same notional amount and for the same period of time. 

Of course, such precise matches occur only occasionally, but close-enough matches occur all the time. Near-matching trades can still offset one another once the difference in value caused by a mismatch in dates and in fixed rate payments is determined and settled. If the parameters for valuing these mismatches can be agreed upon, there is no reason why these swaps cannot be torn up. Running a swaps portfolio with fewer line items significantly reduces operational complexity and risk, such as having to manage multiple variation margin calls.

Terminating and compacting trades is a precursor to central clearing compression, which has been an important tool in reducing the overall size of the global swaps market, with its attendant operational and systemic risks, since 2003. It took dealers many years of terminating and compacting swaps between each other bilaterally before they started to centrally clear and, later, to compress their trades at the clearinghouses. Indeed, compression evolved as a method to allow a dealer to consolidate its portfolio of bilateral swaps without needing to negotiate individual tear-ups with multiple bilateral counterparties. Now this overall effort is being extended to include the buy side.

2013 will live long in the memories of buy-side operations folks as a challenge. Central clearing, SEF trading, changes to terminations workflow – it is a far cry from the days when swaps changed hands bilaterally. But in the end, the pain associated with migrating to the new world will be worth it.

Swaps portfolio management is already an operationally complex task; 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 are managed mostly manually. And there are very few solutions available for managing swap portfolios in a world populated by multiple central counterparty clearinghouses (CCPs), each with its own set of data requirements for position recognition. The buy side is looking for a system that can communicate with clearinghouses agnostically, one that can draw down pre-existing swaps so that the necessary data fields for offsetting trades can be auto-filled and the termination process executed, netted and settled in real time.