LCH-Clearnet US chief plays the innovation game

The ‘market infrastructure’ industry, which provides all the endless plumbing and platforms necessary for the functioning of the over-the-counter (OTC) derivatives market, has been an area of immense change in the past few years. 

The term often conjures images of worthy but dull operations, dutifully building the services required by regulators and doing the unseen work that keeps the market running smoothly. However, it is also an area of huge innovation, from the smallest tech firm to large, established service providers. 

LCH.Clearnet, one of the largest OTC clearing houses in the world, certainly falls into the latter category. In April 2015, it became the first central counterparty (CCP) to launch a clearing service for inflation-linked swaps, beating its close rival Eurex to the punch. In the months since then, more than 9300 trades have been cleared, representing some $300bn in notional value. About $16bn of that figure has come from ‘client clearing’, a process that allows the clients of CCP members access to clearing services via those members. Eleven of LCH’s members, typically large dealer banks, initially signed up to the service, and that number has grown to 32 in the intervening months.

A positive start 

Inflation-linked swaps are most commonly used by large insurance funds, pension funds or other asset managers seeking to hedge out long-term inflation exposure. As such, the individual trades are often large and lengthy in tenor (50-year deals are not uncommon), and can be fairly complex in their specifics. This, at a time when much of the OTC market is becoming more standardised, simpler and shorter dated, presents a unique challenge to the clearing house. 

“Our inflation-linked swaps clearing service has had an extremely positive start, thanks in part to our rigorous approach to risk management and the strong demand from our members and their clients,” says David Weisbrod, chief executive of LCH.Clearnet in the US. 

The firm is now working on a repurchase agreement (repo) clearing service that will be available for clearing members and their clients in the US and Europe, though Mr Weisbrod is reluctant to set out a precise timetable for its introduction. LCH already runs a repo clearing service for the interbank market in Europe, and regulators in the US have been enthusiastic about its introduction on their shores. In November, Jerome Powell, a governor of the US Federal Reserve, noted in a speech that repo clearing could "bring a range of benefits", including a reduction of the cost and capital pressure on bank balance sheets. 

The repo market is a critical one, used as a source of financing by banks and non-bank financial companies and as a safe haven for investors during periods of extreme market stress. CCPs also place cash collateral posted by counterparties into the repo market, and use the interest earned as part of their liquidity supply. 

Despite this importance, the repo market has had a troubled few years. According to Federal Reserve data, the outstanding notional in the repo and reverse repo market has now slipped below $4000bn, the lowest level since 2002. This is largely due to changes in regulation, which have damaged the market on many fronts. Changes to liquidity standards means that banks can no longer seek as much funding from short-term sources, such as the repo market, as they could in the past. Higher capital ratios also mean that bank balance sheets are more constrained, further limiting the use of the product.

Work to do 

Central clearing may go some way to arrest this decline, but for the CCP itself it poses a different challenge to run-of-the-mill swaps clearing. 

“The main difference between swaps and repo clearing is the issue of physical cash settlement at the conclusion of the trade, which is necessary for the latter but not for the former. It is also a significant innovation to extend repo clearing to clearing member clients,” says Mr Weisbrod. 

Another area of work for the clearer is portfolio margining, a scheme that would allow clients within LCH’s interest rate swap clearing service, SwapClear, to net all the collateral demands from their SwapClear positions with the listed interest rate derivatives positions they have on-exchange. By boiling collateral demands down to one number, there should be a reduction in the amount of collateral that actually needs to change hands between counterparties. In theory, the service could be a big boost for large derivative users, particularly those such as dealer banks that generally keep a balanced book of short and long positions – for these participants, the amounts of collateral due to be paid out and paid in could effectively cancel each other out, freeing up balance sheet for other uses. 

The service will be constructed on an open-access basis. Though LCH is currently owned by the London Stock Exchange, any exchange could choose to partner with LCH and allow their clients to access the margining service. SwapClear already deals with listed derivative trades transacted on the Nasdaq NLX platform. 

“We expect to go live with portfolio margining early next year, subject to regulatory approval, to enable margin offsets between clients’ OTC and listed derivatives position. The most important aspect of this service is that it is done on an open-access basis. When you are looking for life insurance, car insurance, house insurance, there is no requirement to buy all these from the same provider. Why should we compel people to act within the same entity when it comes to trading and clearing?” says Mr Weisbrod. 

Skin in the game 

With great power comes great responsibility. The regulatory changes over the past half-decade or more have transformed CCPs into a fundamental lynch-pin of the derivatives market, as systemically important as the largest banks in the world. The notional value of trades being pushed in and out of their doors is vast, and will soon grow ever bigger as more clearing mandates are brought in by regulators. CCP failure, then, is not an option. 

CCPs construct elaborate ‘risk waterfalls’ to ensure they have enough resources on hand to keep all users whole in the event of a member default and ensure its own survival. Initial and variation margin posted by counterparties are generally the first line of defence, followed by member contributions to the overall default fund. There is also the possibility that regulators will require CCPs to put some of their own resources, be it capital or liquidity, on the line as well. The ‘skin in the game’ concept has formed a key part of the discussions around CCP recovery and resolution, and the industry awaits a firm view on the matter from regulators.   

“The real decision on ‘skin in the game’ will come from regulators. If CCPs were asked to provide materially larger amounts of capital to serve as a loss-sharing tranche of the risk waterfall, the cost of doing so could jeopardise the clearing process altogether, which is an outcome that no one wants,” says Mr Weisbrod. “The role of ‘skin in the game’ was intended to ensure that incentives of the clearing house operator are aligned with those of the members. On that basis, we do very much support ‘skin in the game’  and see it as an important component of CCP resilience.”

Derivatives downturn 

While these debates roll on, the derivatives market itself is going through a tough time. The same pressures that have weakened repo trading – new requirements around capital and liquidity, higher cost pressures and tighter balance sheets – have threatened the smooth functioning of OTC trading. Banks are pulling back from some derivatives trading, or in some cases shutting down their market-making services altogether. Regulatory differences between the US and Europe have produced a liquidity split in the swaps market, which threatens to make pricing less efficient. 

For the moment, things are still looking rosy for LCH. “We have seen an inflow of business into LCH.Clearnet. The market recognises that we offer a good place to clear swaps and other instruments. We have not experienced issues with liquidity,” says Mr Weisbrod. 

However, the clearer is mindful of the threat posed by a proposed change to the Basel III leverage ratio that would see segregated margin posted by banks to cover mark-to-market exposures on cleared derivatives trades included in the measure. Dealers warn that this would hugely increase the cost of clearing and irreparably damage the OTC market. LCH has also added its voice to the opposition.

“We are reliant, as the market is, on dealer banks finding it commercially attractive to clear trades. That is why we have spoken in favour of alterations to the leverage ratio rules, which we believe in their current form may prove damaging to the market,” says Mr Weisbrod.