A way to reduce the margining burden of derivatives clearing

Clearing houses are set to manage an increasing proportion of interest rate swaps (IRS) as the result of regulations already passed in the US and due to come into force in Europe. At present, LCH.Clearnet is the predominant central counterparty for the IRS market, managing notional of about $420,000bn. Driven partly via the expansion of client clearing, LCH.Clearnet has expanded away from its original core group of global investment banks into regional banks and asset managers accessing the clearing house through general clearing members.

One of the key risks of client clearing is the timing mismatch between demand for variation margin from the clearing house (same day) and collecting variation margin from clients (usually delayed one day). Clearing houses require that variation margin is posted to collateralise the mark-to-market value of cleared portfolios. Under normal market conditions, portfolios are valued, and variation margin calls issued, daily.

Causes of portfolio value fluctuations may be divided into market changes (which cannot be predicted) and changes in remaining cashflows within the portfolio, such as interest coupons (which can). Clearing houses could employ the following described method to predict and net upcoming cashflows against variation margin calls before they become due, and hence reduce fluctuations in variation margin required and the counterparty risk between the clearing house and its members.

For example...

Let us take an illustrative example. Assume that under an existing interest rate swap counterparty A is due to make a net payment of €10m to Counterparty B. This payment may be the net coupon due under an interest rate swap, or indeed any other payment that may be required. Prior to the payment, Counterparty A’s position value is reduced by €10m from Counterparty A’s perspective, against the position’s expected value post-cashflow, due to the upcoming liability. Following the payment, the liability pertaining to that cashflow is extinguished, and reduces to 0. Therefore, Counterparty A’s position increases in relative value by €10m concomitant with the payment. All things being equal, the change in portfolio value then causes Counterparty A to make a call for variation margin of €10m from Counterparty B.

From a different angle, if the €10m payment were the final payment due under a swap, the payer has a liability of €10m and the recipient has an asset of €10m. Executing the final payment extinguishes the payer’s liability, enabling him to claim back his collateral. Receiving the final payment prompts the recipient to return the collateral to the payer. In the absence of market moves, there would be no net change in the cash positions of counterparties A or B after the payment and variation margin are exchanged.

Liquidity gap

Under a regular daily margining arrangement there is a delay inherent, particularly under client clearing arrangements. Counterparty A’s payment of €10m would trigger the related return of collateral from Counterparty B with a delay. Counterparty A has to source the liquidity required to make the payment to Counterparty B, until it receives the variation margin back from Counterparty B. This is inefficient and costly.

The proposed arrangement is that payment due under the contract is netted against the payment that would become due via the margining process. Counterparty A would simply not make the transaction-related cash payment to Counterparty B; instead the €10m would be transferred internally from Counterparty A’s trade ledger where the transaction is being recorded to its margin account. Counterparty B would mirror this transfer in reverse, making a transfer of €10m from its margin account to the trade ledger. No cashflows are made between Counterparty A or Counterparty B.

There are three benefits to this. Counterparty A does not have to source the liquidity to make the payment to Counterparty B. Counterparty A reduces its counterparty credit risk on Counterparty B, as it no longer awaits the return of the cash in the form of variation margin. And operational risk is reduced as there are fewer payments required system-wide. There would likely be an initial set-up cost to changing the margining systems, but this should be set against the benefits over time.

As a change to margining processes could not be implemented unilaterally, this system would be best implemented system-wide, and investment banks would have to mutually agree to implement it. It would appear natural that this would be easiest to implement in cleared products, as the clearing house can implement its own rules across its membership. Given the (actual and expected) introduction of mandatory clearing of over-the-counter IRS in the US and Europe, the clearing houses have a good opportunity to implement this improvement more effectively.

Stephen Elliott is an investment banker and chartered financial analyst specialising in fixed income and derivatives, with a particular expertise in clearing house risk.