Interest rate product continues to dominate the derivatives world, accounting for $418tr of the total $544tr notional value outstanding derivatives, according to the Bank for International Settlements.
Although not as intimately linked to the financial crisis as credit default swaps, interest rate derivatives — and the institutions that handle them — have been at the centre of post-2008 reform.
Above all, this has meant moving vast swathes of over-the-counter derivatives into central counterparty (CCP) clearing houses, which have been used for many decades to ensure the robustness of futures and options markets.
By December 2016, 76% of the positions held by dealers reporting to BIS were booked against a CCP, such as SwapClear, owned by LCH Group, in turn majority owned by the London Stock Exchange Group.
In 2008, the proportion of OTC contracts centrally cleared was only half or a third of that, according to BIS estimates.
Despite the huge change this has involved, the market has coped. Eric Litvack, chairman of the International Swaps and Derivatives Association, observed in May that the adoption of clearing and fuller reporting on trades had brought benefits.
“The financial system is more resilient as a result,” he told delegates at ISDA’s 2017 annual general meeting in Lisbon. “Just think back on what’s happened over the past two years. We’ve seen a succession of shock events — Brexit, the US elections, the unpegging of the Swiss franc and [wars in] Ukraine and Crimea.
“These events have been accompanied by sudden, violent and sometimes unprecedented moves in markets. Yet despite these moves, at no point has anyone said they’re worried about the financial system. Yes, there have been localised issues, but these have been contained. There may have been shocks, but there has not been panic.”
But despite the regulatory effort of the past eight years there is still much work left to create a well oiled interest rate derivative market. Participants believe some post-crisis regulation needs fine tuning, and in its current form could hamper clearing efforts.
Regulators seem to be coming round to that point of view. Since late 2016, senior officials in both Europe and the US have made speeches and proposals championing simpler and improved derivatives markets, though with CCP clearing remaining at the heart of the market.
In November 2016, the European Commission proposed amendments to the Basel capital framework for banks that would free them from counting clients’ initial margin as part of their leverage ratio exposure. Industry spokespeople believe this would facilitate greater access to clearing services.
The EC has also shown flexibility in extending a clearing exemption for pension funds, big users of interest rate derivatives, to give them more time to find a solution for meeting cash collateral requirements — some pension funds argue that holding required levels of cash does not fit with their business models.
Political tug-of-war
There seems to be enough common ground between regulators and the derivatives industry that they can collaborate on improving market infrastructure without risking financial stability.
But achieving that goal will not be straightforward. Even if the inevitable legal wrangling proceeds at a steady clip, negotiations will take place against an increasingly aggravated scene of political grandstanding.
As the UK negotiates its exit from the European Union, some continental politicians’ desire to bring clearing activity in euro denominated derivatives into the eurozone is likely to create disruption that will leak into markets.
Price discrepancies may evolve between products cleared through London-based LCH and clearing houses on the continent, if Brexit negotiations pull business away from London.
“We are in an environment where bilateral risk is clearly priced differently to cleared products,” says Fabio Bassi, chief European rates strategist at JP Morgan in London. “But the centralisation and offsetting of risk at the clearing level will also create different price dynamics, relative to clearing house exposure. This is likely to take place for some time.”
The battle for euro clearing is not just a European issue. If elements in the EU try to insist euro clearing is done in the eurozone, that could rile the US. Christopher Giancarlo, acting chairman of the US Commodity Futures Trading Commission, hinted heavily in May that the CFTC could copy European regulators if they push back on globalisation in clearing.
Fragmenting clearing into national or regional silos creates a risk of increasing derivatives users’ costs, as they might stand to lose the benefits of netting multiple positions with one clearing house.
When other classes of derivative are playing catch-up on interest rate products’ march into CCP clearing, a move away from centralisation could hit the entire derivative industry.
“We have learned the lessons of bilateral trading and its ill effects on counterparty credit and margin,” says Chris Yoshida, a former global head of rates sales at Deutsche Bank, now working at TrueEx, an interest rate swap trading platform.
“Clients can’t post margin to 15 different players, it’s not an efficient use of their capital,” he adds. “We need to make sure that clients are optimising margin with their clearing houses and have the ability to readily report positions and risk profile to utilise portfolio margining.”
In portfolio margining, the margin, or risk protection collateral, a firm has to post against its derivative positions is assessed on a whole portfolio, rather than contract by contract or asset class by asset class. The result is usually less margin.
“There is still further to go,” Yoshida says, “because the macro community is trading a lot of asset classes at once around a similar view such as loosening or tightening financial conditions. Currently, they are required to post margin on all these different venues and dealers. The need to harmonise that really efficiently is a necessity. It has to evolve, because right now it is a problem and will continue to be one until all asset classes are housed in a streamlined process.”
Hedging upswing
While OTC interest rate derivatives have been moving into clearing houses, another trend has been going on: they have declined in volume. A BIS report in May noted that, at $368tr, the notional amount of contracts is at its lowest since 2007.
The fall was especially noticeable in interest rate swaps, which BIS attributed in part to the ending of redundant contracts by compression — when contracts that offset each other are matched and cancelled.
But some also attribute the decline to subdued rate volatility in the post-crisis years sapping the need to hedge. While political risks have swung rates markets, this volatility has proved short lived. Traders have been reassured by central banks’ bond buying programmes and determination to squash short term rates.
As those programmes roll back, albeit at different paces, the need to hedge will become more prevalent as rates rise.
“The pension and insurance community, which are clear heavyweights in the interest rate swaps market, have been hyper-concerned with their asset liability management ratios over the last five years, when rates were zero and in many cases negative and returns looked horribly off,” says Yoshida.
Now these institutions have a new problem: market value losses on their huge fixed income portfolios, as yield curves rise back to normal levels. They will need to hedge that rate exposure, Yoshida believes, as the duration on bonds issued over the last five years is still, on average, just over five years.
“The majority of the curve was so flat that corporates and governments could issue longer debt at an attractive rate,” he says.
“That has all gone into pension funds and insurance companies. They need to wear that duration down over time before it immunises the portfolio from duration risk. The way to do that is through swap hedging, with swaptions. Those institutional investors can’t sell a large portfolio so they are better off immunising it and reallocating their asset mix.”
