Trading swaps in a cleared world


Meet Joe. Joe is a swaps trader within a small institution that has a straightforward hedging strategy at both the micro and macro level. Being a price-taker, Joe has built and maintained broker relationships that enable him to easily get a swap priced at an acceptable level provided counterparty limits allow. Joe’s back office is practicing weekly collateral exchange with various counterparties in cash. As such, Joe lives in a very comfortable world.

But Joe is in for a nasty surprise. The practice of looking for a good price from a trusted broker dealer is about to be turned upside down. Regulations spanning from Basel III and CRD IV to Dodd-Frank and EMIR will make the decision of where to trade what and with whom a lot more complicated. Deciding on a trade has become extremely varied across cleared trades, electronic trading and bilateral trades.  A number of additional influencing factors play a significant role with the added complication that these factors are not always correlated. Some factors are the:

  • cost of clearing
  • size and cost of posting initial margin, at the CCP as well as bilaterally
  • cost of collateral transformation
  • cost of capital

These are some examples of what Joe needs to consider in the future:

  • If the intended swap is eligible for clearing, what will the clearing cost be?
  • Collateral now needs to be posted daily, and not only variation margin but also initial margin. And margin posted to the clearing broker needs to be paid on the same day. Where does Joe fund that money from?
  • Which clearing broker do I use?
    • This involves thinking about the impact on initial margin requirements that the change of the swap portfolio held at that clearing broker would result in
    • Interest on initial margins at clearing houses typically does not yield market rates as clearing houses take a cut, e.g. EONIA -30 basis points, which would mean an interest loss as Joe needs to fund the amount posted as initial margin at market rates
    • Would it now make sense to backload some existing bilateral trades into clearing to reduce the initial margin? How does that offset correlate with the cost of backloading?

This train of thought is endless and it puts Joe in a very dire situation. There is no immediate remedy such as an algorithm that could be employed to help with his trading decision. This calls for a set of strategic trading policies that Joe should adhere to which should be combined with regular reviews of such policies and their resultant cost of trading.

The incoming regulations will no doubt be costly but being smart and strategic in dealing with the consequences ensures that the cost will not break Joe’s or your business.

Next week marks the last instalment of the OTC blog series, this time covering the impact of the new regulatory regimes on corporates.


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