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23 November 2012

OTC Clearing Part 9: Trading Swaps in a Cleared World

Looking for a good swaps price from a trusted broker-dealer is about to be turned upside down. Regulations will make the decision of where to trade what and with whom a lot more complicated, says Capco's Tom Riesack.

Meet Joe. Joe is a swaps trader within a small institution that has a straightforward hedging strategy at both the micro and macro levels. 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.

[Related:OTC Clearing Part 8: Bilateral Margin Requirements -- A Liquidity Vortex?”]

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. The following simplified, non-exhaustive view shows how varied -- and not always correlated -- the influencing factors for deciding on a trade have become.

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 -- 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 would result from the change of the swap portfolio held at that clearing broker.
  • Interest on initial margins at clearinghouses typically does not yield market rates, as clearinghouses 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?

[Related:Easing the Pain of Margin Requirements in Interest Rate Swaps”]

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 to which Joe should adhere that 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.

In the last instalment of his series on OTC Clearing, Capco’s Tom Riesack examines the impact of the new regulatory regimes on corporates.

Spotlight-white-trans For more stories in the OTC Derivatives Reform Spotlight Series click here.

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