Clarus Financial Technology

Moving Euro Clearing out of the UK: the $77bn problem?

Clarus Team

Bloomberg Reporting

There has been a lot of coverage in the press recently, particularly by Bloomberg, on what could happen if EUR clearing were to be forced out of the UK upon Brexit. There are several stories, including:

Banks Said to Plan for Loss of Euro Clearing After Brexit
LSE’s Rolet Says 100,000 Jobs at Risk If Clearing Leaves London
Bank of America Official Likens Brexit to Nuclear Waste Move

But let’s approach this from a data angle. Can we estimate the effect on the market from bifurcating Interest Rate Derivative portfolios in a way that leaves non-EUR business in London and EUR-denominated business elsewhere?

Using public data we outline a methodology that can be used. It is important to understand the caveats that go hand-in-hand with this methodology:

Nonetheless, we present an estimate that we feel is credible given the data available. Feel free to reach out to us or comment below with any thoughts.

Total Margin

As Amir has noted in his blogs about the disclosures, CCPView now includes details about how much Initial Margin is held by CCPs. For LCH, we can see that this has been steadily increasing since September 2015:

Initial Margin (in $) held at LCH

Showing;

Outstanding Notional

To work out the impact on Initial Margin from moving the EUR business out of the current London location, we need to have an estimate of how much of the outstanding notional at LCH is currently denominated in EUR. This is super simple using CCPView:

Outstanding notional (in $) at LCH SwapClear

Showing;

Volume Weighted Average Maturity

To estimate the impact on the industry, as well as knowing the size of positions, we also need an idea of the average maturity that the outstanding notional applies to. Let’s also assume that it is mainly Outright risk that is the driver of IM, therefore this is the trade type we are most interested in.

From SDRView Res, we can therefore use our Tenor view to estimate the Volume Weighted Average Maturity for the LCH SwapClear portfolio. Across USD, EUR, GBP and JPY , which make up 86% + of notional outstanding, we see the following tenors traded:

Volume Weighted Average Maturity

Showing;

Estimating the Impact on IM

Given these two facts, can we simply model the LCH portfolio as $46.6tn of 12 year USD IRS vs $49.5tn of 12 year EUR IRS? Sadly not. The notional outstanding does not give us an idea of what positions are driving IM for example, and notional outstanding is not the equivalent of Open Interest in Futures.

Instead, we need to guesstimate a representative portfolio of Interest Rate risks that will generate an IM of $83bn. To do this, we will split the risk according to the ratio of notionals outstanding in each currency. We therefore turn to CHARM and some IM modelling.

First, let’s see what a portfolio of 12 year swaps looks like with the currency split according to that of the notional outstanding:

Portfolio of Risk

Showing;

Before we show the IM figure for this portfolio, it is worth running over the following thought experiment:

Initial Margin Numbers

To model the whole market, we therefore have to scale this portfolio up by 83.34 bn divided by 6.9 m – i.e. we need to look at a position over 12 thousand times bigger. This results in positions of almost one trillion dollars in 12 year EUR and USD swaps! The exact positions are shown in the table.

The Initial Margin results are linear – because we are calculating without add-ons. Therefore, we see:

Which as expected adds up to a total of $83.34bn.

Is this believable/possible? It’s important to understand the caveats!

The above analysis suggests that if Euro clearing were to leave LCH in London, then the net effect would be to move over €1 trillion of 12 year swaps to a new clearing location (in the Eurozone). In risk terms, that is moving over $1.2 billion in DV01.

Recall that as at the end of March 2016, when the IM numbers were calculated, the total Open Interest for EUR swaps was nearly $50 trillion. We are therefore saying that the overall outright position is around 2% of the outstanding notional. This doesn’t actually sound too far-fetched.

However, we should note that this number assumes there are only two accounts at LCH – Side 1 and Side 2. In reality, LCH obviously have a multilateral network of counterparties, which grosses up IM – as we have discussed numerous times in blogs such as this, this and this.

When calculating IM, we have also ignored add-ons (as we like to work with linear problems) and assumes everything is house business, therefore ignoring Client add-on factors.

Due to these caveats, using the public data available to us will likely end up with a figure closer to the maximum possible impact rather than the actual impact.

This is due to grossing up over hundreds of accounts. We are modelling only two accounts to arrive at an IM figure of $83bn. In reality, there will be far more accounts (probably hundreds), meaning that the amount of risk required to create $83bn of IM is much smaller.

The IM Impact to the London Clearing House

With these caveats clearly stated, let’s go ahead and run the numbers.

Moving EUR clearing out of LCH SwapClear, using our methodology, will involve removing €1trn of 12 year EUR swaps from our model portfolios. This results in the following IM changes:

Half a billion dollars? Across the whole industry? As a maximum? That doesn’t sound much….we bet you were expecting a much higher number, right?

Take a quick look at the scenarios below (click to enlarge):

This scenario analysis shows that when we remove the EUR risk from the portfolio, the driving scenarios of IM change. This is because the IM of the portfolio is now driven by a large outright USD position in 12 year swaps, instead of a EUR vs USD 12 year spread when the EUR risk was present.

IM Impact at a Eurozone Clearing House

The impact at the London Clearing House looks fairly manageable. However, the EUR trades still have to go somewhere!

Both sides of every EUR position will now have to post IM at a clearing house outside of the UK. Clearing this EUR position on a standalone basis will result in an additional IM requirement. Because we are moving €1 trillion of 12 years in a directional position, this is a very risky thing to do and hence results in a very large IM requirement:

As we see in the following scenarios, this IM is driven entirely by the EUR 12 year positions, as expected:

Overall, bifurcating the existing LCH portfolio into EUR risk and non-EUR risk leads to an increase in IM requirements of $77.5bn.

To reiterate, this is to clear exactly the same risk. The bifurcation would nearly double the amount of IM that is currently being posted.

Hopefully, this would not be the day one impact – this is the result of moving the entire portfolio, which would take a considerable amount of time. For something so unprecedented, we do not know how that would work – whether only new EUR trades would have to be cleared in the Eurozone, or whether regional CCP transfer trades would have to be enacted.

There may also be impacts on Variation Margin and Compression (from separating old and new trades), plus overall increases in Default Fund contributions (mainly at the new CCP).

In Summary

Stay informed with our FREE newsletter, subscribe here.

Exit mobile version