An article in IFR “Pension funds begin clearing swaps” by Christopher Whittall was primarily about OTC derivatives but had some important side comments on LCH.Clearnet and cleared repo. We take a look at what was said and what it means.The primary point of the article is to note that some European pensions funds have begun the move to central clearing of their derivatives transactions. The unusual part of this is that pension funds are not actually required to centrally clear derivatives just yet. European regulators have given them a 3 year pass which could then be extended for another 3 years if necessary. So why would a pension fund voluntarily give up bilateral trading? One thing about central clearing — no one does it before they have to without some really compelling incentives.
Often derivatives dealers won’t ask for initial margin (or sometimes VM) on bilateral trades, absorbing the credit exposure since the counterparts are so strong. But on trades done via CCPs this goes away. Everyone pays IM and VM for trades booked in CCPs. The pension funds have to manage their collateral — cash or eligible securities — a lot more carefully under central clearing than they did with bilateral trades and this costs money and time. It could be that their dealers are expressing a strong preference (read: paying cash to get the pension funds to move before they have to) on dealing through CCPs. Given the lower capital, CVA, and FVA costs, it might make sense.
Derivatives dealers are in a rush to renegotiate bilateral ISDA CSA agreements and those documents will not skip the IM or VM. As a template, they look to ISOCO/BCBS rules on non-centrally cleared derivatives trades that will require financials to post (fairly onerous) IM and VM on bilateral dealers. But those requirements are years away.
But we buried the lead on this article. Whittall says:
“…Perhaps the thorniest project is designing a robust process for pension funds to transform their financial assets (such as large portfolios of government bonds) into cash for collateral purposes. Posting bonds or other securities as variation margin hugely complicates the valuation of swaps portfolios. As a result, CCPs are unwilling to accept non-cash collateral.
“We’re not just boneheaded or reluctant,” said Davie [head of LCH.Clearnet]. “It’s a major structural problem for CCPs taking cash. However, we do think there is a solution, which is to give clients more access to repo markets.”
LCH.Clearnet is looking to leverage off its position as a major repo CCP to allow clients direct access to repo markets, where they could exchange bonds for cash, and is hammering out with the industry how this could work in practice…”
LCH is in a unique position since they run both derivatives and repo central clearing. WIll LCH somehow allow non-dealer clients direct access to repo via Clearnet? Lots of people have advocated giving clients a seat at the table, but (as far we are aware) only Eurex has successfully put this into place. Investors typically hate mutualization of risk and aren’t too fond of contributing to default funds. Will LCH.Clearnet be changing their repo clearing business model and, if so, how? Or is this about introducing the pension funds to repo dealers who can then service their collateral transformation needs?
The article implies that the kind of repo that pension funds would be doing is more about lending high quality assets for cash and then using that cash for variation margin. Something sounds a little funny about that. Variation margin only comes when markets move. So new trades, done at par, won’t have big VM requirements unless markets move a lot (although being prepared is always a good thing). We usually read about collateral transformation in the context of investors who don’t have HQLA for initial margin purposes and not so much for finding liquidity for VM. Could the LCH people have been doing a little spin, simply fishing for interest from pension funds for both derivatives and repo central clearing?