CME gets ready to add swaptions to central clearing. Not everyone is happy.

An April 23, 2015 article in IFR “Swaptions clearing raises CCP risk fears” by Helen Bartholomew continues a debate on what derivatives are appropriate for central clearing and which may not.

The article quoted Emily Portney, global head of clearing and collateral management at JP Morgan, who was speaking at ISDA’s recent Annual General Meeting.

From the IFR article:

“…’We feel there’s more work to be done on default management of the product before it becomes eligible for clearing,’ she told delegates at the event…”

The article said that CME was close to starting to clear swaptions. LCH.Clearnet’s Swapsclear had been looking at clearing swaptions, but is said to have put it off for the time being.

By adding swaptions to vanilla IRS clearing, the CME will offer a more efficient product vis-à-vis portfolio netting. From a letter sent by the CME to the CFTC, dated September 14, 2014 “Regulation 40.10 Submission Regarding the Acceptance of Swaptions for Clearing, CME Submission No. 14-327”:

“…By accepting Swaptions for clearing, CME Clearing would provide market participants the opportunity to manage risk associated with IRS and Swaptions on a portfolio basis by combining cleared IRS and Swaptions portfolios, which would mitigate risks and inefficiencies present in the over-the-counter (“OTC”) Swaptions market due to mandatory clearing of IRS. Swaptions and IRS demonstrate strongly correlated responses to changes in interest rate levels…”

Key to central clearing is reliable, accurate pricing and a market that is deep enough to allow for orderly auctions. There is divided opinion on whether swaptions quality. Some, like Amir Khwaja have said swaptions are liquid. Others have been pretty iffy on that front.

From the IFR article:

“…But swaptions are typically tailored contracts, often including different strikes, maturities and underlyings depending on the exposure the end-user desires, making it one of the less standardised markets in the light exotics space…”

and

“…“The problem with swaptions is that there is huge jump-to-default risk, and clearing brokers are cautious about that. There’s no doubt that swaptions can be cleared, but it may be wise to wait until they are traded in a more standardised format,” said an executive at one clearing house, speaking on the sidelines of the conference…”

That jump to default risk is code for there is liquidity until there is not. This is also the case for single name CDS. Clearing single name CDS has had an on-again off-again history, often blamed on the difficulty of pricing given the jump-to-default issue.

We wrote two posts on LCH.Clearnet’s ideas about stress testing CCPs that would be useful context for the discussion about central clearing for swaptions. Take a look at LCH.Clearnet on stress testing CCPs, Part 1 (March 31, 2015) and LCH.Clearnet on stress testing CCPs, Part 2 (April 1, 2015).

These kinds of discussions also play into the debate between Clearing Members and the CCPs on risk management, default funds, and capital. If the CCP is going to take on greater market liquidity risk by clearing swaptions, somewhere along the line the risk waterfall needs to get beefed up. The question is: whose pocket will it come from?

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