Swaps Clearing and Collateral

Swaps Clearing

Dodd Frank’s Goals & Objectives for Clearing Swaps

1. Market Transparency, Price Liquidity & Systemic Risk Transparency
2. Swaps Execution Facilities will create more Price Liquidity by market participants posting their price interests into an SEF
3. Trade reporting (Trade Repositories) create greater Trade Transparency by including both cleared and uncleared derivatives. Having a picture of the entire market, allows banks and regulators to monitor systemic risk in a particular product, maturity or asset class.
4. Systemic Risk transparency by having all swaps cleared through a central counterparty (CCP) gives the market a piece of information with regard to liquidity needs and concentration risk.
5. Transparency of market risk allows market participants and regulators to monitor and manage systemic risk
6. Although swap dealers generally signed Collateral Support Annexes with their clients, it was far from uniform and administratively intensive.
7. By requiring Initial Margin and Variation Margin, the Swap would be collateralized like a future.
8. A counterparty can transact a swap bilaterally with a swap dealer because it was the best price they received at the moment. But they don’t have the clear the transaction with that same entity. Rather they can “give-up” their side of the trade to another clearing member. That clearing member will submit the trade to the CCP on the client’s behalf.
   • Whether a swap is cleared through a CCP or transacted privately between two counterparties (bilateral/OTC) the transaction the transaction can be submitted to a Swaps Clearinghouse on behalf of a client.
   • While this hasn’t been as widely used as regulators would like, many open bilateral swaps counterparties are corporations and other entities unable to comply with clearinghouse regulations today.
9. Allowing EXECUTION to stand separate from how a transaction is CLEARED allows market participants and regulators greater transparency in systemic risk
10. Since clearinghouses will then be responsible for collection of collateral and payment of profits, this allows permits market participants and regulators to monitor concentration risks, institutions trading outside of their trading limits or tenor limits.

Cleared Derivatives

The ultimate goal is for all swaps to be executed via an SEF and cleared in a swaps clearinghouse (CCP). Submission to a Central Counterparty (CCP) clearinghouse for clearing and administration of cash flows and collateral.

Swaps Clearinghouses versus Futures Clearinghouses: Compare & Contrast:

1. Terms of futures contracts are identical & offset risk across the entire market.
2. Futures contract have a single maturity date one which all contracts expire.
3. Swap contracts have multiple settlement dates (accrual dates) on which the difference between fixed & floating rates will be paid (received) by the appropriate counterparty.

Bilateral Contracts a.k.a. Uncleared Derivatives

Bilateral Contracts can be executed by phone between two non-clearing members, then submitted to a clearing member for clearing. This is simply a preference of execution type or perhaps the contract is part of a larger transaction. Alternatively, a bilateral contract can remain outside of the clearinghouse. Uncleared Contracts are swaps that will never be submitted to a clearing house and will remain Over-The-Counter. Uncleared Contracts now have Standard Initial Margin requirements, Eligible Collateral lists, set by the Bank of International Settlements. Currently only Corporate Counterparties and swap with embedded options (callable swaps) are allowed to be held by a swaps dealer (and their counterparty) outside of the clearinghouse.

Cleared vs. Uncleared Derivatives – Compare & Contrast:

1. Cleared Derivatives will be collateralized per Clearinghouse rules
2. Uncleared Derivatives will be collateralized per BIS Minimums, which can be raised by the counterparty
3. The clearinghouse mitigates counterparty Credit risk across the board, with all transactions equally protected
4. Uncleared derivatives has embedded inequity in counterparty risk mitigation. As the counterparty’s credit risk changes over time, the uncleared derivatives credit risk rises and falls.
5. Clearinghouses Initial Margin takes into account other risks in addition to credit risk. How much is changed for each of these risks is known

Onboarding Dated Bilateral Swaps to a Clearinghouse

Compression is an important part of the onboarding swap positions into a CCP. If a counterparty can collapse down offsetting positions across a range of counterparties it will greatly reduce the overall risk in the system. Sites for Clearing Issues (brought to you by Practical Law): COMPRESSION REPORT, COMPRESSION AND LEVERAGE RATIOS (ISDA) Swaps clearinghouse is an organization of mutuality (mutual risk among all owners)

CM = clearing member; IB = Introducing Broker; A/C = account

Swaps Clearinghouses (CCP = Central Counterparty)

Central Counterparty Clearing (Clearinghouses) are organizations of mutuality or mutual risk. They mitigate the credit risk of each clearing member and provide several key administrative duties. Most of these duties serve to mitigate counterparty credit risk:

1. Collect Initial Margin
2. Collect Variation Margin
3. Make Net Accrual Payments on Interest Rate Swaps
4. Compile data and report all risk to each Clearing member

As an organization of mutual risk, the clearinghouse collects funds from each clearing member. The amount each clearing member posts is based on several things:

1. The size of the clearing member
2. The credit rating of the clearing member
3. The total number of clearing members in the clearinghouse

Each clearing member shares in the risk on a pro-rate basis in the event of a default. The clearing model above has developed since 1850 when the CBT first opened its doors to trade agriculture futures. Since 2008, use of the clearing mechanism is broadening to include contracts which may be executed OTC and submitted to a CCP for clearance and administration.

Current List of Swaps Clearinghouses (CCP’s)