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)

Swaps Margin – Uncleared Swaps

To calculate margin on an interest rate swap you need two pieces of information:

  1. The % of notional amount required to be posted as collateral (appendix A)
  2. Based on what asset and maturity you choose to post, the prop haircut required for that asset (Appendix B)

Appendix A – Standardized Initial Margin Schedule

Source: BIS Non-Centrally cleared derivatives 2013, Initial Margin Requirement, % of notional exposure)

Appendix B. Standardized Haircut Schedule

Source: BIS Summary of changes to implementation of the margin requirements for non-centrally cleared derivatives

Initial Margin – Interest Rate Swap

EXAMPLE SWAP: Economic Terms
Notional Amount $100 million
Maturity 4 years
Fixed Leg Paid Semi-Annual
Floating Leg Received Quarterly (RESET RATE = 3 Month LIBOR)
Margin (% of notional) 2% of notional amount (see appendix A)
Collateral Posted 1 year US treasury
Haircut (1yr. Treasury) 2% (see Appendix B)

N.B. Haircut minimizes administrative expense of sending collateral back and forth by taking into account the volatility and credit quality of the collateral asset. In order to meet this initial margin call this counterparty will post $2,041,000 U.S. Treasuries maturing In one year.

Variation Margin – Interest Rate Swap

EXAMPLE SWAP: Economic Terms
Notional Amount $100 million
Maturity 4 years
Fixed Leg Paid Semi-Annual
Floating Leg Received Quarterly (RESET RATE = 3 Month LIBOR)
Margin (% of notional) 2% of notional amount (see appendix A)
Collateral Posted 1 year US treasury
Haircut (1yr. Treasury) 2% (see Appendix B)
INITIAL MARGIN $2,041,000  U.S. Treasuries maturing In one year
  • The following day, the 4 year swap rate goes up 10 bps
  • This counterparty makes 10 bps = Variation Margin = $33,500
  • $33,500 Adjusted for haircut of 2% (presumes counterparty posts 1 year US treasury note)

Segregated Funds

One of the cornerstones upon which leverage trading stands is the manner in which collateral posted against positions can be used. In the futures world, funds posted as margin are segregated from the clearing firm or parent institutions assets. Segregated funds are similar to the capital or reserves a bank must put aside to meet their obligations. 2008 taught us quite a few lessons about the double-edge sword of fractionalized lending at banks. 2011 would teach us about the same risk at clearinghouses.

The Story of M.F. Global

M.F. Global was an enormous financial services firm which was formed by EDF Man, one of the finer futures’ clearinghouses and its hedge fund subsidiary Man International. Man was ahead of the curve in forming hedge funds and fund of funds for high net worth individuals and institutions. As the nineties became the naughts, Man Financial (now renamed MF Global) decided to grow an American Investment bank of sorts. All seemed to go well for a time. The firm was highly respected, their globalized trading operation gained a good reputation and cultivated a great staff. Enter: Jon Corzine. He’d done well for himself at Goldman Sachs. Thereafter he ran for Governor of New Jersey and won. Sadly, the Governor got into a traffic accident without his seatbelt and suffered substantially in the accident. He emerged several years later at M.F. Global as CEO and Chairman. Old sayings generally become old because they’re true. At least in this case, Jon Corzine hadn’t lost the itch to trade. And trade he did. But it was one rather large trade to which Mr. Corzine became particularly wedded that would cause his downfall. M.F. Global business lines included executing and clearing trades for roughly 36,000 clients. Their clients ran the gamut from institutional corporate clients hedging their businesses, floor traders on futures exchanges where MF Global owned seats to small retail accounts. As E.D.F. Man they cleared many traders on the New York Mercantile Exchange, where I was a member. As a clearing firm providing services to floor traders, the clearinghouses hold member’s good faith deposits. These good faith deposits are in addition to initial margin posted on open contracts. All of these deposits: Exchange good faith deposits, Margin funds (initial margin), variation margin (profit & loss) and the positions they finance belong to the client.

Shock & Awe

Mr. Corzine’s trade went against him. At some point in October 2011 the trade went so badly against him, he began using segregated funds to post collateral on the firm’s badly underwater trade. I wasn’t trading on the exchange floor at the time. But I recall the night in late October 2011 I received phone calls from friends who would be unable to get onto the trading floor and trade in the morning. Their exchange good faith deposits were gone. Poof. In an instant they were barred from entering the exchanges on which they were members and central to their businesses. I sat in silence as I read emails from other friends and students who would no longer have a job and ruminated on how things went wrong. Weren’t there brakes to prevent funds from being released from these segregated accounts? These were my friends. They’d spent many years building up their businesses. For now they would have to trade from their homes or friends offices – able to only close out positions unless they had other risk capital somewhere. I went into the bathroom, and threw up.


Regardless of who polluted the segregation process, the situation caused many people to think about the security of the newly formed Central Counterparty (CCP) system created for Swaps in the wake of the credit crisis. M.F. Global’s clients were very lucky. The appointed Trustee, James Giddens from Hughes Hubbard & Reed was able to return 100% of client funds. 75% came back to client rather quickly, the balance came back as Mr. Gidden’s located the firms to whom Mr. Corzine had posted collateral. That Mr. Corzine had the temerity to state this proved the funds were never really missing is beyond the pale of logic. Mr. Giddens was successful because the firm had records of the firms to whom they’d posted collateral against their trades. The very fact that the funds were posted as collateral is the crime.

Managing Segregated Funds in Swaps Clearinghouses

Dodd-Frank’s mandate for central clearing of swap contracts is intended to make the market safer for all participants. The CME, LCH & SwapsClear the three largest CCPs support Legally Segregated/Operationally Comingled (LSOC) protocols.

Legally Segregated/Operationally Comingled (LSOC)

Roughly 60% of all Interest rate swaps are cleared at a Swaps Clearinghouse. Swaps clearinghouses provide tremendous risk mitigation and systemic risk. There are competing interests which must be balanced.

  1. The risk such as the one described above with M.F. Global, more generally that you are at risk to your clearing agent losing money on their other activities.
  2. “Investment risk” to a much lesser extent due to the Clearinghouse investing in an interest bearing vehicle resulting from their obligation to pay interest on margin deposits.
    • LSOC mitigates this risk by strictly limiting the securities in which a CCP can invest.
  3. “Fellow customer” risk, or the risk that another client of your clearinghouse defaults and, unless legally segregated, might dip into your collateral in order to cure the default.
  4. The risk of being able to move your portfolio to another CCP in the event of a default.

These need to be weighed against the issues facing your Clearing Agent (clearing member of the CCP) or the Central Counterparty (CCP or clearinghouse) itself.

  1. Preserving the operational efficiency of each FCM in the absence of default
  2. Ensuring the solvency and operational continuity of a CCP in the event of a related FCM or customer’s default.

LSOC strikes a balance between these two by providing the client the protection of segregation while allowing the clearinghouse (CCP) to operate normally. Here are some links which speak to LSOC in greater detail.