The benefit that swaps bring to liability driven investing, of being able to create a bespoke hedge across almost the entire tenor of a scheme-specific liabilities curve, comes at a price: concentrated counterparty risk. The interbank market in swaps has not had to worry about that since 1999, when LCH.Clearnet created SwapClear - still the only clearing service for interest rate swaps. When two banks confirm a trade, it gets sent to SwapClear, which then becomes a counterparty, holds the positions, nets trades and resets margin accounts. The banks thereby have exposure to LCH.Clearnet, not one another.
Ten years later, LCH.Clearnet has opened the same opportunities up to institutional investors on the buyside, launching the SwapClear Client Clearing Service. The Bank of International Settlements reckons that this market represents a notional value of $208trn, and LCH.Clearnet thinks that $146trn of that could be eligible for protection through SwapClear.
The key advantages of central clearing are margin segregation and portability of contracts. For the buyside, these features have been enhanced by combining the clearing house's statutory powers with a Deed of Assignment that enables it to move clients' money, positions and margins to new clearing members selected by the client at the beginning of the relationship with LCH.Clearnet, in the event of a member defaulting. Subject to regulatory approval in the relevant jurisdictions, the list of dealers committed to offering the service will be Banca IMI, Barclays Capital, BNP Paribas, BofA Merrill Lynch, Calyon, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, Nomura, Royal Bank of Scotland, Société Générale and UBS.
"[Clients now have] absolute certainty that they are not going to get caught up in any bankruptcy process," says Alberto Pravettoni, managing director at LCH.Clearnet Group. "During the Lehman crisis, customers were able to have their futures positions moved, but not their margins - which meant that many found themselves having to double-margin, because their initial margin was stuck with the administrator and their new clearing member was obviously demanding their own margin."
How much will this protection cost the buyside is difficult to tell, as ultimately the buyside will access the service through the clearing members they use - but competition for those relationships should restrain members from passing their costs on, as should the fact that there is growing regulatory pressure for capital charges to be imposed on non-cleared trades.
Even more importantly, the service does not compromise the bespoke fit by trying to force the swaps market into a futures-shaped suit. Asset segragation is part of that, as is the range of contracts that SwapClear has experience with and capacity for: overnight index swaps out to two years in four currencies; interest rate swaps out to 30 years in 14 currencies. Swaps out to 50 years have sufficient liquidity in certain currencies, and LCH.Clearnet has plans to extend its service that way soon.
"Over 90% of the circa 1.1 million OTC trades cleared through SwapClear over the last 10 years are diverse or non-standardised - they have different start and end dates, and so on," says Pravettoni. "We are not trying to retrofit, to turn an OTC contract into a future-type contract, as some other players are."
Furthermore, buyside clients can backload their entire book of existing contracts onto SwapClear, too. "This is critical in the OTC market: we are not talking about a business that has thousands of transactions per day. This is a highly-bespoke business, so being able to backload all of those existing swaps rather than having to transact them all again is crucial."
Getting a centrally-cleared OTC swaps market right is crucial, as it may be the only thing that gets in the way of regulatory pressure to push contracts on-exchange. If that happens, the utility of the market for pension schemes would be severely compromised. "You don't need an exchange screen to have the best clearing - we've been proving that for years," says Pravettoni. "And extending that to the buyside doesn't necessarily have to change the structure of the marketplace - it can still be a genuinely OTC market."