In a DerivSource webinar held in Nov 2018 with Eurex Clearing, a panel explored how this CCP clearing environment in Europe may evolve post-Brexit and the challenges various different relocation scenarios may pose from an operational, regulatory and legal perspective. In this feature, Matthias Graulich, Chief Strategy Officer, Member of the Executive Board, Eurex Clearing, addresses some of the audience questions relating to the changes to organizational and technical procedures, possible costs and opportunities through change. If you missed the webinar, you can watch the recording of the webinar “Euro Clearing Post-Brexit – Are You Ready” here.
Audience questions on organizational and technical procedures
Audience question: Can you please explain how the ‘porting’ of positions is taking place?
Matthias: Yes. First, I think we have to distinguish whether we port positions within a central counterparty (CCP) or across CCPs. If we talk about porting of positions within a CCP, then it is a simple change of the clearing member, which is taking positions out of one client account and transferring them over to another client account. This is something we have been doing already on a regular basis in the context of Brexit preparation, when a client switched from a UK-based clearing member to an EU-based clearing member.
If we talk about switching positions or porting positions from one CCP to another CCP, things are a bit more complex because you always need the other side of the transaction. This is not a unilateral process like switching within a CCP; this is a multilateral process. Therefore, there are a few options available. One option is that you as a client enter into a transaction with your clearing broker as the counterpart taking the other position, and doing equal and opposite trades in two CCPs – one CCP reducing the risk, the other CCP taking on the risk equally and opposite.
Now, there is another service currently in development, which is called a multilateral CCP switch facility. This will provide the market with another option on how to port or transfer positions between CCPs. These multilateral CCP switch facilities allow transactions or demands for a certain type of transactions to be entered, lowering risk in one CCP and opening that same equal and opposite risk in the other CCP, on a multilateral basis. These services are in development, and should be up and running and live in the first quarter of 2019.
Audience question: When transferring Interest Rate Derivatives (IRD) contracts from a UK CCP to an EU27 CCP you need a counterparty, which helps you close out the position in UK and open up the same position with you in EU27. As a consequence, this counterparty has to face new margin obligations and new spread risks which will increase the price for this transaction. Any ideas on how to solve this problem?
Matthias: The challenge described here will automatically be solved by insuring that there is a two-way flow from end clients. So, there will be demand for migrating business from receiver clients (e.g. insurance firms and pension funds), but also from the fixed payer side (e.g. regional banks or asset managers). If you have this, then you have natural interest from both sides to port positions. This would not trigger new margin obligations because from a dealer perspective, you are transferring a kind of balanced book to the other CCP. Therefore, it is just transferring the same risk profile from a dealer perspective, assuming that you have demand from both sides to transfer risk.
Audience questions on opportunities through change
Audience question: How much is the CCP business impacted concretely in the derivatives world in this regulatory debacle?
Matthias: For Eurex Clearing and as a CCP, because the UK will be getting a third country status either end of March 2019 or after a transition period, we have to get authorizations in the UK to distribute our services to the UK. This will be the same for UK CCPs in the other direction.
Generally, how much CCPs will be impacted depends on how passporting will evolve. For example, assuming there will be no passporting available, which is the most likely outcome after the UK becomes a third country, our EU 27 clients, will have to use an EU 27 clearing member. This new scenario will drive the necessity for clearing service providers to get new entities admitted at Eurex, which is a process which requires significant effort and is currently the driver behind a large proportion of our and our clients’ Brexit preparations.
Audience question: Has Eurex developed a roadmap for adding non-EUR products they currently do not clear or are they sticking to clearing obligation currencies only?
Matthias: We currently have nine currencies available to clear at Eurex. Of course, we would expand this list if there is client demand for additional currencies. However, currently we have not seen a significant demand for additional currencies and have thus not prioritized expansion at this time.
Having said that, we are clearly focused on euro-denominated products, euro-denominated swaps, repos, and exchange-traded derivatives. This is our strategic focus, but, of course, for product coverage completeness, we are always looking to expand currency coverage based on market demand. And if market participants want to communicate their interest in additional currencies, they can contact us via our website or get in touch with their local Eurex representative.
Audience questions on costs
Audience question: What are the costs that should be foreseen regarding the transfer of derivatives from LCH?
Matthias: If we look at the biggest cost items from an end-client perspective, the single biggest cost is the bid-offer spread. Depending on whether you are a payer or a receiver, at this point in time you have a cost for, as a payer client, with regards to the basis. On the other hand, if you are a receiver client, you receive the basis, so this is a benefit. And in the scenario where you would do a transfer with separate, equal and opposite transactions, closing the risk at LCH and opening the risk at Eurex, then you would incur the bid-offer spread or at least a portion, which is a relevant cost item.
On the other hand, if you use facilities that do these two transactions not separately but as a bundle, your service provider, your dealer, might be willing to support you by not taking the full spread because essentially you are not effectively closing a position or opening a position, you are just transferring a position from one CCP to another. Therefore, the position is still existing. It’s just switching the counterparty, the CCP counterparty and as such, people might see that they do this kind of service at a significantly smaller bid-offer spread compared to conducting two regular market transactions.
Available tools which are currently being developed, like the multilateral CCP switch facilities previously mentioned, and offered by TriOptima or Capitalab, are expected to create these transactions at mid-market. This would mean no bid-offer costs for people who are interested and want to utilize these facilities to transfer positions from one CCP to another. Of course, there are some transaction-type costs for these services, but relevant to incurring a bid-offer, they are almost negligible. Therefore, there are possibilities to do these transactions at very low cost, but of course some costs will still appear.
Audience question: Why would non-EU counterparties move EUR Interest Rate Swaps (IRS) to EUREX. 75% of liquidity is currently at LCH? Do you think the whole EUR market will move or just EU clients?
Matthias: There are various elements to this question. One is that EU counterparties, from a regulatory certainty perspective, have an incentive to do business within the EU to make sure that the swaps (e.g. 10-year, 20-year, 50-year swaps) they are taking on now, are in a safe place from a regulatory perspective going forward.
Now, looking at non-EU counterparts, let’s take hedge funds domiciled on the Cayman Islands as an example. These often trade a future and a swap in a bundle. Today, they already do this future with Eurex, the Bund Future. Today, they do the 10-year swap, which is at the end the other side of this trade, at LCH. If they do these two transactions in the same CCP, they immediately benefit from a significant reduction in risk, and therefore a reduction in margin requirements. So they reduce their margin requirement by using the CCP, for example, by using a 10-year swap and a Bund Future, by 70%.
Now, why didn’t they do that in the past? The simple reason is the execution prices they have seen on Tradeweb and Bloomberg. The bid-offer spreads were really double or triple relative to those quoted for LCH. However, with increased liquidity, we see this picture has fundamentally changed. This bid-offer spread barrier in the past has been removed so now market participants can take advantage of secondary benefits, which are very relevant, and have the same bid-offer spreads offered and the same sizes offered by a significant number of dealers on the relevant execution platforms.
Eurex’s ambition until end of 2019 is to get to a 25% market share of euro-denominated swaps. Whether this will be exactly reached end of 2019 or whether this will be a bit sooner or later will likely depend on how much pressure is in the market due to the different variations and timelines attached to Brexit. By comparison, if I look at developments in other markets, like in Japan, we can see that in the meantime the vast majority, around 70% of the business, is in Japanese Securities Clearing Corp (JSCC), so in the kind of home market for Yen swaps.
Japan’s situation could be a reference case for the euro swaps. I think there is roughly room for two players globally, or three players even, if we look at Yen. We have JSCC with the vast majority, LCH, who is at 25% share, and CME, with around 5%. This is an outcome which I could also foresee happening in euro, but the time span looking at JSCC is then more a five-year-plus horizon to get to this kind of target state.
Audience question: Is there be a point when UK CCPs would not be willing to trade with an EU client?
Matthias: I think this is not a question of willingness but more whether the UK CCPs are allowed to distribute services, and this depends on them being permissioned within the EU to distribute their services to EU clients and clearing members. This is all dependent on the outcome of Brexit and specifically on equivalence considerations. We have had indications from the EU Commission that even in a hard Brexit they would ensure that there is a transition period as to avoid any cliff-edge risks.
