Clearing houses may be increasing risk for their members by adding products that some market participants believe are best suited to the bilateral environment.
Speaking on a central counterparty clearing panel at ISDA’s AGM in Montreal, Emily Portney, global head of clearing and collateral management at JP Morgan Securities, warned that the introduction of swaptions into the cleared environment may be putting clearing brokers at greater risk.
“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.
CME is poised to begin clearing swaptions, pending regulatory approval, leapfrogging LCH.Clearnet’s Swapclear, which has been tussling with the product for a number of years, but has now put plans on the back burner.
For CCP’s that are vying for a slice of the growing market for over-the-counter derivatives clearing, swaptions have been viewed as a key battleground as global regulators attempt to push as much of the OTC derivatives market as possible through central clearing in order to reduce systemic risk.
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.
Industry participants warn that swaptions are fiendishly difficult to risk-manage given their sensitivity to interest rate moves, volatility and term structure. And although dealers have invested heavily to build sophisticated risk management systems, some believe it may not be efficient for CCPs to replicate.
“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.
While CCPs themselves have long argued that their role is risk neutral, JP Morgan’s Portney is concerned that adding more exotic products into the mix can increase risk for clearing members.
“CCPs are in the business of risk mitigation, but by virtue of the decisions they make, they can bring risk into the system in a range of ways including clearing member eligibility, new products and the default management procedure,” she said.
While clearing members can vote with their feet, few expect to see any exodus on the back of CME’s plans to add swaptions into the mix.
“Clearing members aren’t going to walk away as a result of this,” said a senior executive at another CCP. “Even if brokers don’t like the risk that swaptions bring, they aren’t going to leave as they need access to clearing for the US dollar market, which CME owns.”
Speaking on the panel, executives from the InterContinental Exchange and LCH.Clearnet noted that new products are added in consultation with the risk committee. But JPM’s Portney believes this might not go far enough and that clearing members could have a greater say in business decisions given the role that they play in mutualising default risk.
“We do participate on risk management committees but we don’t have a vote on new products that get added,” she said.
Interest rate derivatives make up the lion’s share of the OTC universe at US$563trn, and swaptions represent just under 10% of that total, according to figures from the Bank for International Settlements. Recent statistics from ISDA show that 76% of total average daily notional in interest rate derivatives was cleared through 2014.
