Swap Clear, CME & Javelin on swap clearing

By Yiying Luthra


Buyside readiness

Participants in the USD derivatives markets are braced for another year of tightening regulation. Clearinghouses and other players are seeing increasing buyside preparedness even though critical issues, such as real time processing of clearing and cross margining, are still being worked on. At the same time, capitalization and anonymous trading continue to be key factors for clearers and dealers.

Jeff Gooch CEO MarkitSERV sees a progression in buyside preparedness, noting that while 2010 saw “little real progress beyond a few trophy cleared client trades,” in 2011 firms made “serious progress in getting the technology in place.”

Laurent Paulhac, MD of OTC Products & Services at the CME, says that buyside onboarding saw “more acceleration back in August of last year” as more institutions are looking to leverage clearing to mitigate their bilateral risk. Paulhac says the CME has roughly 1,300 buyside accounts with open interest while roughly another 1,000 are in testing. He sees a “wide variety of buyside participants going through the clearing onboarding process - from asset managers and hedge funds, to small banks.”

“In some ways 2011 was a great year of procrastination for some buyside and dealers, but going into 2012, a lot of people are focused on systems, back end, and front end readiness,” explains Javelin CEO James Cawley. Still, he believes there is “a spectrum of readiness - some guys are ready and set to go, while others are scratching their heads. There are [also] those wishing that Dodd Frank would just go away.”

CME’s Paulhac explains that, as with any new transformation, there is a range from early adopters to laggards. “Some firms may wait until the mandate while others may want to clear well ahead of the mandate.”

For the more proactive accounts, he explains that some firms “see that there could be a traffic jam and want to clear that hurdle well in advance,” noting that once a firm enters into a negotiating process, the timeframe expands to “weeks or months” as “the entire onboarding process takes a bit of time.”

Real and potential credit problems at banks have accelerated buyside interest in readiness. “The credit issues facing some US banks has accelerated the process and some firms in the latter half of the year really began to ramp up,” MarkitSERV CEO Gooch finds. As for US versus Europe, Gooch sees that “US clients are more proactive than Europeans as most perceive that some of the Dodd-Frank rules will be mandatory in 2012.” Still, he explains that buyside participants “generally find clearing operationally complex and expensive."

Real time anonymous trading?

Though rules for Swap Execution Facilities (SEFs) still need to be finalized, real time anonymous trading and straight through processing of clearing are key issues for the buyside in the new world of cleared swaps. Javelin demonstrated in Q4 last year that real time anonymous trading of swaps in good size was achievable (please see USD Swaps: Flatter; New Javelin record for details) in under two seconds.

Javelin CEO Cawley explains the demonstration “in part was to make a point that trades can be executed and cleared using existing plumbing” and that is not necessary to create a “death star” like clearing hub, as “trades of true market size can be transacted within a couple of seconds.” Cawley says that “one of the concerns from clients was the time lag if a trade does not end up going through, but with the virtual real time clearing, that has been effectively answered.”

The whole real time acceptance debate is “really a proxy fight over the right to trade anonymously,” reckons Cawley, as firms like hedge funds and mortgage portfolios “do not want to advertise their trading activity.”

Real time straight through processing is already a feature of the CME and the trades done through the Javelin platform were then cleared at the CME. CME’s Paulhac believes that two second clearing “could become the norm” and furthermore reckons that the market “could become even more efficient.” Paulhac adds that the ability to do real time processing is “very important for clients.” He notes that their OTC model for clearing is “designed to do real time straight through processing” and explains “to do real time straight through processing there is a collection of challenges and we’ve developed and designed a collection of important features to address this.”

The other major OTC swap clearer, LCH Clearnet’s SwapClear, does not have continuous processing. Dan Maguire, head of the US SwapClear platform, explains that with the impending CFTC mandate and increasing client demand, “there is pressure to have a higher frequency of trade registration.” As of right now “trades register as quickly as every fifteen minutes” but he adds that some market participants “want it even faster than that.”

Maguire explains SwapClear’s approach to continuous clearing. “Compared with futures, derivatives products have a much more complex risk profile and are of longer durations.” He notes that “fundamentally, the risk profile of OTC interest rate swaps is different from listed and standardized futures.” Currently, LCH “adds the incoming trades and recalibrates the existing portfolio with those new trades in a process called incremental VaR” - a process Maguire considers the “safest and most efficient use of collateral.” However, he adds that the existing process does take time to recalculate the aggregate risk of the portfolio.

In contrast, CME uses a historical 99% 5-day VaR, based on five years of data. CME’s Paulhac describes the internal CME check “the easy part” and takes “sub seconds and is enormously efficient.” On the other hand, he acknowledges that real time processing “does rely on a fair amount of automation with a real time API and if risk systems are not fully automated then that could slow the process down,” adding that “each clearing firm is addressing this differently and at a different pace.”

LCH SwapClear’s Maguire expects that real time registration is achievable at SwapClear, saying that the firm is aiming for Q2 2012. Still, he stresses that LCH.Clearnet has “a robust risk management policy and is therefore taking a measured and phased approach to ensure that any changes to our operating model for trade registration continue to tie in with our stringent risk principles.” Maguire explains that in order to do continuous processing, the clearer is “looking at alternate strategies incorporating limits, tolerance and threshold, but overall we have to ensure any methodology is bullet proof” as clearing processes “must work not only in peacetime, but also in wartime.”

MarkitSERV CEO Gooch believes that the two second clearing gap “could dwindle down further.” In the post trade processing world, the challenge becomes “allocations of the trades and whether or not things are allocated in advance” but he believes that even clearing at the block level “should be very fast.”

Cross margining and product development

Real time processing is not the only battle between rival clearinghouses and trading platforms. As a futures provider, the CME is looking to implement cross-margining. “It is part of our plan but not in effect yet,” CME’s Paulhac says. “We have done a lot of work on it and a lot of analysis. We have a good sense of how it will work for house accounts, the dealer side of the trade in effect; it will be a relatively easy transition.”

On the other hand with respect to cross-margining client segregated accounts, CME’s Paulhac says “we do require regulatory approval” and explains that the CME “is working with our regulators and have consulted with clients as the whole process needs thorough analysis.” CFTC this week voted 4-1 to mandate collateral segregation for cleared swaps.

LCH.SwapClear is currently the leader in terms of the scope of cleared OTC products, offering 17 currencies for IRS clearing, OIS clearing out to two years in four currencies, FRAs in ten currencies as well as amortizing and accreting swaps in three currencies. CME plans to roll out JPY, CHF and AUD OTC vanilla swaps this quarter and OIS and FRA and amortizers “are on the road map and will be launching in due time,” says Paulhac.

Both clearers have been working on swaption clearing, but with the timeframe extending out until at least sometime this year, the dealer community has accelerated forward premium trading with a marked acceptance in trading of swaptions and caps/floors on a forward premium basis at the start of this year to alleviate funding concerns.

For swaptions, CME’s Paulhac says that “the risk management framework requires more effort” and while “analyzing the risk on our part is easier, we need to make sure it is accepted by all market participants.”

The time table for LCH.Clearnet on swaption clearing is similarly vague as the firm is also doing a lot of background work on feasibility and risk management (for more please see SwapClear on amortizers, options, GSEs & MF).

Concerning the possible $50m capital threshold for membership of a clearing house, as proposed by the CFTC, Paulhac explains that “size of balance sheet is only a small portion of our evaluation of a firm to be a clearing member.” In addition to balance sheet, the CME also looks at “the firm’s expertise and its ability to effectively manage risk.” Javelin CEO Cawley considers the $50m threshold to be “quite high” in terms of capital requirements for other cleared products, such as futures. SwapClear’s net capital requirement for membership is $5bn.

As for the fallout from the MF Global bankruptcy, CME’s Paulhac stresses that “the integrity of our markets and protection of our customers are our foremost concerns” and explains that the firm is “focused on working with the Trustee to speed the return of customer funds to our clients - as much as possible, as soon as possible.” In addition Paulhac adds that “we’re pleased that our financial guarantees helped to accelerate that process” and in the future says that the CME “will be a leading voice in working with the industry to develop solutions that better protect customer funds held at the firm level.”

Looking at the relationship of clearing and execution and possible barriers to entry, Javelin’s Cawley finds that there is currently “an unnatural link of clearing and execution as you must be able to execute swaps (have a swaps desk) in order to clear” and suggests that “this can be viewed as restricting competition.” He wonders “what does it matter where the prices come from and why can’t it be a partnership?”


The implementation of Dodd-Frank continues to challenge participants on all sides as regulatory pressures reshape OTC derivatives trading. For clearers and trading platforms, the race is not just to gain market share, but to balance risk management with an expansion in the range of products going through clearing.

On the buyside, the process of setting up for clearing may reap benefits in future but is currently eating up time and money. For new entrants, the new regime may offer as many opportunities as threats while established players continue seek out ways to hold onto market share, information and leverage.

Javelin’s Cawley reflects "with any change, there is always some resistance and the historical bilateral world has served some firms very well, but overall the OTC bilateral world hasn’t served the interests of the economy overall and has retarded growth.”