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 In the last month, dealers have frequently been forced to pay a
costly premium on London's LCH.Clearnet to offset their risk for
facilitating interest rate swaps on smaller rival Chicago Mercantile
Exchange on behalf of their clients.
The higher costs may further exacerbate bouts of extreme illiquidity
and swings that have recently plagued the bond market, such as the
"flash crash" in bond yields last October, an event that has alarmed
and baffled regulators. It could test the resolve of dealers to
provide liquidity in a pinch.
"Everyone is concerned about it," Jonathan Rick, an interest rate
derivatives strategist at Credit Agricole in New York, said about
the price disparity.
The rate swaps, in which parties exchange the cash flows from
different types of bonds, are an integral part of the fixed-income
market, amounting to $381 trillion in notional value. Investors and
dealers use swaps as another way to bet for or against bonds as well
as to hedge their portfolios.
Due to their importance, regulators required dealers and investors
by 2014 to book their interest rate swaps with clearinghouses or
centralized counterparties (CCPs) like those operated by the CME
Group <CME.O> and its larger rival LCH.Clearnet.
The clearinghouses take on the risk of these trades so they require
the swap parties to post margins on them.
There has been a "basis" or pricing differential to clear between
LCH and CME, the main CCPs for dollar swaps, because of such things
as differences on required margins and costs to finance the margins.
Until recently, it hasn't been a problem. The price of a swap
cleared at CME or LCH was miniscule, roughly 0.15 basis point more
on CME for a 30-year swap.
But since early May, the spread widened nearly 17 fold at one point.
It has eased somewhat recently but remains stretched.
It's unclear what has caused the LCH-CME spread to widen so
dramatically.
Some analysts reckoned it might be due to the recent surge in
corporate bond supply. Others speculated it might stem from a dealer
reaching a threshold on its swap exposure.
Either way, it has occurred at a time when bond yields have risen as
investors grow more confident that the Fed will raise rates this
year for the first time since 2006. That could be enhancing demand
among bond managers to swap fixed rates for floating rates, putting
the dealers who facilitate those trades largely on the same side of
the market.
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The price disparity means that on a $25 million 30-year swap trade,
for example, a dealer could be on the hook for about a $100,000 loss
if he is paying a fixed rate on a CME swap and has arranged to
receive an offsetting fixed rate on a LCH swap.
With this potential loss, a dealer might raise how much he charges a
fund to receive fixed-rate payments on a CME swap, traders said.
PREFERENCE AT A PRICE
A fund manager who buys interest rate futures or a fixed-rate
corporate bond typically offsets the position by entering into an
interest rate swap with a bond dealer. And the swap is often cleared
through the CME.
Then, the dealer enters into a swap with another dealer, often
cleared through, LCH in an effort to lower his interest rate risk.
Asset managers prefer swaps cleared via CME, while dealers do more
through LCH so there has been an imbalance.
"When this imbalance is large enough, hedging flows related to the
basis risk can cause the kind of cross-CCP spread we are currently
seeing in the market," J.P. Morgan analysts wrote in a research note
last month.
CME said it cleared a third of swaps between investors and dealers.
But it has a much smaller share in total swap clearing, which LCH
dominates.
For dealers, the jump in swap clearing cost has become a trading
loss.
In response, dealers may pass on the higher cost to asset managers
and other clients, analysts said. Barring that, they may limit their
participation, potentially contributing to a liquidity drought.
(Reporting by Richard Leong. Editing by Dan Burns and John
Pickering)
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