A European Union proposal aimed at forcing some derivatives instruments to be cleared onshore risks imposing an ‘import tax’ on end-users, senior buy-side market participants have warned. They fear their firms may be pushed onto the wrong side of a pricing discrepancy between euro interest rate swaps cleared on Frankfurt based-Eurex and London-based LCH.
The active account requirement, which forms part of the second major revision of the European Market Infrastructure Regulation – popularly known as Emir 3.0 – would require financial and non-financial firms subject to the EU clearing obligation to clear a portion of systemically important trades at EU-based central counterparties (CCPs). This could force firms to clear more euro interest rate swaps at Eurex, where prices can be higher because dealers need to hedge exposures in the more liquid LCH pool.
“It forces the markets to trade at Eurex, which means you are forcing the market to import that liquidity from LCH,” said Pierre-Antoine Masset, counterparty manager at Nordea Asset Management, on June 14. “If you add to that all the cost of operations … it really sounds like and smells like an import tax that European market players would have to pay for that liquidity, which I don’t think is ideal for any of us.”
In March, the price gap between 10-year euro swaps cleared through London’s LCH SwapClear and identical instruments cleared at Eurex jumped above 4 basis points. A widening basis between similar instruments traded at two CCPs suggests each has a directional bias in activity towards payers or receivers, requiring dealers to clear offsetting trades at an alternative CCP, and exposing them to higher margin costs.
Barry Hadingham, head of derivatives and counterparty risk at Aviva Investors, also singled out volatility in the Eurex-LCH basis as a key problem with the active account proposal: “The thing that concerns me most with this proposal is [the] CCP basis and the unpredictability of that over time. I think there could well be a reasonably high correlation between when you are required to use an active account and when that basis might be at its most significant.”
If volumes for a specific firm rose due to market volatility, this could trigger any quantitative threshold to clear some of those trades at Eurex. But that volatility would also likely cause the basis to widen out.
It really sounds like and smells like an import tax that European market players would have to pay for that liquidity, which I don’t think is ideal for any of us
Pierre-Antoine Masset, Nordea Asset Management
Masset and Hadingham were speaking on a webinar hosted by the European Fund and Asset Management Association on June 14.
Hadingham added that the impact of this basis could be “significantly detrimental to a client”: “It’s something that we can’t control – no-one can control it.”
He warned it would be difficult to justify to a client the decision to clear at a CCP where the pricing was worse. For example, a €10 million ($10.8 million) 10-year swap with a 5bp differential would cost an additional €50,000 over its life.
The active account requirement is expected to take effect in 2024, although the exact calibration of the rule is still under discussion. While some have argued for a quantitative threshold, requiring a set portion of trades to be cleared onshore, others prefer to limit the requirement to an operational setup at an onshore CCP.
Pensions add to pain
Even if a portion of trades were forced into Eurex, Masset warned the additional liquidity might do little to tame the basis. He noted that the basis between US dollar swaps cleared at CME and LCH as a fraction of a basis point. In part, this reflects the fact that the market for US dollar swaps remains relatively local, with over 80% of liquidity provided by US players. This means US dollar swap clearing at CME is reflective of the wider market, rather than being directional. In Europe, however, EU players provide only 24% of euro liquidity.
“If you look at the basis evolution since 2012, the average of this [CME/LCH] basis has been much lower over the last year compared to the basis at Eurex. This is partly because the European pool is not necessarily representative of the global euro market, because 70% of this liquidity is international,” he said.
Hadingham warned there could be further basis volatility on the horizon. From June 19, European pension scheme arrangements (PSAs) will lose their temporary carve-out from the clearing mandate under Emir.
“There are plans to mandate clearing for pension funds in Europe, which could potentially – given the directional nature of those positions – cause further impact on that basis,” said Hadingham.
Pension funds and other liability-driven investors typically receive fixed rates at the long end to hedge their borrowings. This bias pushed the basis for 30-year swaps at Eurex into negative territory in late 2022 as investors scrambled to hedge rate rises.
Hadingham called on regulators to “wait and see what that impact is, before going anywhere near mandating these active accounts”.
Panellists on the webinar cited an array of additional costs associated with the active account proposal, which could hamper their fiduciary responsibility to achieve best execution for clients. For example, many asset managers typically engage in block trading, where traders execute a single large trade, which they subsequently allocate across a number of individual funds.
“This kind of block trading won’t work if a part of that would have to go to an EU CCP, whereas other parts go to a non-EU CCP,” said Christian Schmaus, senior policy and regulatory affairs adviser at Allianz Global Investors. “Because of the different pricing spreads involved, we would have to somehow split the blocks initially to continue with this routing and processing.”
Nafisa Yusuf, director of market structure at BlackRock echoed those concerns: “We trade in blocks, and therefore having to split blocks between two different liquidity pools could lead to different pricing outcomes for our clients.”
The thing that concerns me most with this proposal is [the] CCP basis and the unpredictability of that over time
Barry Hadingham, Aviva Investors
She warned that firms that were forced to relocate their trades to Eurex could also lose crucial margin netting efficiencies.
A comparison of sample portfolios by BlackRock using CCP margin simulators found that a large financial counterparty clearing mandated products (alongside some voluntary clearing) was able to achieve a $2.5 million margin saving by keeping all currencies at LCH.
“If we were to move the euro swaps out of LCH and into Eurex, what you then find is you’re paying two different sets of margin at two different CCPs, but you find the margin at LCH increases as you have less netting opportunity,” said Yusuf. “This is where we start to see the benefits of netting everything together at one CCP.”
Eurex clears 11 currencies, compared with LCH’s 27. Liquidity at the Frankfurt CCP remains largely restricted to euro instruments, in which it claimed a 13.5% market share in the first four months of this year. Eurex’s €33 trillion in euro swaps notional remains vastly overshadowed by €137 trillion at LCH.
BlackRock’s sample study found that cross-product margining at Eurex between interest rate swaps and other products such as interest rate futures, delivered only “marginal” netting benefits compared with cross-currency netting at LCH.
Masset agreed with this assessment, adding that while firms clearing US dollar swaps at CME could benefit from offsets against SOFR futures – the most liquid listed instrument in the world – the most liquid Euribor futures contract resided at Ice, rather than Eurex.
It forces the markets to trade at Eurex, which means you are forcing the market to import that liquidity from LCH
Pierre-Antoine Masset, Nordea Asset Management
“Looking at one or two portfolios, the savings you may get [from cross-product margining] are in the thousands, compared with in the millions when you’re netting between currencies,” said Yusuf.
The margin impact could be even bigger for firms clearing products voluntarily, such as inflation-linked swaps.
“Those savings are in the region of $200 million in terms of the margin you save by netting your risk,” said Yusuf. “Splitting out your euro interest rate swaps and having your inflation-linked voluntary clearing in a separate CCP, you end up paying very high margin calls at two different CCPs.”
The cost also depends on the tenor and direction of swaps, as well as the level of the CCP basis.
“For some portfolios more than others, having everything cleared at the same CCP actually results in greater efficiencies in netting and optimises from a margin perspective,” said Yusuf.
Editing by Philip Alexander