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Learning Curve: CCP switching post-Brexit

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Not a day goes by without some analyst, regulator or senior exchange executive weighing in on where the clearing of euro swaps should reside post-Brexit.

By Peter Rippon, CEO of Opengamma.

Political posturing from both the European Union and UK is showing no signs of diminishing. So for anyone clearing swaps at either LCH or Eurex, the only certainty right now is continued uncertainty. 

But scratch beneath the surface of the politics, and one finds an interesting market development which shines a light on one of the primary concerns for banks caught up in this battle — the market to move risk between clearing houses. Or more specifically, the market for moving risk from LCH to Eurex and vice versa. 

What is the CCP switching market?

The same euro swap cleared at Eurex or LCH is worth different amounts. The problem here is that the difference in the prices can swing around over time, creating unwanted volatility. 

This risk can be minimised by choosing to move the risk to whichever clearing house has the most liquidity. The cost of shifting this risk from LCH to Eurex, or the other way around, is priced in the clearing house switching market run by the likes of Tradition and TP ICAP. The price difference between swaps cleared at two different clearing houses has led to the broking of switch trading activity.

Depending on whether a firm is shifting liquidity from LCH to Eurex or the other way around, there is always a different price. The problem is that with Brexit creating so much market uncertainty right now, the liquidity levels are far from certain. Therefore a key driver of the switching cost is the level of liquidity at each clearing house, with a premium paid to move risk to a clearing house with higher liquidity. 

Brexit uncertainty

Euro swap relocation would have a significant impact on levels of liquidity, directly affecting the cost to move risk. This has a significant impact on clearing house switching market prices.

Banks operating in this market are constantly looking for ways to calculate, based on their trading positions, what a fair price to switch between clearing houses looks like. While switching risk between clearing houses is not new, a lack of clarity about where euro swaps will be cleared has put this market back under the spotlight. Indeed, sentiment across this switching market will be a key barometer to the final outcome of where euro-clearing will ultimately reside.

The process of moving risk between clearing houses involves finding a counterparty willing to execute two swap trades at the same time, in opposite direction, with each cleared at a different clearing house. The net effect of these two trades is that risk is transferred from one clearing house to another, say LCH to Eurex, at a certain price. 

For example, two different banks may have opposing positions at each clearing house e.g. Bank A is a net payer at LCH, and Bank B is a net payer at Eurex. The switching market brings these banks together to find the price at which both are willing to make the switch trade that would flatten the position at both clearing houses for both banks, removing unwanted volatility. 

"Twists and turns"

Interestingly, over the last few months, the cost of shifting risk from Eurex to LCH has reduced from 1.9 to 1.3 basis points. This 0.6bp difference translates into €60,000 on a €100m 10 year notional swap. Indeed, this fall may well be linked to the market’s increasingly positive expectation of liquidity developing at Eurex as Brexit looms.

Based on the UK government's hard-line position on being outside the single market, significant euro-denominated trades could well move to Eurex, providing meaningful choice on clearing house. While there are likely to be a few twists and turns to come, those embroiled in the LCH-Eurex switching market right now can’t afford to wait for the final decision. Trying to analyse how to access the most cost-effective venue during this prolonged period of political unpredictability has to be at the heart of any bank's clearing contingency plan right now.