The CFTC had a large meeting to discuss futurised OTC products, below is a 15 minute extract of the full 6 hours where Kim Taylor (President of their Clearing Business) and Dan Maguire (President of Yorkshire, and a Senior in SwapClear US), speak about the topic.
Key points from Kim
- Capital was insufficient to cover market losses in the crisis, leading to a spiral of margin calls and a bail out, Dodd Frank is the US approach to solving this problem
- The DFA is one solution, to redesign the OTC market, and enhanced use of Futures is also a legitimate approach to the same goals
- There are 40-50 ‘line items’ for Deliverable Swap Futures, meaning 40-50 distinct products
- There were 60,000 ‘line items’ for Lehman in SwapClear. BH: I don’t count each slight permutation of an IRS as a distinct “product”, so an IRS based on ACT/360 isn’t so different from a swap based on ACT/365, in my opinion
- The diverse set of line items in the OTC market prevents liquidity formation. BH: I disagree, true liquidity can be measured from market activity by looking inside MarkitWire / SwapClear, and then into the CME Deliverable Swap Future stats.
- Compare turnover of trades to open positions, in futures the market rotates 25 times per year, in OTCs about 2.5 times (no background data provided)
- There are an estimated 5m participants in the futures market, compared to 30,000 in the OTC market.
- BH comments:
- But do those 5m all trade deliverable swap futures? And would they step up to take the other side of a DSF when CME were trying to sell off a defaulters portfolio?
- The SwapClear model mandates that surviving members must participate in the auction process, of which there are now around 70 corporate groups representing a large proportion of the whole swap market.
- Are traders in DSFs obliged to participate in a liquidation situation?
- The reduced number of line items means trade netting is an order of magnitude better in futures than OTC
- BH: Both CME and SwapClear provide trade netting of OTC IRS in their CCPs, it’s relatively easy, although not intrinsic to the IRS product the way a future contract is
- Methods of liquidation in Deliverable Swap Futures
- Open market sale
- Private negotiated sale
- Competitive auction
- For an OTC default CME only use a competitive auction, due to the different profile of an IRS portfolio
- An FCM must post the minimum CCP margin, but can collect more if they wish
Key points from Dan
- SwapClear contains 60-70% of the global OTC IR swap market
- SwapClear has cleared $19trn of the $20trn buy-side Swaps anywhere in the world (i.e. other CCPs have only captured $1trn of buy-side business)
- SwapClear clears $2trn notional per day, higher than implied by Kim perhaps
- Also torn up $170trn of IRS (I assume he means in partnership with TriOptima / TriReduce)
- Workflow for OTC is now more standardised, the flow from execution to clearing is much smoother
- OTC products hedge non-standard risks – the raison d’être of the market
- The portfolio at SwapClear when Lehman defaulted was 66,000 IRS in 5 currencies, $9trn of notional, maximum maturity of 30 years
- 30% to 40% of Lehman’s IM was used during the Default Management Process, the remainder returned to the estate of Lehman / their administrators
- No-one in SwapClear lost a penny as a result (is that a US cent or an English 1p?)
- Rate risk can be transferred and transformed, but doesn’t “disappear” so transmuting OTC Swaps into Futures will just move the problem, not solve it
- Why would a $10m DV01 in exposure attract a 2 day VaR holding period on an Exchange, and the same risk as an OTC cleared product attract a 5 day holding period?
- The key is: do you have access to liquidity in a default?
- Shouldn’t the holding period in any market be derived from the liquidity [and other key issues in a default], rather than by top down regulatory mandate?
I cut Dan off slighty short on the video, sorry Dan.
My key points
- You can download a spreadsheet of volumes of DSFs here: http://www.cmegroup.com/trading/interest-rates/dsf-volume-and-oi-tracker.html
- More work needs to be done to relate the holding period on a VaR calculation back to the participants in the market, and conditions in a default.
- Likewise the legal basis which obliges (or doesn’t) oblige folks to take a defaulters positions need examination
- The point about DV01 above is worth more examination
Source videos, 6 hours long: http://www.cftc.gov/PressRoom/Events/opaevent_cftcstaff013113