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  • Elephant in the (Swap Trading) Room: Exposing dealer trading costs for cleared and uncleared swaps

Blog written By Dr. Marc Henrard, Head of Quantitative research at OpenGamma and visiting professor at University College London. Marc is the acclaimed author of Interest Rate Modelling in the Multi-Curve Framework as well as Algorithmic Differentiation in Finance Explained. His other publications can be found on SSRN and IDEAS.

Are you a Cat 3, Cat 4 or exempted entity as defined under EMIR? If so, have you evaluated the commercial merits of voluntary clearing vs bilateral OTC?

Assessing the impact of these costs against today’s backdrop of ongoing regulatory, political and market infrastructure fragmentation is not straightforward. In this blog, we shed light on the complexities of these costs and the hidden benefits that arise from certain trading scenarios.

Our analysis highlights that when the costs of bilateral OTC are fully accounted for, cleared swaps offer significant capital and MVA savings for dealers, which should translate into tighter bid/offer spreads. More precisely, the bid/offer spread for an uncleared 10yr USD vanilla IR Swap held to maturity that is used in this analysis, is approximately 2 bps greater than when cleared through a CCP with an established liquidity pool.

Our study looks at the trading costs for cleared and uncleared swaps from the counterparty perspective in various trading scenarios, highlighting to the buy-side what the sell side drivers impacting all-in risk price are. We quantify the direct cost to the dealer for both margin and capital, resulting in the true theoretical differential (that dealers could/should be charging) between cleared and uncleared swap execution spreads.

For OTC uncleared, two cost scenarios are examined. One where Variation Margin (VM) is paid (mandatory since March 2017) and one where VM as well as Initial Margin (IM) are paid (mandatory for largest players and to be extended to more participants in the coming years). For full info on BCBS IOSCO’s framework on margin requirements for non-centrally cleared derivatives click here.

As illustrated in the chart below, from the buy-side perspective, the choice in terms of cost between cleared and uncleared swaps trading appears to be obvious – bilateral is cheaper than cleared – as VM has no associated cost at all, bilateral-VM-IM has an MVA cost and cleared swaps attract both MVA and fee costs.

This chart shows the costs associated with a 10Y vanilla IRS trade from a buy-side perspective. The costs are expressed in terms of the swap PV01.

However, this view is a simplistic assessment that ignores the array of dealer expenses that should theoretically be being passed on to clients in the form of adjusted bid/offer spreads.

If we carry out the analysis from the dealer perspective, we see a more complete picture. In the most extreme of examples, where the highest possible costs that a dealer would charge is the case (e.g. a dealer isn’t able to achieve internal portfolio netting when looking to price a new client trade), bid/offer spreads would naturally widen, as a direct consequence of the various component costs. And bilateral trading is still cheaper than when cleared. The chart below illustrates this scenario:

This chart depicts the sizes and sources of costs associated with a 10Y vanilla IRS trade, from a broker perspective.

However, though insightful, this standalone basis does not reflect the norm for most trading scenarios today. In a case where effective netting between different clients is taken into account by the broker, a very different story unfolds – bilateral trading costs become vastly higher than cleared. The cleared case results in almost no cost on the broker side and costs on the clearing broker side are covered by the clearing fees. This scenario is illustrated in the chart below:

This chart shows from the broker perspective the cost of trading, when effective netting is taken into consideration.

When looked at from the buy-side perspective, the following is exposed:

This chart shows from the buy-side perspective, the hidden costs of trading cleared and uncleared swaps.

This analysis shows that clearing in comparison with uncleared swaps offers the potential of significantly more balance sheet and cost-efficient trading of OTC swaps for dealers and, in turn, for the buy-side.

To conclude, comparison of the costs of trading cleared and uncleared swaps is complex, requiring analysis of both direct and indirect costs. Our analysis shows that the indirect impact on the dealer margin and balance sheet costs can be significant for bilateral trades, creating a strong incentive for dealers to move more business into clearing.

Buy-side swap users that are able to quantify these impacts on an ongoing basis will ensure that they make optimal decisions as to when it becomes commercially appropriate to begin voluntary CCP clearing.