Since 2008, the growth of central counterparties has been one of the most profound changes in the over-the-counter derivative market, and particularly striking is the performance of the London Clearing House.
From clearing just 28% of OTC interest rate derivatives in 2008, the LCH’s Swapclear service now clears over 70%, with $311 trillion of notional outstanding at the end of October. Compare that with the $416 trillion of total swap notional reported by the Bank for International Settlements.
Ten years ago, dealer banks accounted for the lion’s share of BIS notionals. If a bank entered a swap with an end user, it would offset or hedge the trade with another bank, creating a web of opaque exposures that threatened to topple the financial system after Lehman Brothers.
Post-crisis reforms such as the Dodd-Frank Act and Basel III penalised inter-dealer swap exposures and encouraged CCPs. New trades were now offset with CCPs, existing inter-dealer trades novated or transferred across, and Swapclear’s positions ballooned. Even though portfolio compression has reduced exposures below their 2013 peak, they are still more than three times greater than 2008 levels.
Controlling 95% of the market for interest rate derivative clearing, LCH is unashamedly a too-big-to-fail institution, and at first sight appears safer than the banks ever did. Until recently, dealers only posted variation margin on swap positions between themselves as mark-to-market values changed. As a CCP, Swapclear supplements variation margin with upfront initial margin payments.
Calculated for each clearing member’s portfolio using a value-at-risk type model, initial margin is supposed to protect against 2008-type scenarios of extreme market moves combined with dealer default. Swapclear’s total margin balance has risen to €143 billion as of October, up from €66 billion in 2013, as clearing volumes increased.
And if initial margin isn’t enough to protect the LCH from dealer default, clearing members also contribute to a backstop default fund which currently stands at €8 billion. Taken together, this amounts to significant risk capital provided by the banks.
This isn’t shared equally among Swapclear’s 107 members though. For example, Goldman Sachs reported in June 2017 that it had posted a total of $33 billion of initial margin to ‘investment grade clearing organisations’. Given Goldman’s leading position in interest rate derivatives, a sizeable chunk of this would have gone to Swapclear.
And this brings us to Brexit. A lesson of 2008 was that model-based capital requirements eventually fail. €150 billion of capital sounds like a lot but it still is dwarfed by Swapclear’s €318 trillion of derivatives notional. Governments that ultimately stand behind systemically important banks outside the UK are entitled to ask whether an entity based in the UK would be able to repatriate initial margin in the event of a default.
The surprising thing is that before 2016, this question was barely asked. When it approved Dodd-Frank, Congress didn’t require American banks to hold their swap clearing balances within the US. Clearing organisations – including Swapclear – don’t have to register in the US if they can show they are “subject to comparable, comprehensive supervision” in their home country.
But then came the Brexit vote. For many in Frankfurt and Paris, it seems intolerable that euro swap margins posted by their domestic banks will be held post-2019, in the land of Boris Johnson. For LCH, this is proving an existential threat, while long-time German rival Eurex smells a golden opportunity.
In its position papers, the LCH’s majority owner, London Stock Exchange Group, lobbies for the softest of Brexits. It wants EU regulators to be able to supervise UK clearing organisations. One wonders how this compromise on sovereignty would go down with the likes of hard-line Brexiteer Jacob Rees-Mogg, currently a bookies’ favourite to lead the Conservative Party. 
A hard Brexit would be a worst-case scenario for LCH. The LSEG paper warns that ‘denial of recognition’ – a European Commission refusal to recognise Swapclear as a CCP for EU banks – would create a ‘small EU captive market’, fragmenting liquidity.
That may be wishful thinking. A key reason why global dealers like putting all their trades through a single CCP like Swapclear is that initial margin calculations benefit from portfolio model diversification across multiple products and currencies.
Splitting things up between London and Frankfurt would increase the total initial margin that banks would have to post, because diversification between EU and non-EU trades wouldn’t appear in the models.
This is why recent tweets by Goldman CEO Lloyd Blankfein about moving more business to Frankfurt would have made LCH’s blood run cold. After all, why shouldn’t Goldman just move all cleared trades to the EU, and save on margin costs? If Blankfein did that, what could the UK do?
The consequences of a hard Brexit – economic weakness, political paralysis and a likely sovereign credit downgrade – make this outcome increasingly probable.
