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Thursday, 30 March 2017

Clearinghouse basis hits interest-rate hedging

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A difference in pricing for interest rate swaps across the two main clearinghouses for US derivative contracts has blown out to all-time wides this week, leading to higher costs for banks and fund managers looking to hedge interest rate exposures.

The cost of paying fixed rates on a 30-year interest rate swap that clears through the CME Group rose to 3.75bp higher than the cost of the same position at LCH.Clearnet – the widest spread ever between the two positions.

The spread on the 30-year part of the curve has risen from 2.2bp on October 28, according to swaps data provider ClarusFT. The previous wide prior to the spike of the last three weeks broke through 3.0bp.

The spread widening this week has baffled traders who had grown accustomed to a much tighter spread over the summer, after a basis between the two positions first emerged in the early part of this year.

“I can’t come up with a lot of strong explanations for why this is happening, to me it just implies that there is something structurally wrong with the market,” said Michael O’Brien, head of fixed income trading at Eaton Vance.

“I understand that some basis between the two is likely to exist, but it should not be this wide.”

Structural imbalances between buy and sellside demand for cleared swaps contributed to widening of the basis this past summer. Buyside funds prefer to pay fixed rates on swaps at CME Group, while sellside firms prefer to received fixed rates on swaps at LCH.

The buyside preference for CME stems from margin savings offered by CME. The sellside preference comes from the fact LCH has long operated an inter-dealer market for cleared swaps, and moving demand over to CME could risk showing their hand.

That divergence of demand was partially absorbed by the market over the summer. After widening out to 2.75bp on the 30-year part of the curve, the basis settled down to about 1.8bp in July, according to Clarus data.

The recent widening is leading to higher costs. For example, paying fixed rates on a US$100mn 30-year swap at CME currently costs roughly US$700,000 more than if they traded at LCH, according to trader calculations.

The divergence is also occurring just as US swap spreads test all-time negative levels, which is also leading to a higher cost of hedging. The spread between 10-year US dollar interest rate swaps and related Treasury yields tipped its most negative level at -18bp on November 5 according to Tradeweb data.

Why now?

The basis between CME and LCH was somewhat expected to occur as a result of Dodd-Frank regulations requiring swaps to be cleared – and the differing business models between the two clearinghouses. But traders are at a loss to explain why the widening is happening so sharply now.

“The best explanation I’ve heard for the current widening is that it is near the end of the year and firms are looking to clean up the outstanding risk associated with these books,” said O’Brien. “That could be the case but it is very hard to tell.”

In the meantime, a basis trading market has developed at swap execution platforms that allows traders to ‘switch’ their exposures between CME and LCH.

Inter-dealer brokers Tradition and ICAP are offering the largest markets. On Monday of this week, US$11.4bn notional traded in ‘CCP switch’ markets, according to Clarus. The monthly average of the past four months is US$35bn – equal to the total of just the last five trading days – according to Clarus.

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