LSEG to launch equity swap clearing
The London Stock Exchange Group will begin clearing OTC equity total return swaps in the first quarter of 2023, which could help address concerns about an asset class that contributed to the failure of 10 billion dollars from the family office Archegos Capital Management last year.
The planned service will operate as a partnership between two LSEG units: Turquoise Nylon derivatives trading platform and CHLof the EquityClear platform. The structure aims to reconcile the bespoke nature of total return swaps with the standardization required for clearing – a conundrum that overturned early efforts to steer instruments to central counterparties.
Sean Francos, senior product manager at Turquoise Nylon, explains that the service aims to square the circle: “When people trade equity swaps, it’s often on very bespoke terms. On the other hand, when you bring business into the clearing and into a venue, it normally requires some level of standardization,” he says.
Equity swaps have so far escaped a regulatory clearing mandate. The low volumes of the asset class relative to other derivatives such as forex or interest rates have also provided little incentive for companies to offset voluntarily. But rules on margining for uncleared derivatives and the capital impact of clearing new Basel standards could prompt market participants to clear equity swaps, experts say.
The clearing service will allow counterparties to negotiate flexible bilateral agreements outside of the clearing house. These are created according to the rules of Turquoise’s multilateral trading system using a new rights function. Tailored agreements, which include such things as trade breaks, substitutions, and increments, refer to equal and opposite pairs of standardized contracts that are transferred to the central counterparty once the bilateral agreement is concluded.
Where counterparties choose to invoke bespoke legal rights contained in the bilateral agreement – for example replacing a single name exposure with an alternative – a corresponding instruction is sent to the clearinghouse to terminate the standard instruments and replace with new versions reflecting the changes.
Francos points out that the service retains OTC standards, with transactions remaining negotiated bilaterally between counterparties.
“We are not looking to change the way people find liquidity with their customers and counterparties. We seek to introduce post-negotiation efficiencies into these relationships. This is reflected in the design of the platform, the product and the contract,” says Francos.
This time it’s different
Typically offered to hedge funds and other buying firms through prime synthetic brokerage units, equity total return swaps are contracts in which counterparties exchange fixed or floating rate payments for linked returns to an underlying share or a basket of instruments.
CCPs have been toying with equity total return swap clearing since post-crisis reforms forced other asset classes, including interest rate swaps and credit derivatives, to contact the clearing houses.
However, the first projects of rivals, CME among them, failed to take off as low volumes pushed the asset class down the priority list for voluntary adoption. At $3.97 trillion, equity swaps and futures account for less than 1% of total OTC derivatives notional, according to the latest data from the Bank for International Settlements.
For dealers to reap the benefits of clearing, any service must cover a wide range of unique names. Early discussions focused on liquid indices and eventually evolved into a listed product: total return futures.
LSEG plans to cover a long list of unique names in its clearing service. The group already covers more than 10,000 cash equity products on its EquityClear platform.
“We clear a wide range of stocks listed on a number of exchanges and multilateral trading systems,” says Tom Archer, Head of Equity Products at CHL. “With equity swaps, the main driver is the risk of the underlying equity, which is similar to the risk we’ve been managing for some time in our equity cash clearing service, so it’s a natural place for this product.”
Changes to clearing and banking capital regulations may also give businesses a boost to sign up for the service. The unmatched margin rules, which were rolled out to more than 1,000 largely buy-side companies on September 1, impose a 15% collateral requirement on bilateral equity exposures for in-scope companies. application using the standard regulatory schedule. A new risk-sensitive framework within the standardized approach to counterparty credit risk also increases the benefits of netting – a core feature of netting.
“Before, you didn’t have the pressure on uncompensated margin rules or the intense focus on capital that we have now,” says Indrajit Bardhan, consultant at Panoramix Partners and leading services expert. “There just weren’t enough coins on the table to push dealers to clear equity swaps given all their other priorities. This time the solution is much closer to what the market is used to and there are enough external pushes to push it forward.
Cleared instruments have the added benefit of the market-settled approach, which treats variation margin as settlement and reduces the value of individual trades to zero on a daily basis. This allows long-term instruments to be placed in the lower maturity bucket for calculating the leverage ratio, thereby reducing the amount of capital that needs to be allocated to trades.
“The benefits of clearing equity derivatives with a central counterparty are no different than clearing any other type of derivatives. It’s all about multilateral netting and having your exposures under one roof against the same counterparty to reduce your overall exposure. This can potentially reduce your margin liability and risk-based or leverage-based capital costs,” says CHLis Archer.
The strongest push to embrace netting, however, may come from a regulatory focus on assets. Although there is little appetite to extend the clearing requirement to equity instruments, total return swaps have come under increased scrutiny from regulators given their role at the center of the default of Archegos Capital Management in March 2021. After the instruments inflicted $10 billion in losses across the street, the WE Federal Reserve and UK The Prudential Regulatory Authority has called on banks to review risk practices around their equity financing activities. In December 2021, the Securities and Exchange Commission proposed additional disclosures for securities-based swap holdings that exceed 5% of a company’s stock – similar to requirements already in place for cash stock holdings.
All cleared trades would be reported on a post-trade basis, allowing firms and regulators to see exposures being built up in the clearing house.
“There is a natural increase in transparency by bringing business to one site and to a central counterparty,” Francos explains. “When you look at a futures or options exchange and how you can recreate open interest, you can see exposures and activity, anonymously, bringing business to a place. I think this is going to be useful for all kinds of participants in the OTC markets. »
Editing by Alex Krohn