Regulators introduced the concept of frontloading – whereby a trade might be sent to a clearing house some time after execution – when they drafted the European Market Infrastructure Regulation to mandate swaps clearing.
Once a clearing house is authorized to clear products, the European Securities and Markets Authority (ESMA) – Europe’s financial regulator – has to recommend which of its products are suitable for clearing.
So far, Nasdaq OMX in Sweden, EuroCCP in the Netherlands, Polish post-trade provider KDPW and Deutsche Börse’s clearing house Eurex Clearing have been authorized.
Trades executed from the moment the clearing house is authorized have to be cleared at some point, but here is the catch: traders do not know which products will need to be cleared until ESMA makes its final decision, which could take months.
The rationale behind frontloading is that trades can be captured under the clearing scope as soon as possible, even before the mandate comes into force later this year or early next year.
However, in reality, it has left traders stumped as to how they should price swaps. Currently, a dealer that trades bilaterally with a client will trade according to the collateral agreement – the credit support annex (CSA) – they have in place.
For example, a euro deal with a US client will most likely have dollar CSA conditions, so the client can post collateral in dollars. However, if the trade has to eventually be moved to a clearing house then traders will use a euro CSA, because collateral on cleared swaps must be the same currency as the denomination of the swap.
Mohamed Braham, deputy global head of rates trading at Société Générale, says: “Therefore, I will price a euro deal with a euro CSA, but if the deal is not cleared I will end up managing wrong risk and a wrong P&L. If the nature of a contract changes, this will have an impact on risk and P&L when the change is enforced.”
Swap trading is now tricky because it is difficult to work out what credit risk and funding premium to apply on a swap, as it is unclear whether a product will end up being cleared or not. For example, a 30-year swap with a risky counterparty will typically have a higher risk premium if it is not cleared.
Furthermore, both counterparties now have to agree upfront which clearing house to use in case it transpires the swap needs to be cleared at a later stage, says John Wilson, head of OTC clearing at brokerage firm Newedge.
Kick the problem into the long grass
The debacle was discussed in crisis talks between ESMA, the European Commission and members of the European Parliament at the beginning of the month.
Market participants suggest the best solution would be to kick the problem into the long grass, and rule that only long-dated swaps will be affected. Frontloading would only affect a sliver of the market, and most swaps would be exempt if the minimum remaining maturity (MRM) was set high, at say 30 years.
Traders are waiting on tenterhooks for the regulator to decide.
One rates trader at a UK investment bank says: “Without knowing the MRM, how do we price the swap? I don’t know and I’m having to do it on a daily basis. It’s a royal regulatory cock up.”
Another trader heard on the grapevine that the regulator will make an announcement in the next 10 days to exclude swaps with a maturity under 30 years. ESMA confirmed last week’s meeting with the EC and the European Parliament, but declined to comment on possible outcomes or follow-up meetings.
A spokeswoman for the European Parliament says discussions haven’t finished yet and “it is still not clear which contracts would be affected, which creates legal uncertainty”.
However, traders are furious the situation has arisen.
“The issue of frontloading was raised by many, including ISDA [International Swaps and Derivatives Association], at the time of drafting the law, but it never grabbed the attention of lawmakers,” says Newedge’s Wilson.
Société Générale’s Braham adds: “We spotted this problem from the start. Regulators did not see the potential impact of the frontloading rules right from the beginning.
“I don’t see the need for frontloading rules to be in place. We could just wait for the clearing houses to be approved and then clear new deals.”