Assessment of LCH Limited's SwapClear Service 4. Activity and Risk at SwapClear
4.1 Global Activity
The notional value of new trades registered by SwapClear's 122 direct participants during the assessment period consolidated at around US$75 trillion per month across all currencies, after contracting from the peak seen in early 2020 (Graph 1).[3]
Activity in shorter-dated products, including forward rate agreements (FRA) and most activity in overnight interest rate swaps (OIS), have declined after spiking in early 2020. This largely reflected expectations that short-term interest rates across the advanced economies will remain low and stable for some time (Graph 2). By contrast, activity in interest rate swaps (IRS), which tend to be longer-dated products, increased. Reflecting these offsetting trends, the stock of derivatives outstanding was broadly stable with the composition shifting towards longer-dated products (Graph 3).
OIS, FRA and IRS accounted for 95 per cent of the notional value of trades registered.
SwapClear clears OTC interest rate derivatives in 27 currencies. Around 43 per cent of trades registered were denominated in USD, 25 per cent in EUR and 19 per cent in GBP (Graph 4). The AUD is SwapClear's fourth most registered currency and accounts for around 3 per cent of trade registrations.
Total initial margin requirements, which is an indicator of the level of risk the CCP manages, declined since the peak in March 2020, but has remained above pre-pandemic levels (Graph 5). The relative importance of initial margin add-ons – called to cover risks not covered in the base initial margin model, such as specific credit, liquidity, concentration and sovereign risks – increased. As outlined in Box A, the change in the importance of add-ons during this period was largely due to the anti-procyclical effects of the unscaled initial margin floor add-on acting to partially offset some of the responsiveness of the base initial margin model to changes in market conditions.
Box A: Initial Margin and Procyclicality
Initial margin (IM) forms part of the financial resources of a CCP that will be used in the event of a participant default. It is designed to cover most but not all losses on a participant's portfolio based on historical price movements. It also covers risks arising from the specific positioning of participant portfolios – including credit, liquidity, concentration and sovereign risks. IM is responsive to changes in the composition of the participant's portfolio and market conditions such as market volatility or the correlation of different assets.
CCPs must manage a trade-off between the responsiveness of their IM model to changes in market conditions with the extra liquidity demands imposed on participants. An IM model that is more responsive to market conditions will place greater liquidity demands on participants at times of high volatility, whereas a model that is less responsive to market conditions may result in higher IM than would otherwise be required during less volatile periods. To control the procyclicality of its IM model, SwapClear limits the extent to which its participant's IM requirements can decline during periods of low market volatility; that is, it imposes an IM ‘floor’.
The COVID-19 pandemic offers a unique period to consider the effectiveness of SwapClear's procyclicality controls. In the first quarter of 2020, SwapClear's IM requirements increased by around 25 per cent. Most of the increase was attributable to participants taking on larger risk positions (orange bars in Graph 6). While the base IM model did respond in a procyclical fashion to market volatility associated with the onset of COVID-19 (purple bars), these effects were cushioned by the offsetting effect of the IM floor add-on (blue bars).
As volatility reverted to more normal levels, the effect of market conditions on IM requirements subsequently decayed, and the initial effect of the IM floor progressively reversed. In more recent months, total IM requirements at SwapClear have settled at a new, higher level largely reflecting the increase in the riskiness of participant portfolios relative to just prior to the pandemic.
Variation margin flows, which prevent the build-up of current exposures as prices move, reverted to around pre-pandemic levels, although there was a slight pick-up in flows in the first quarter of 2021 coinciding with an uptick in market volatility (Graph 7). The number and value of intraday margin calls, which are made when a participants' margin liabilities exceed a predetermined credit threshold, followed a similar pattern (Graph 8).
LCH Ltd accepts cash and non-cash collateral in a range of currencies, with collateral eligibility differing between types of margin calls and default fund contributions.[4] Total collateral held by the SwapClear service decreased from the peak of March 2020 in line with total margin requirements (Graph 9). While LCH Ltd accepts Australian Government Securities and AUD cash as initial margin, AUD collateral accounts for less than 1 per cent of total collateral held. Over 85 per cent of total collateral held is denominated in USD, GBP or EUR.
The Rates service default fund – covering the SwapClear and Listed Rates services – is a pool of mutualised financial resources, prefunded by clearing participants. It is used in the event that a defaulting participant's own margin and default fund contributions are insufficient to cover losses arising from the default. The Rates service default fund is comprised of a core component and an additional component that is used to facilitate real-time trade registration (Graph 10).
The core component of the default fund is calibrated to cover the sum of the stress test losses over initial margin (STLOIM) of the two clearing participants (including their affiliates and clients) generating the largest expected financial exposure under extreme but plausible conditions.
To prevent a single participant with a large exposure driving up the contribution of other participants, LCH Ltd may call default fund additional margin (DFAM) from participants to offset stress losses in excess of initial margin that would exceed 45 per cent of the default fund. In addition, the default fund is capped at £6 billion. Participants can ask clients to cover their own stress test losses (rather than the participant paying DFAM) through the provision of ‘stress loss margin’.
4.2 Australian Activity
SwapClear has six Australian-domiciled direct clearing participants – Australia and New Zealand Banking Group Ltd, Commonwealth Bank of Australia, Goldman Sachs Financial Markets Pty Ltd, Macquarie Bank Limited, National Australia Bank Limited, and Westpac Banking Corporation.
The total notional value of Australian participants' interest rate derivatives outstanding (in all currencies) cleared via SwapClear declined by 4 per cent in AUD terms over the year (Graph 11).
Overall, an estimated 90 per cent of all centrally cleared AUD-denominated OTC interest rate derivatives were cleared via SwapClear. Trading activity in AUD interest rate derivatives broadly mirrored trends in activity across all currencies, although there was a much larger decline in AUD OIS activity in the middle of the year. (Graph 12).
4.3 Operational Performance
The average number of trades registered at SwapClear was little changed throughout 2021 (Graph 13). LCH Ltd deems its capacity utilisation target to be met if the service has the capacity to handle the greater of either (i) two times current daily peak throughput of trades registered over the previous two years, or (ii) the projected daily average throughput in 12 months' time. The SwapClear service met its target in all months during the assessment period.
LCH Ltd targets IT system availability for the SwapClear service equivalent to at least 99.7 per cent. In effect this means that system outages should last no more than 2 hours in any one calendar month.[5] This target was met by SwapClear in 11 months of the assessment period (see also section 3.3 - SwapClear operational incident for more details). Overall, IT system availability averaged 99.8 per cent.
Endnotes
Unless otherwise stated, all positions data reported in this Appendix are as at 30 September 2021 while all activity data and growth rates are reported over the 12 months to this date. [3]
LCH Ltd accepts: GBP cash for default fund contributions, eligible cash and non-cash collateral for initial margin, and eligible cash for intraday margin calls. Variation margin must be met in the currency of the underlying exposure. For further information, see LCH Ltd's website on LTD Acceptable Collateral. Available at <https://www.lch.com/collateral-management/ltd-collateral-management/ltd-acceptable-collateral>. [4]
LCH Ltd weights outages to calculate service availability: a weight of one where there is full service outage; a weight of 0.5 or 0.25 for partial outages, depending on the incident; and a weight of zero for partial losses of resilience, such as when the service is still operating but an additional server used to share the load is unavailable. [5]