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Trading swaps in a cleared world

OTC Clearing Part 9

Meet Joe. Joe is a swaps trader within a small institution that has a straightforward hedging strategy at both the micro and macro level. Being a price-taker, Joe has built and maintained broker relationships that enable him to easily get a swap priced at an acceptable level provided counterparty limits allow. Joe’s back office is practicing weekly collateral exchange with various counterparties in cash. As such, Joe lives in a very comfortable world.

Bilateral Trades: Cost of trading

But Joe is in for a nasty surprise. The practice of looking for a good price from a trusted broker dealer is about to be turned upside down. Regulations spanning from Basel III and CRD IV to Dodd-Frank and EMIR will make the decision of where to trade what and with whom a lot more complicated. The following simplified, non-exhaustive view shows how varied and not always correlated the influencing factors for deciding on a trade have become.

Cleared Trades, Bialateral Trades

These are some examples of what Joe needs to consider in the future:

  • If the intended swap is eligible for clearing, what will the clearing cost be?

  • Collateral now needs to be posted daily, and not only variation margin but also initial margin. And margin posted to the clearing broker needs to be paid on the same day. Where does Joe fund that money from?

  • Which clearing broker do I use?

    • This involves thinking about the impact on initial margin requirements that the change of the swap portfolio held at that clearing broker would result in

    • Interest on initial margins at clearing houses typically does not yield market rates as clearing houses take a cut, e.g. EONIA -30 basis points, which would mean an interest loss as Joe needs to fund the amount posted as initial margin at market rates

    • Would it now make sense to backload some existing bilateral trades into clearing to reduce the initial margin? How does that offset correlate with the cost of backloading?

This train of thought is endless and it puts Joe in a very dire situation. There is no immediate remedy such as an algorithm that could be employed to help with his trading decision. This calls for a set of strategic trading policies that Joe should adhere to which should be combined with regular reviews of such policies and their resultant cost of trading.

The incoming regulations will no doubt be costly but being smart and strategic in dealing with the consequences ensures that the cost will not break Joe’s or your business.

Next week marks the last instalment of the OTC blog series, this time covering the impact of the new regulatory regimes on corporates.


This sounds like an exchange traded futures dilema. The exchange does the clearing, which broker you use should not matter very much and post T-bills as margin. Whats more Joe's institution should have been something aside to compensate for the counterparty risk on a swap anyway. If not then the new regulations will force them to do this - and probably about time too! Taking this into account then the new regs will not impinge very much on Joe at all and in fact once things are up and running could turn out to be much simpler and smoother to maintain. Less profit for the swap price giver though.

Dear Anonymous (sic),

Yes, margins will be reduced for the sell-side but who do you think will pick up the tab? And what's more, most smaller institutions are either not able to post securities as margin or simply do not have eligible material. And getting non-eligible material transformed by your clearing broker is again costly. I do maintain that the future of swap trading will see a dramatic change, especially for the smaller banks who are merely looking to hedge their risks.

And yes, bilateral trades will be far more costly than cleared ones in terms of capital consumption and in conjunction with dedicated margining (variation AND initial margin). But the definition of a "standardised" OTC derivative does not cover all relevant instruments traded by a typical buy-side. And the longer the tenor of my bilateral trades and the lesser the rating of my counterparty the worse my cost of capital becomes.

I definitely do not want to be in Joe's shoes right now... But, I concur that over time this complication will become the new normal and the market will adapt. What I am not so sure of is if Joe will then still be part of the market...



Regarding the central clearing (at least in Europe) Variation Margin will have to be paid in cash and in the underlying deal currency. So, posting T-bill may not be possible without transformation.

The new collateral framework will still be a challenge especially for the buy side. Typical asset managers have plenty of securities but few available cash.

As of today Joe probably considers the collateral as a MO/BO topic and does not pay too much attention to it. He will need adive in the new regs' impacts.

Hi Thomas, well said.

Today's traders have not had the need to worry too much about what is happening after they have done the trade. Usually their back office has sorted out the finer details of confirming trades and ensuring daily margining.

Going forward this view needs to change as the trading decision will have material impact on core capital consumption, size of margins and much more.

It's gonna be a different world.

Best, Tom


Thank you very much! Very useful!!




Many thanks for this article, very good. Little additional comment. Some exchange heads said, "that large banks are becoming more supportive of some futures contracts that they have previously failed to back, as new rules designed to reduce the risks of privately traded derivatives draw more investors towards exchange-traded products. On the other hand, that not all market evolution under new regulations will be in the direction of futures-style contracts ("futurization" of swaps), and that some rules may push more activity to swaps, depending on factors including tax considerations, etc." Fact is that the future participation of small institution on this market will be questionable.

Best regards,


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