LCH.Clearnet re-values $218 trillion swap portfolio using OIS
Author: Christopher Whittall
Source: Risk magazine | 17 Jun 2010
Categories: Risk Management, Interest Rate Derivatives
Topics: clearing, OTC derivatives markets, interest rate swaps, LCH.Clearnet, collateral value
Changes in valuation were “relatively small”, says clearing house
LCH.Clearnet is now valuing variation margin in all US dollar, sterling and euro interest rate swaps using overnight indexed swaps (OIS), affecting $218 trillion of swaps.
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The move came following a consultation with its SwapClear members, which were asked what process they would use to value a bid for a portfolio in an auction process in the event of a member default, on the basis the positions were fully cash collateralised and receiving an overnight rate of interest.
"A high percentage of dealers advised they would quote us on a mid-market OIS basis plus or minus a spread. Following some testing and further consultation, we decided to implement this as quickly as possible to remove any of this potential risk that could materialise should there be a member default," says Daniel Maguire, director and head of interest rates and foreign exchange, risk and operations at LCH.Clearnet in London.
The move is something of a watershed in the interbank derivatives market. Collateralised derivatives trades have traditionally been priced using Libor curves. However, OIS was theoretically identified by dealers as the correct discount rate for collateralised trades, as interest on collateral is paid at an overnight rate. Prior to 2007, the relatively small basis between Libor and OIS meant dealers in practice would discount all trades using Libor.
The ballooning of the Libor-OIS basis during the credit crisis led dealers to move towards OIS discounting for collateralised trades. But as the vast majority of interest rate swaps are cleared through the LCH.Clearnet – which used Libor discounting – there was no official market standard for the pricing of collateralised positions.
"The market has come to the consensus that this is the correct way to value swap trades, so it is impressive to see LCH.Clearnet is able to put this into effect so quickly. Obviously, it is very important to correctly value all the swaps that are cleared in order to avoid market distortions and reduce the chance of loss in any default event," says Simon Wilson, deputy head of delta trading for Europe, the Middle East and Africa at Royal Bank of Scotland in London.
Changes in the value of variation margin would have passed directly through to swap counterparties and would not have resulted in losses or gains for LCH.Clearnet. However, it is important for the clearing house to present value positions correctly so it would not be left exposed in the event of a dealer default. Maguire declined to comment on the exact size of the valuation adjustments.
"We didn't have a material exposure and the changes in valuation were relatively small: none of the changes were anywhere near the size of the initial margin on any portfolio," he says.
It is understood the US dollar, sterling and euro swaps portfolios revaluations were prioritised, as they represent the majority of LCH.Clearnet's risk. Considerations such as what to do about initial margin and other currencies are likely to be reviewed later this year.
"We looked at initial margin, but decided it was not a material problem in need of addressing in the short term. We expect to examine initial margin and other currencies in the fourth quarter," says Maguire.