LCH SwapClear unveils its pre-cessation trigger approach: market fragmentation in sight!

LCH is proposing to changes the LCH Limited Rulebook. The details can be found at: https://www.lch.com/membership/ltd-membership/ltd-member-updates/lch-limited-rule-change-committee-10-january-2020

This post is a work of fiction, an extreme fiction. The official narrative is also a work of fiction, also an extreme fiction and consequently I feel allowed to write my own fiction about this very important topic. Reality is probably between the extremes of fiction.

You can't have your cake and eat it too

CCPs want fees related to risk management of large portfolios but at the same time want to get rid of the risk as soon as the risk is about to materialize. Default fund and margin haircut on the materialization of credit risk through default, default fund usage in case of bad management of their funds investment process, and more recently remove LIBOR risk as soon as there is a LIBOR discontinuation risk is about to materialize. This is this last point that interests us here.

For CCPS, the LIBOR fallback risk is a third order risk: default of a counterparty during the specific period just before the fallback which may be such that there is a reduced liquidity at that time and the IM amount, including the liquidity add-on, is not enough to liquidate the portfolio without loss. Because CCPs are afraid of that third order risk they propose to create a certain first order problem to all other market participants; the certain problem is the fallback timing and exact methodology. The reasoning behind the mandatory clearing is that CCP are better equipped than "simple" market participant to deal with settlement, default, and margin period of risk. Maybe we should review that reasoning if the CCPs themselves tell us that they are afraid of dealing with that third order risk.

Methodological ignorance?

CCPs should remember that IM is composed of based IM (market risk) and liquidity add-on (cost of liquidation). Saying that they need to protect against this potential third order risk is saying that they cannot understand the cost of liquidation in that short period (couple of months according to their arguments) and cannot develop a temporary methodology for the add-on to take into account that specific issue. This implies penalizing the whole derivative market that, is forced by regulation to use the clearing services, to protect the de facto monopoly from its own incompetence.

To make sure that two outcomes are identical, throw two dices and pray the numbers match!

The explanation for the choice of a different fallback methodology from the proposed bilateral (ISDA) approach appears to be: let's change two features (pre-cessation trigger instead of current cessation only trigger and spread computation on fallback date instead of the announcement date). The rational for this double divergence is the hope that they will cancel and that the spreads will actually be the same. This is quite unlikely but we can always hope and pray.

What about coordination and market coherence?

That seems a very convoluted and uncertain way to obtain the result. Let me propose a incredibly innovative approach: use the same method for cleared and bilateral swaps and base the method on the term sheet of trades at inception; as long as LIBOR is published it is used, when LIBOR is not published anymore its is replace it by something else, with that something else being the same in all cases. It has to be very innovative, because I have not seen such a proposal in any ISDA or CCP document...

In the current master agreements and rule-book, the only event that leads to a fallback is the non-publication of the rate, there is no notion of announcement date and even less "pre-cessation" trigger. Any discussion about those event leading to a fallback creates a market fragmentation. Maybe a market fragmentation is a lesser evil in some cases, but any talk of pre-cessation trigger reducing the market fragmentation (as for example in some FSB letter) is pure fiction.

It seems to me that there are so many imaginative fiction writers in the financial market nowadays... That is a lot of competition for my finance fiction series. But I don't mind, I fundamentally believe that competition is good.

My fiction is is probably an extreme view of the issue but one that needs to be taken into account before allowing a for-profit corporations to take a decision for the rest of the world. The impact is not only on clearing members and on clearing clients but on all derivative users, even the bilateral only derivative users. The fragmentation of the derivative market would mean it is more expensive to trade a bilateral derivative because there is no clean hedge available anymore. You have to add the "market price of risk" for that non-hedgeable risk on all bilateral derivatives. We enter into the world described in my Risk.Net opinion (subscription required), where valuation becomes user dependent and opinion based. All the standard approach to market infrastructure, including the notion of replication, is thrown away.

This post is a work of fiction, maybe the preface to a horror story. Nevertheless, sleep tight!

Note added 31 January 2020: A recent article in risk about LIBOR fallback (Libor replacement jumble may hike hedging costs) mentions that some products, in the context of loans, "create new basis risks that could be costly to manage". To my opinion this is the case of all the discussion about pre-cessation triggers, different procedure for cleared and non-cleared instruments, mandatory big-bang collateral/discounting changes; they all create extra hedging costs. I also agree with Tamsin Rolls, assistant general counsel at JP Morgan, who says “That’s unfortunate and makes the world a little more complex.”