By Amir Khwaja, Clarus Financial Technology
Originally published on TABB Forum
Swaps compression trades reduce line items, clearing fees and margin. But they come at a price. And determining whether they are cost-effective depends on the details.
In my recent article, “Swaps Compression and Compaction on TrueEX and Tradeweb SEFs,” I looked at the mechanics of these trades and the evidence in SEF and SDR figures, and stated that the benefit was to reduce line items and clearing fees. In this article, in order to determine whether the cost-benefit in terms of fees and margin is a positive factor on the benefit of reducing portfolio complexity by removing line items, I am going to take a deeper look at just the impact of compression on clearing fees and margin.
Client Clearing Fees
For clients, the first set of fees are those charged by their FCMs or clearing brokers.
Such fees typically consist of a new-trade ticket fee, a periodic maintenance fee and a portfolio charge – the latter for the funding cost implications of a segregated account, financial resource utilization and funding of default fund contributions.
The most convenient public disclosure on OTC clearing fees is that required by EMIR. On the assumption that such fees are similar to those charged to US firms under Dodd-Frank, let’s see what a few of these state:
- Barclays Fees, £750 per new trade, £75 per quarter, 100 bps on Initial Margin
- JP Morgan Fees, $1,500 per trade, 60 bps on Initial Margin
- Citi Fees, $750 per trade, 50 bps on Initial Margin
The list shows a wide variation in list prices; however, we can be sure that after negotiation, actual prices will converge – provided a minimum annual revenue threshold of around $250,000 is met.
Let’s assume a client can negotiate a $500-per-ticket fee and 60 bps on IM.
Clearing House Fees
Clearing house fees are passed on by FCMs to clients under two types of plans: a standard plan and a high-turnover one.
- CME OTC IRS fees are $0.25-$24 per million for a trade and then $2.00 per million, per annum, per line item and volume discounts.
- LCH SwapClear fees are $0.9-$18 per million for a new trade and then $3.00 per million, per trade, per annum.
- Both CME & LCH are the same: $25 per ticket plus a monthly charge of 10 bps, annualized, on IM.
A client not only has the funding cost of the Initial Margin requirement, but as we see above, the clearing fees also have a component linked to the IM. Consequently, IM is an important and significant determinant of the overall cost.
Compression - A Simple Example
Let’s now look at an example of compression costs and savings in action.
Assume we just have a single 2Y Swap of $100 million receive fixed in our portfolio, which we executed one week ago and that we now no longer need.
What is the cost of the compression?
As we know from my prior blog, this involves entering into a new swap with the same terms but opposite direction (pay fixed) to the existing swap.
- Let’s first assume there is no explicit execution fee (not unreasonable?), so we are left with clearing and SDR reporting costs.
- Consequently, we need to pay $500 for client clearing fees and $250 for CME or $225 for LCH (assuming the standard plan).
- For SDR reporting, let’s assume $15 per trade.
- So $765 for CME and $740 for LCH.
- Let’s call this $750.
And what is the saving?
- First, we will not have to incur the annual clearing house charge of $200 for CME or $300 for LCH, which for two years is $400 or $600 respectively.
- Second, we no longer have an IM requirement, as the net risk of the two trades is zero.
- Which means that we no longer need to fund the IM requirement and will not have to pay 60bps on IM to our FCM.
- So the saving is either $400 or $600, plus the reduction in funding cost and the IM fee saving.
To proceed we need to determine the IM for our 2Y Swap, which we do in Clarus’s CHARM, as below:
Then, for arguments sake, let’s assume our funding rate is 2% more than the interest we earn on the margin deposit.
So our monthly funding cost is $750 for CME and $950 for LCH, at least for the first month.
After that, IM decreases as our 2Y Swap ages, mainly as DV01 decreases with remaining maturity (a 1Y Swap has less than half the DV01 of a 2Y). As a rough approximation, let’s assume that the average IM over the life of our 2Y Swap is 40% of the IM at inception. Our funding cost over 2Y is then $7,200 for CME and $9,000 for LCH.
Using the same 40% assumption for average IM over the 2Y, we can also estimate the 60bps per annum of IM as $5,400 for CME and $6,800 for LCH.
Bringing all the above figures together:
- Cost of compression trades is $750.
- Benefit over the 2 years is $13,000 for CME and $16,500 for LCH.
So very clearly in this case the cost-benefit of compression is firmly in the positive.
However, in this simple example, given that the DV01 of the 2Y trade is approximately $20,000, the business imperative to neutralize this DV01 is of more importance than the cost benefit of compression.
Consequently, the decision to do compression is not determined by the cost-benefit of compression per se, but simply the use of compression to neutralize the DV01.
Compression - Another Example
Let’s now construct another example, one in which we have already decided to hedge the original Swap, one week later with a new 2Y swap (on-the-run and par), and we are now left with two Swaps with a small difference in fixed rate (e.g., 0.1 bps) and a 1-week mismatch in maturity dates.
We could choose to let these trades run down to maturity. However, let’s see whether compression is also worthwhile in this case.
Cost of compression:
- Enter into two trades to offset the two existing ones.
- So $1,000 in client clearing fees and $500 for CME or $450 for LCH.
- For SDR reporting, let’s assume $15 per trade, so $30 in total.
- A total of $1,530 for CME and $1,480 for LCH.
- Let’s call this $1,500.
- No annual maintenance charge for the two trades, so $800 for CME or $1,200 for LCH.
- Reduction in funding cost and IM fee?
In this case, the reduction in funding costs is much less significant, simply because the 2 original trades are already almost but not quite perfectly hedged – except for 0.1 bps on fixed rate and 1-week maturity mismatch.
In fact, if we construct an account with these two original trades and run in CHARM, we get the following:
So we can see that there is still in fact a small Initial Margin – much less than we had before, but material nonetheless.
The funding cost of this (using the same 2% and 40%) over the 2 years is then $400 for CME and $970 for LCH.
And the 60 bps of IM over 2 years is $300 for CME and $700 for LCH.
Bringing all the above figures together:
- Cost of compression trades is $1,500.
- Benefit over the 2 years is $1,100 for CME and $2,300 for LCH.
So in this case, for CME the cost-benefit is not positive, while for LCH it still is.
However, if we were not on a standard plan but a high-turnover plan, our cost of compression would be just $1,100 as the clearing house fee would be $25 and the 10bps on IM.
This moves the cost-benefit toward positive territory for CME – as would a greater mismatch than 1-week and a greater difference than 0.1 bps.
So we can see that even with seemingly hedged portfolios, there is a cost-benefit in compression to get rid of the residual risk.
Compression - A Portfolio Example
Now, in the real world, we would not be looking at simple portfolios with just our 2Y Swap trade, but a portfolio with many existing trades.
In this case, compression to reduce line items in itself would generate significant savings in the clearing house maintenance charge (and even more savings if our FCM also charges this, as Barclays states).
Let’s say we had 100 line items with gross notional of $5 billion, and an average size of $50 million per trade.
The annual maintenance for these would be $10,000 for CME and $15,000 for LCH – not massive, but it still adds up over the life of these trades, which may be 5Y or 10Y or 30Y.
Meanwhile, the reduction in Initial Margin should be determined as the marginal impact on the portfolio margin of the compression trades.
I won't go into the details of this now, except to note that in some cases it may not be a reduction but an increase in margin and so not a saving but a cost! (If you are interested in details on the portfolio example, please send me an email).
For a compaction, in which we are seeking to not change the risk (or the margin), there would be no reduction in margin. So in this case, the focus is simply on the clearing fees, both the new-trade fees and the reduction in annual maintenance fees.
Very detailed, so thank you for sticking with it. (Any errors in the above calculations are all mine, so please let me know if you find any.)
Compression trades have a cost, as they are new trades that must be cleared.
The cost is in client clearing fees per trade paid to the FCM and clearing house fees.
The reduction in line items reduces portfolio complexity and often is the prime reason for compression.
While the new compression trades attract a new-trade clearing fee, the fact that they net down (extinguish) the existing trades means that there is no longer an annual maintenance fee payable to the clearing house.
The greater the number of trades (line items) removed, the greater this benefit.
Another benefit, often greater, is the reduction in Initial Margin, as this determines both funding cost and the FCM portfolio charge.
The Dodd-Frank Act may just be the best example of unintended consequences in action. It seems like each new rule implementation has created a ripple-effect of reactions in the marketplace, some of which were anticipated and others that took everyone by surprise. Take the central clearing mandate, for example. On the surface, you can imagine how lawmakers envisioned a world in which every swap transaction cleared through a central party would create a more stable derivatives market. What lawmakers likely did not envision was the slew of other technical issues that were raised the moment the idea of a central clearing party was introduced.
One of these is compression. Developed initially at Tradeweb, a leading SEF, as a way to reduce clearing costs, compression allows traders to submit up to 100 line items to market making participants for pricing and execution at one time. Each of these trades can offset existing positions or aggregate other trades at the clearing house. By netting these trades in this manner, traders effectively reduce the number of line items outstanding at the clearinghouse, which reduces overall clearing costs.
That all sounds pragmatic enough, but once market participants started using compression trading on Tradeweb, they also found that the process lent itself very nicely to custom swap lists, essentially making it possible to bunch a large number of unique trades together and for faster, more efficient pricing. To find out more about how market participants are experimenting with compression trading that grew out of Dodd-Frank, DerivAlert sat down with Tradeweb Managing Director Michael Furman.
DerivAlert: Tell us about this new compression functionality; what was your original intent when you launched it?
Michael Furman: The process of consolidating swaps at the clearinghouse is different than that of unwinding a bilateral trade. The clearinghouse requires an exact offset of the original trade to be executed and cleared. We wanted to provide our customers with a tool that allows them to manage their line item exposure, which ultimately aids in the reduction of clearing costs. With the new clearing mandate, you had this situation where a portfolio of swaps would sit at the clearinghouse as a bunch of individual trades each of which would be an outstanding line item on a customer’s book until the underlying swap reached maturity. With our compression tool, offsetting trades can easily be netted to reduce the number of outstanding line items.
DA: Did this concept exist previously or did it grow out of a response to derivatives reform?
MF: As a result of the clearing mandate and procedures implemented by the clearinghouses, customers are now required to execute an equal and offsetting trade in order to collapse a cleared swap position. So yes, this is new. Prior to the launch of the Tradeweb compression tool, the process was highly manual in that it relied on spreadsheets created by customers, each of which could employ varying formats. With our compression tool, we’re automating that process by making it electronic. This process makes it ultra-efficient for a market participant to pull together a large package of trades and shop it to multiple dealers.
DA: What are the initial reactions among customers?
MF: It’s been extremely positive. We are able to compress lists of trades with as many as 100 line items, and we have executed compression trades as large as 85 line items. We are now at the point where we are executing 3-5 of these compression lists every day. In addition, our customers are quickly recognizing that there’s more to compression than just reducing the number of overall line items at the clearinghouse. By making the compression process electronic, we’ve opened up this opportunity for customers to create custom swaps trades with this tool. The framework lends itself to a new form of customization by market participants.
DA: Do you see this kind of functionality inducing more overall swap volume to move onto SEFs
MF: Tradeweb has been supporting electronic derivatives markets since 2005; our proposition has always been that if you make it easier and more efficient to trade electronically, the markets will eventually migrate in your direction. Compression is turning out to be a great example of that theory in practice. We’re seeing both MAT’d and un-MAT’d swaps show up in custom trades that have been built using our compression tool. This is a clear sign that the growth we’ve seen is more than just mandated trading, it is about efficient trading.