Is Clearing a Swap 200 Times as Risky as Clearing a Future?

Originally posted on

Clearinghouses don’t remove risk. In fact, they concentrate it.

But that concentrated risk is mitigated by the structure of the central clearing model. More specifically, position-based margin requirements and minimum excess capital requirements for members create a cushion to absorb losses in the event a member firm collapses. That largely removes the risk from the system. This is nothing new.

Adapting that model to meet the demands of a clearing mandate for much of the over-the-counter derivatives market, however, changes things.

TABB Group has pointed out several times that clearinghouses must be able to value the products they clear so they can accurately margin them. For futures contracts – most of which are relatively liquid – this process is easy since the last trade price provides an accurate valuation.

For OTC derivatives, however, liquidity in most products is shallow, which causes clearinghouses to mark to model. Some models are relatively straightforward (interest rate swaps are mostly just about predictable cash flows) and others less so (CDS valuations take into account probability of default – a guesstimate by its very nature). To account for this complexity, the big OTC derivatives clearinghouses in the U.S. are using the tools at their disposal, margin and capital requirements.

Margin requirements will make trading more costly for many market participants used to trading bilaterally, but most concede that margin is needed because it is the primary tool for clearinghouses to reduce risk. Capital requirements, however, are raising a lot of eyebrows.

Here are the facts:

The minimum capital required to be a broker-dealer, as set by the Securities and Exchange Commission, is $250,000. The minimum capital required to be an FCM, as set by the Commodity Futures Trading Commission, is $1 million (derivatives are more complex and have more leverage built in, after all). To be a futures clearing member of CME Clearing, the capital requirements are higher: $5 million. Each of these amounts increases based on a number of factors including number of clients, open positions, etc. but for the sake of comparison we’re going to focus on the minimums.

Enter OTC derivatives clearing. To be a clearing member at CME to clear interest rate swaps, the minimum capital requirement is $1 billion. To clear CDS at ICE Trust U.S., the minimum capital requirement is $5 billion (as mentioned above, CDS are a more complex product to clear). This would lead us to believe that clearing an interest rate swap is 200 times riskier than clearing an interest rate swap futures contract.

But is it?

The aforementioned clearinghouses have of course run countless scenarios over many months to ensure the soundness of their clearing model. A common approach is to simulate the default of two clearing members simultaneously and then ensure that the clearinghouse could continue to function properly. If those tests show that billions in excess capital are needed per firm to keep systemic risk out of the picture, then it is what it is.

But the disparity leaves me confused. Either minimums on one side are too low or minimums on the other side are too high.

Time will tell.

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