October 16, 2024 — New competition in the market for trading and clearing interest-rate futures and swaps is causing the industry to refocus on margin optimization, a process that allows market participants to reduce margin requirements – and ultimately the cost of trading.
Most experts agree that regulations mandating central clearing of derivatives trades have been effective in reducing systemic risk. However, this risk reduction comes at a cost to market participants in the form of margin requirements. Margin requirements can be safely reduced when offsetting positions within a firm’s portfolio are held at the same clearinghouse. However, today’s competitive landscape has largely kept U.S. dollar denominated swaps and futures tied to U.S. Treasury and SOFR rates separate.
Costs of Market Fragmentation
Higher capital costs have compelled derivatives market participants to be more strategic about how they optimize their margin obligations, driving changes to where they trade and how and where they clear the instruments.
Banks interviewed recently by Coalition Greenwich say “capital efficiency through netting and margin optimization” has become an important factor in how they measure their relationships with central clearinghouses (CCPs).
“Given the prevalence of market participants holding both futures and swaps, a significant opportunity exists to reduce margin requirements and costs by consolidating those positions in a single clearinghouse,” says Stephen Bruel, Senior Analyst at Coalition Greenwich Market Structure & Technology and author of The Portfolio Margining Imperative for Interest-Rate Derivatives. “Not only would individual trading entities benefit, but the financial system would see an improvement in risk efficiency.”
A partnership between FMX and LCH is aimed directly at the costs associated with these fragmented margin pools and has reignited the cross-margining discussion amongst market participants. FMX launched an exchange for U.S. SOFR futures that clear through LCH’s Listed Rates clearing service. It plans to launch U.S. Treasury futures in Q1 2025. In this model, there is the potential to offset margin at scale between the futures and interest-rate swaps aiming to compete with the incumbent.
“We project that market participants who clear SOFR swaps and futures bundles in one place could potentially realize significant margin reduction,” says Stephen Bruel.
The Portfolio Margining Imperative for Interest-Rate Derivatives traces the evolution of derivatives market structure and margin requirements, analyzes current efforts to optimize margin obligations and increase margin efficiency, and examines the mechanics and potential benefits of the new partnership between the FMX and LCH.