Here's an Even Weirder Thing Happening in Financial Markets
"Ladies and gentlemen, step right up. Hurry, hurry. Here's your chance to witness one of the oddities of the financial markets. An occurrence stranger than negative swap spreads, rarer than fractured repo rates, more obscure than the big basis in cash and synthetic credit."
If you thought the widespread plunge below zero in U.S. interest rate swap spreads was an oddity, the ballooning gap between a swap cleared at one exchange vs. another is even stranger and shows more unintended consequences of market structure changes.
That’s what strategists at JPMorgan Chase said last week in a gathering at the firm’s Madison Avenue office to discuss their 2016 outlook.
“In some sense, the fact that CME and LCH swaps are trading at different yield levels by about five basis points now on the 30-year—that’s much weirder than negative swap spreads,” said Joshua Younger, an interest rate derivative strategist at JPMorgan, at the Dec. 2 meeting. “That’s the same instrument. It’s another example of the unintended consequences of how markets have changed in the past 10 years.”
Under provisions of the Dodd-Frank Act of 2010 that came into effect in late 2013, interest rate swaps that once traded over-the-counter have been migrating to central clearing platforms dominated in the U.S. by the CME Group and LCH.Clearnet Group. Regulators' actions sought to stem odds of another financial crisis as clearinghouses cut risk by collecting collateral at the start of each transaction, monitoring daily price moves, and making traders put up more cash as losses occur.
While CME and LCH dominate as central clearinghouses for U.S. swaps, the market has become segmented with clients, such as hedge funds, dealing more with the CME and LCH focused more on interdealer clearing.
The preference of large asset managers to clear swaps through the CME is said to be due to heightened netting effects, as much of their futures trades use that exchange. That has helped trigger the higher rates on this platform, widening what is known as the CME/LCH basis, according to JPMorgan.
Interest rate swap spreads, the difference between the rate to exchange fixed- for floating-payment streams and similar-maturity Treasury yields, are now negative for maturities between five and 30 years, with many maturities reaching record gaps this year. This move, triggered by a mix of factors, has also been tied to the fact that post-crisis regulations on banks have reduced their capacity to warehouse debt securities and caused them to cut activity in the so-called repo market.
In the CME/LCH basis, “what you see is a flows imbalance between client and dealer trades that becomes exacerbated in certain situations,” Younger added in the Dec. 2 talk. “The counterparty credit quality is the same. It’s all about how dealers and clients are dealing with clearinghouses and the pockets of risk in one vs. the other.”