By James Thursfield
In November 2018, LCH’s credit default swap service, CDSClear, launched an Electronic Exercise Platform (EEP) that enables buy-side and sell-side dealers to more efficiently exercise the index options that they have cleared with the clearing house.
“We have released an electronic platform that enables buy-side and sale-side dealers to exercise their index options that they have cleared with us automatically, electronically, with sub one-second latency on an anonymous basis,” said Frank Soussan, global head of CDSClear.
Prior to the launch of the platform members that wanted to exercise their options on expiry day between 9am-4pm London time, would have to do so by reaching a counterparty by phone or through instant messaging. In both cases, formal exercise notices would have to be delivered by email.
Soussan highlighted that with the new system, members have the opportunity to notify the clearing house of their options exercise intentions via the GUI or an API instance of the EEP. This will in turn notify the other side of this exercise intents – a process which significantly improves efficiency and cuts down on operational risk.
“By clearing with CDSClear, participants now face one single counterparty and only need to exercise their net position on a given strike once. Without clearing their options, members would have to exercise multiple options trades on the same strike as facing multiple counterparties. Simply by moving to a cleared model, firms are reducing their operational risk.”
“Once a trader goes to the EEP screen, they can see all their cleared options positions, and simply click on the ones they want to exercise. That exercise instruction will go directly to LCH to be matched with a counterparty, enabling a real-time, all to all, and anonymous exercise process,” he said.
Soussan went on to highlight the benefits of clearing credit swaptions for the market.
“The benefits of clearing credit swaptions are threefold. Beside mitigating the operational risk and providing an automated, anonymous way of exercising options, it also allows members to be more efficient from a capital and initial margin standpoint,” he said.
Usually options are traded alongside a hedge on the index. Before CDSClear provided the ability for participants to clear credit index options, firms would have been forced to un-package the two products. Trading the credit options bilaterally, while clearing the underlying index means a bank would have to put up initial margin for both products.
“Now if you have the ability to clear the option at the same CCP where you clear the index, it means you are going to have reduced initial margin as the CCP allows for portfolio margining in its risk framework.”
“We have seen participants saving up to 95% on initial margin of the package when clearing index options on a delta hedge versus clearing the two separately,” he added.
Portfolio margining position incentives
Soussan explained that the portfolio margining system could also incentivise LCH’s customers to have broadly hedged positions by providing them with lower initial margin calls for more balanced books.
He explained that the way CDSClear calculates margin taking into account the overall risk of a customer’s global portfolio.
“If you buy protection on a given instrument and you sell it on another given instrument and these instruments were historically highly correlated, we would reflect that in the margin we call.”
By allowing portfolio margining, the margin called would be less than calling the two positions independently.
“We do it because it is a sound risk management framework and it incentivises our customers to have hedged or balanced positions with us,” he added.
Soussan emphasised that there had been a positive market response to CDSClear’s credit index options offering. Five dealers have already live and another three are due to sign up in early 2019.
Going forward the ambition is to facilitate more dealer liquidity in order to harness an enthusiastic buy-side looking for a highly liquid and low cost credit clearing service.
He reiterated that CDSClear aims to be a “one-stop shop” for European clients, who could trade US and European portfolios without needing to go through multiple CCPs – providing much needed market competition in the market and aiming to be the CCP of choice in Europe for credit derivatives.
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