#### Need to know

• LCH’s SwapAgent racked up six-fold growth in 2021, driven by a surge in cross-currency swap volumes.
• Users benefit from operational and capital efficiencies stemming from standardised CSAs and net settlement. Some believe this could translate into a pricing basis between SwapAgent and bilateral trades, similar to a basis for interest rate swaps that emerged between CCPs.
• There are fears that a basis could hurt the market “You don’t want to be splitting liquidity, especially in a market that’s already illiquid,” says Simon Payne at Icap.
• Long-dated cross-currency swaps trading on “old-fashioned” euro and sterling CSAs already trade at a basis to those on dollar CSAs.
• A changing regulatory capital regime, including the shift to SA-CCR, may make it more difficult to calculate a market-wide pricing benefit for SwapAgent trades.

Almost five years after its first trades went live, LCH’s SwapAgent is finally hitting critical mass for cross-currency swaps, as dealers embrace the operational and capital benefits associated with the standardised collateral agreements underpinning the platform.

Now, with 34 banks onboard, some participants question whether these benefits could translate into a pricing basis between SwapAgent contracts and those traded on pure bilateral credit support annexes (CSAs) – similar to the basis which emerged between vanilla interest rate swaps that trade at different central counterparties (CCPs) such as Eurex and LCH.

“Once you have critical mass, you may end up seeing a basis forming between a SwapAgent and a non SwapAgent cross-currency swap,” says Dan Maguire, head of post trade at the London Stock Exchange Group, LCH’s parent.

“I don’t think we’re there yet but from an execution standpoint the pricing is pretty straightforward relative to a non-standard CSA.”

SwapAgent registered over 10,000 trades in 2021, a six-fold year-on-year increase. Activity continues to ramp up, with average daily volume rising to $11.8 billion during the second quarter of this year, almost three times higher compared to a year earlier. Participants reckon the platform now accounts for more than a quarter of all cross-currency swap trading. In interdealer euro/US dollar and sterling/US dollar cross-currency swaps, it represents an estimated 40% of activity. Some dealers say they put as much as 80% of their cross-currency swaps on the platform, with some even refusing pure bilateral trades, particularly if they are backed by euro-denominated CSAs that are “old-fashioned, illiquid and out-of-date”, in the words of Richard Hogan, head of cross-currency swaps and forward FX at NatWest Markets. “People want to trade with SwapAgent counterparties, and all the big banks are on it. If you’ve not got your ducks in a row, you might find that people don’t want to deal with you,” he says. Designed as a halfway house between the cleared and bilateral world, SwapAgent is underpinned by a standard CSA and offers many of the same operational and capital efficiencies as a clearing house, yet without the mutualisation of risk. An informal basis has long existed between non-cleared derivatives based on CSAs. This typically depended on whether the collateral was cash or securities. Dealers say some pricing basis also exists in the cross-currency market for cash CSAs in different currencies: longer-dated cross-currency swaps under euro CSAs are typically quoted at a worse price than US dollar CSAs, both for pure bilateral trades and on SwapAgent. The difference in capital treatment between SwapAgent and bilateral trades on US dollar CSAs, though, is not yet reflected in cross-currency swap pricing. This may, in part, reflect new regulatory capital rules including Basel’s standardised approach to counterparty credit risk (SA-CCR), which mean the capital benefit is patchy across the industry. Some believe that could change as the platform gains traction “If you’ve got two dollar CSAs side by side and one is SwapAgent and one is non-SwapAgent, should they be more aggressive for the SwapAgent one because it’s cheaper capital? I think based on bid/offers today that’s probably not the case, but as time goes on, maybe it will,” says a risk management expert at a vendor. “The basis should be that it’s cheaper to hold a trade in SwapAgent.” While any fracture in pricing could accelerate take-up by second-tier banks which have yet to sign up to the platform, some worry about the potential dangers of a split liquidity pool. “You don’t want to be splitting liquidity, especially in a market that’s already illiquid. It’s not positive for the market. Eventually the market’s going to go that way organically and most banks will sign up to SwapAgent. It might just take longer to happen,” says Simon Payne, head of the cross-currency basis swap desk at Icap. ### SA-CCR complexity Launched in 2017, with support from 14 major dealers including Citi, Deutsche Bank, Goldman Sachs and Morgan Stanley, SwapAgent saw its first trades in September 2017. Cross-currency swaps began trading later that year and constitute the bulk of the$665 billion notional traded on the platform during the first quarter of 2022.

Brokers say cross-currency swap volumes on the platform vary. “Some days we see as much as 50% of cross currency basis swaps on SwapAgent, on others it can be much less,” says Icap’s Payne.

The amount of derivatives notional is high, Payne says, because “most of the big players in the short-end are signed up”. But levels of traded risk going through the platform – expressed as DV01, or the change in dollar value from a one basis point move in rates – can be lower.

“It’s certainly gaining a lot of traction,” he adds.

Like a clearing house, the platform nets coupon payments and variation margin into a single payment. This reduces the amount of collateral in transit and paves the way for variation margin to be treated as settlement – so called settled-to-market (STM). The approach returns the value of individual trades to zero on a daily basis. This allows long-dated instruments to be placed into the lowest maturity bucket for calculating the leverage ratio, which ultimately reduces the amount of capital which must be allocated to trades.

“You get real risk reduction and the associated capital benefits through daily settlement and the netting of variation margin and trade cashflows such as coupons – eliminating unnecessary overnight counterparty risk that exists in today’s bilateral market,” says Maguire.

While the benefits of the STM approach can be quantified to calculate a distinct pricing improvement, dealers say changes to the regulatory capital regime mean this can vary dramatically across counterparties, ultimately making it more difficult to derive a market-wide pricing differential.

Under the outgoing current exposure method for calculating counterparty credit risk, leverage and risk-weighted asset calculations for foreign exchange products, including cross-currency swaps, are subject to a gross notional multiplier. For products of five years or longer, this is set at 7.5%. Using the STM approach, which shunts products into the shortest bucket, the multiplier falls to just 0.5%.

The switch to SA-CCR, which became into force for US banks from January this year and for European banks six months earlier, lumps all instruments into a single maturity bucket – part of an effort to improve netting opportunities.

Benefits are still available given the difference in maturity factor for STM trades compared to the alternative collateralised-to-market (CTM), which is standard for bilateral activities. SA-CCR applies a 20-day margin period of risk plus a 1.5 times multiplier to CTM trades, while STM trades are treated as uncollateralised, with a one-day maturity horizon.

According to Magnus Lindahl, an XVA trader at Nomura, this equates to a capital benefit of 50%–53% for SwapAgent STM trades under SA-CCR.

While the improvement appears diluted compared to the current exposure method, Lindahl adds that SA-CCR applies this benefit across all trades, including short-dated instruments, which are often heavily traded in interdealer markets.

“It may be less clear cut but there are potentially more benefits than before. Previously there wouldn’t have been any benefit for shorter dated trades, whereas now you’ll get a 53% reduction across the board. So potentially it has been increased, but it has also been made a lot more complicated,” says Lindahl.

Jurisdictional quirks many also keep a lid on any industry-wide pricing basis.

Under the original Basel language, SA-CCR does not allow for netting between different CSAs. This means SwapAgent and pure bilateral trades reside in separate netting sets. While Japanese regulators stuck with the original Basel language, EU regulators permit some netting, providing contracts have the same margin period of risk. US regulators went a step further in permitting netting between STM and CTM.

“To get the benefits, one would either have to reduce the amount of bifurcation – so put everything in and over time you get that reduction, or make sure you’re optimised on an ongoing basis. You could end up increasing capital requirements if you have offsetting risk between two different silos,” says Lindahl.

Optimisation firm Quantile – which will be acquired by LCH’s parent, the London Stock Exchange Group, subject to regulatory approval – is already working with banks to transfer risk from legacy bilateral contracts into SwapAgent.

“We are moving FX risk into SwapAgent,” says Andrew Williams, chief executive of Quantile. “If you have an outright FX position in your bilateral portfolio, you can move that into your SwapAgent portfolio, net down the risk and reduce your capital requirements. We’re doing that today.”

### Euro basis

Swap traders are no strangers to pricing variation in seemingly identical instruments. A basis emerged between US dollar interest rate swaps cleared at LCH and CME in 2015, and when Eurex began clearing euro interest rate swaps, a basis emerged between contracts cleared at the German exchange and LCH. In 2017, this euro swap gap hit a high of 2.5 basis point in 10-year contracts.

Since then, the basis has narrowed, and typically bounces around zero, reflecting imbalances between payers and receivers.

Some pricing differentials already exist in the cross-currency market. Many second-tier European banks trading with non-standard CSAs, such as euro or sterling, are already seeing a deterioration in pricing for cross-currency swaps compared to dollar CSAs.

While dealers typically prefer vanilla swaps to be collateralised and discounted using the same currency as the trade itself, for foreign exchange contracts they prefer US dollar CSAs. Trading cross-currency contracts under a euro or sterling CSA exposes the trades to cross-gamma risks. This stems from structural correlations between interest rates and some currency pairs, which create biases to trade one way.

For this reason, cross-currency swaps are typically quoted assuming a dollar CSA and pricing is adjusted according to any non-standard terms in the collateral agreement.

###### More and more banks are going onto SwapAgent with its standard SOFR discounting CSA
Richard Hogan, NatWest Markets

“The market in general is simpler if all single currency products trade on a CSA in the same currency and all FX products trade against a dollar CSA. That’s in essence what a SwapAgent CSA and a cleared CSA is. It gives you a cleaner book with fewer cross gamma effects,” says Lindahl.

Dealers say the difference for a euro or sterling CSA is typically up to half a basis point for trades of 20 years or longer

“If you don’t have a dollar CSA with the name, you adjust the price and might see half point more negative,” says Hogan.

“More and more banks are going onto SwapAgent with its standard SOFR discounting CSA. If you’re not on the platform and still facing everyone on your old-fashioned, illiquid and out-of-date euro CSA or sterling CSAs, you’d have to have the price adjustment,” he adds.

Some dealers argue the kinds of imbalances which drive the CCP basis simply don’t exist between SwapAgent and non-SwapAgent trades. Any gap in pricing – they say – would be largely one way, and simply act as a pricing tool to usher laggard banks on to the platform.

“We’ve seen a basis emerge between CCPs and that’s a proper, tradable market. To some extent you get this on the cleared versus bilateral in the inflation market as well, but I don’t see there being a moving basis market for SwapAgent trades, it would be more of a tool to facilitate market activity,” says Payne.

Hogan believes there could soon be insufficient non-SwapAgent activity – particularly in interdealer markets – to support a basis.

“I can’t see that SwapAgent won’t become completely standard, so there won’t be enough volume in non-SwapAgent trades for that to be a quoted, tradeable basis. You’d need a lot of trades non-SwapAgent trades for that to come into being and I don’t think there will be enough,” he says.

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