The Eurex-LCH Basis: A Persistent Puzzle in Euro Swaps
The difference in pricing between euro interest rate swaps cleared at Eurex and LCH remains a key topic in derivatives markets. Whereas active hedge fund trading has narrowed the gap at the short finish, a persistent basis exists, prompting discussion about how to optimize price discovery and encourage greater competition in clearing.
The Broker Quoting Gap: A Key Obstacle
A central issue contributing to the ongoing basis is the way interdealer brokers currently quote prices. Currently, brokers don’t routinely separate quotes for Eurex and LCH. Some market participants believe that routinely quoting Eurex prices separately would shrink the basis, fostering more transparent price discovery. This would allow for a clearer understanding of the true value of clearing at each central counterparty (CCP).
Eurex’s Growing Resilience: Passing the Volatility Test
Eurex has demonstrated its ability to withstand market stress, even during periods of high volatility like the onset of the COVID-19 pandemic. Analysis of request-for-quotation (RFQ) data shows a relatively even split between Eurex Clearing and LCH, suggesting the market didn’t automatically revert to LCH during a crisis. In some instances, dealers even quoted more competitive bids on Eurex than on LCH, indicating growing liquidity and competitive pricing.
Portfolio Balance Indicator (PBI) and Market Dynamics
Eurex actively monitors the balance of fixed payer and receiver positions among its clients using a metric called the Portfolio Balance Indicator (PBI). This helps them understand exposure and manage risk effectively. The tenor of the swap significantly impacts the Eurex-LCH basis, highlighting the need for a nuanced understanding of market dynamics across different maturities.
Recent Volatility and the Widening Basis
In early 2023, the price gap between euro swaps cleared in London and Frankfurt reached new highs, coinciding with increased interest rate volatility and uncertainty surrounding potential shifts in clearing activity driven by European Commission proposals. This suggests an imbalance in flows and highlights the sensitivity of the basis to broader market conditions.
The Role of Regulation and Market Structure
European Commission proposals aimed at increasing clearing within the Eurozone are likely influencing the basis. The uncertainty surrounding the extent to which activity will transfer to Eurex Clearing contributes to the current imbalance. The interplay between regulatory initiatives and market structure is crucial in shaping the future of the Eurex-LCH basis.
What Does This Mean for Market Participants?
The ongoing basis presents both challenges and opportunities for market participants. Those actively managing risk and seeking competitive pricing need to carefully monitor the basis and understand the factors driving it. Increased transparency through differentiated broker quotes could lead to more efficient pricing and reduced costs.
FAQ
Q: What is the Eurex-LCH basis?
A: It’s the price difference between euro interest rate swaps cleared at Eurex and LCH.
Q: Why does the basis exist?
A: Factors include differences in clearing costs, collateral requirements and market dynamics.
Q: Could the basis disappear entirely?
A: It’s possible, but unlikely in the short term. Increased competition and transparency are needed to narrow the gap significantly.
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