What firms should know about the complexities of Repo clearing

What firms should know about the complexities of Repo clearing

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By Jo Burnham, Risk and Margining SME at OpenGamma

With more financial institutions being brought into the uncleared margin rules (UMR) next month, the Repo market is being used to gain access to liquidity. Recently there has been a lot more interest in the clearing of Repos and the subsequential impact on margin.

Ultimately, if a firm is going to make the decision to clear Repos, then they need to know where they can be cleared and how margin is calculated by each of the central counterparties (CCPs). The market takes inspiration from the techniques used on both over-the-counter (OTC) cleared and exchange-traded derivatives (ETD) markets, so there is quite a lot to understand.

LCH has been clearing Repos via its RepoClear service for over two decades now. Initially this business was supported via LCH Ltd, but the service has now been split in two, with LCH Ltd responsible for the UK market and LCH SA looking after the European markets. The other main service in Europe is provided by Eurex, who has also been clearing Repos for over 20 years, starting with the Swiss Franc market. It now covers a similar range of markets to LCH.

However, there are other clearing solutions available, for example Euronext Clearing (ex CC&G) which covers the Italian market and BME clearing which clears Spanish, Italian, Portuguese, French, German, Austrian and Dutch Sovereign Debt. Each of these markets has its own methodology covering both initial and variation margin and, while there are some similarities, there are also differences.

On the major Repo clearing markets, cash variation margin is paid or received in the currency of the contract. This is based on the change in net present value (NPV) of the portfolio. However, because in the OTC world these cash transfers would not take place, an adjustment is made to ensure that the variation margin does not impact the pricing of the contracts. This takes the form of Price Alignment Interest (PAI) – interest is charged on cash received and paid on cash paid in Variation Margin. Although, cash Variation Margin is not always required. BME, for example, calculates a Mark to Market which is then used to either increase or decrease the total margin, in the same way as Option Value on ETD markets.

When it comes to calculating initial margin, the algorithms used vary considerably between the different CCPs. When LCH first launched it was using SPAN, and similarly Eurex implemented Risk Based Margin (RBM) as its initial margin methodology. However, since then they have both moved to VaR. Eurex is now using its VaR based Prisma for calculating Initial Margin on Repo portfolios. Similarly, LCH Ltd moved away from SPAN to utilising its VaR based methodology, and although LCH SA continued to use a SPAN like algorithm for a while, it too moved to VaR in June 2022.

Not to be outdone, Euronext went live with FIRE, its VaR based methodology, on exactly the same day as LCH SA. This replaced MVP, a SPAN based algorithm, that it had used previously. BME, however, is still using a model similar to SPAN called MEFFCOM2. All these algorithms have their own nuances and include multiple components, covering, for example, concentration risk.

The landscape of the cleared Repo market is possibly one of the most varied of all the OTC cleared markets. There are differences in the way that Variation Margin is treated, as well as multiple Initial Margin algorithms going from SPAN-like to VaR based methodologies.

This means that there is a lot to understand and a number of different calculations to replicate if firms want to clear Repos and efficiently manage margin. The cash flows will vary by CCP, as will the collateral that can be used to cover any requirements. Optimising margin will be an option because of the multiple clearing venues available, but choice of CCP will be difficult to predict because of the different features of the initial margin algorithms.

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