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NEW YORK (Reuters) - A widening gap in the costs to hedge interest rate risk between platforms based in London and Chicago is generating losses for Wall Street dealers and creating concern about how well this corner of the bond market will respond when the Federal Reserve raises rates.
In the last month, dealers have frequently been forced to pay a costly premium on London's LCH.Clearnet to offset their risk for facilitating interest rate swaps on smaller rival Chicago Mercantile Exchange on behalf of their clients.
The higher costs may further exacerbate bouts of extreme illiquidity and swings that have recently plagued the bond market, such as the "flash crash" in bond yields last October, an event that has alarmed and baffled regulators. It could test the resolve of dealers to provide liquidity in a pinch.
"Everyone is concerned about it," Jonathan Rick, an interest rate derivatives strategist at Credit Agricole in New York, said about the price disparity.
The rate swaps, in which parties exchange the cash flows from different types of bonds, are an integral part of the fixed-income market, amounting to $381 trillion in notional value. Investors and dealers use swaps as another way to bet for or against bonds as well as to hedge their portfolios.
Due to their importance, regulators required dealers and investors by 2014 to book their interest rate swaps with clearinghouses or centralized counterparties (CCPs) like those operated by the CME Group (CME.O) and its larger rival LCH.Clearnet.
The clearinghouses take on the risk of these trades so they require the swap parties to post margins on them.
There has been a "basis" or pricing differential to clear between LCH and CME, the main CCPs for dollar swaps, because of such things as differences on required margins and costs to finance the margins.
Until recently, it hasn't been a problem. The price of a swap cleared at CME or LCH was miniscule, roughly 0.15 basis point more on CME for a 30-year swap.
But since early May, the spread widened nearly 17 fold at one point. It has eased somewhat recently but remains stretched.
It's unclear what has caused the LCH-CME spread to widen so dramatically.
Some analysts reckoned it might be due to the recent surge in corporate bond supply. Others speculated it might stem from a dealer reaching a threshold on its swap exposure.
Either way, it has occurred at a time when bond yields have risen as investors grow more confident that the Fed will raise rates this year for the first time since 2006. That could be enhancing demand among bond managers to swap fixed rates for floating rates, putting the dealers who facilitate those trades largely on the same side of the market.
The price disparity means that on a $25 million 30-year swap trade, for example, a dealer could be on the hook for about a $100,000 loss if he is paying a fixed rate on a CME swap and has arranged to receive an offsetting fixed rate on a LCH swap.
With this potential loss, a dealer might raise how much he charges a fund to receive fixed-rate payments on a CME swap, traders said.
A fund manager who buys interest rate futures or a fixed-rate corporate bond typically offsets the position by entering into an interest rate swap with a bond dealer. And the swap is often cleared through the CME.
Then, the dealer enters into a swap with another dealer, often cleared through, LCH in an effort to lower his interest rate risk.
Asset managers prefer swaps cleared via CME, while dealers do more through LCH so there has been an imbalance.
"When this imbalance is large enough, hedging flows related to the basis risk can cause the kind of cross-CCP spread we are currently seeing in the market," J.P. Morgan analysts wrote in a research note last month.
CME said it cleared a third of swaps between investors and dealers. But it has a much smaller share in total swap clearing, which LCH dominates.
For dealers, the jump in swap clearing cost has become a trading loss.
In response, dealers may pass on the higher cost to asset managers and other clients, analysts said. Barring that, they may limit their participation, potentially contributing to a liquidity drought.
Reporting by Richard Leong. Editing by Dan Burns and John Pickering