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Why LCH and Bilateral Inflation Swap Basis Can Persist

Article Quant Q&A · Author: dvar
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Summary

The note explains why UK RPI zero-coupon inflation swaps can trade at different levels when cleared through LCH versus bilaterally. It identifies two conditions behind such a basis: dealers face an imbalance in client demand across the two markets, and holding the resulting exposure has a funding cost.

The proposed cost is chiefly initial margin. Cleared initial margin ties up cash that earns a risk-free rate, while raising that cash costs a dealer more than the risk-free rate. Bilateral variation margin under a credit support agreement may be passed through, but that does not eliminate the initial-margin funding burden. The explanation is qualitative: it gives no data, model, or estimate of the basis, and says the initial-margin cost can sometimes apply bilaterally as well.

Key ideas

  • A clearing basis can arise when dealer supply and demand are imbalanced across cleared and bilateral markets.
  • Dealers may require compensation when that imbalance leaves them holding a costly exposure.
  • Initial margin uses cash resources and can cost more to fund than the return it earns.
  • Variation margin pass-through does not remove the distinct funding cost of initial margin.

Tags

Fixed incomeDerivatives pricingRisk management
Full text
# LCH/Bilat basis for inflation swaps


# LCH/Bilat basis for inflation swaps












Why does the LCH/Bilat basis for UK RPI ZC swaps exist and what are the drivers behind this basis?

I don't think I've found a convincing answer for this either here, or after a google search. On google, the main reason most came up with were saying corporates are generally payers of inflation and pension funds/insurers are receivers of inflation but wouldn't this bring the basis to 0 as there're flows on both sides? Is it imbalanced with one side being a more dominant force in this market?

I've also seen explanations to do with counterparty risk which I agree exists but it does so for all other bilaterally traded derivatives, and margining requirement differences but isn't most bilateral trading daily margined under a CSA now?

## Answer by dm63 (score 4, accepted)

https://quant.stackexchange.com/a/83716

A bilat/cleared basis typically exists when two conditions exist : (a) a systematic supply/demand imbalance , where dealers end up being received on one and paid on the other and (b) a financial penalty for the dealer to be in that position. The financial penalty is the requirement to put initial margin on the cleared side , and sometimes also on the bilateral side. Note this is different from variation margin, where as you point out, the flows from the bilateral CSA can be passed through to the exchange. The initial margin requirement uses up cash resources, because you typically have to deposit cash at the clearing house on which you receive the risk free rate, but it costs a dealer higher than the risk free rate to raise that cash.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.