In this this third video in this series we examine interest rate swap clearing.
Firstly we look at why we need clearing. With long dated contracts such as interest rate swaps there is a chance that a party may default. If the impact of this insolvency is limited to this defaulting party only, then there is perhaps not much cause for concern. But if other firms are dependent on payments received from the bankrupt firm then there is a chance of a cascading series of defaults and systemic risk to the market.
Swap clearing houses thus manage credit risk and serves a circuit breaker against systemic default. Where a default by one party causes multiple insolvency events in other parties. Clearing houses firstly stop large exposures in the market from building up by requiring daily exchanges of variation margin. Secondly in the event of a member’s default they will neutralise the risk in that portfolio while using the defaulter’s initial margin to pay for variation margin gains in surviving member’s portfolios.
This video takes a closer look at the default 'waterfall' structure. This comprises the clearing houses layered defences against a systeming default. This includes variation & initial margin, CCP 'Skin-in-the-game' and a mutualised default fund.
Finally we observe that all of these complex structures, that often require legal, compliance and risk oversight & _could_ all be replaced with SmartContracts. These SmartContract clearing house rules are automatically executed and payments between parties accounts are automatically made.
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