Derivatives users hit as negative rates raise collateral costs

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Derivatives users are the latest group to be hurt by negative interest rates as they get penalized for the cash they park at Europe's biggest clearinghouses. Traders can thank European Central Bank president Mario Draghi.

Futures and swaps are used to hedge or speculate on everything from German interest rates to oil prices. To avoid taking a loss if a counterparty to a trade defaults, they post collateral, such as government bonds or cash, at a clearinghouse. In Europe, the biggest ones are in Frankfurt and London. But with German and British debt yields so low, or even negative, clearinghouse customers are sometimes losing money on those assets.

Europe's big clearing firms are operated by the likes of Deutsche Boerse AG, Intercontinental Exchange Inc. and LCH, which is majority owned by London Stock Exchange Group PLC. To varying degrees, they have customers who lose money on euro collateral, whereas they used to receive a return. Two-year German debt yields minus 0.64 per cent. An important benchmark known as Eonia, the euro overnight index average, is at minus 0.34 per cent.

While the costs don't so far seem to be impeding trading or collateral holdings, they're a sign that monetary policy may be reaching its limits, as central bankers such as Mr. Draghi have reduced interest rates and bought up vast amount of assets to try to boost weak economic growth. The unusual costs to hold cash at clearinghouses suggest the measures are starting to have unintended consequences.

"It's gotten to the extent that you're seeing negative reactions," said Gregor Macintosh, chief investment officer macro and fixed income at Lombard Odier Investment Managers in Geneva. "The expansion of these easing programs risks enhancing the negative feedback loop. As returns from investment are further suppressed, in turn it's further reducing the incentive to invest."

As clearinghouse members, banks help facilitate clearing for investors such as pension and hedge funds.

While banks may have been willing until recently to absorb the extra clearing cost, Royal Bank of Scotland Group PLC, for example, last week said it is passing along that expense to large institutional clients.

Collateral is vital across the financial system. As new regulations meant to make financial markets safer are implemented, banks and investors are tying up more and more money in cash and government bonds – money that previously could have been used in more profitable ways. In the case of clearinghouses, they could lose money even on cash holdings.

"It's not the cost of clearing that people are worried about, it's the collateral associated with clearing that they care about," said Peter Lenardos, an analyst at RBC Capital Markets in London. "Banks are tying up collateral that is in short supply, and that sits at clearinghouses earning them nothing, and now it may even cost them something."

Low and negative interest rates have been a major burden for banks because they threaten to erode their main profit driver: the gap between their cost of funding and their revenue from lending. The further rates fall, the greater the pressure.

While charges for collateral set by clearinghouses are one thing, banks are reluctant to pass on negative interest rates to retail and commercial depositors for fear that they'll withdraw their cash, which is a crucial source of funding.