Enhancing the euro yield curve: Eurex rates come of age

It has been a difficult twelve months for many swap users, buffeted by a combination of geopolitical risks and regulatory headwinds, but for Eurex the

By Radi Khasawneh

The origins of the Deutsche Boerseowned interest rate swap clearing business can be traced to the fateful decision by the UK to leave the European Union – the result of a referendum vote in 2016 and finally enacted in 2020. The move undermined the status of the dominant interest rate swap clearing house based in London – London Stock Exchange Groupowned LCH.

From the beginning, Matthias Graulich, global head of fixed income, funding and financing strategy and development at Deutsche Boerse and member of the executive board at

Eurex Clearing, says its strategy has been to create an integrated regional hub for cross product trading across interest rate products, setting it apart from competitors.

“We have strived over the last couple of years to build out this idea of creating a platform that is the home of the euro yield curve,” Graulich told

Global Investor. “We firmly believe that the efficiencies we can achieve as a central counterparty (CCP) across products through multilateral netting, within the common denominator of the euro currency are significant and we believe this is much more sustainable and systematic than what others do across currencies. This preference is likely built on the historic organisation of banks where trading desk were setup along products across currencies, but the need for higher efficiencies have also started to change set-up in banks.

“These different products – bonds, repos, swaps, futures in euro all have something to do with each other in a systematic way. This is what we are continuously rolling out and expanding. So it would be shortsighted when you look at our progress and strategy to look at individual products but rather the development of this broad approach.”

The euro rates strategy has reaped initial rewards for Eurex’s clearing arm. Annual notional outstanding volumes have grown from €12.9 trillion (£11.3 tn) at the end of 2019 to €26.2 trillion in 2022, rising 30% yearon-year (the overall figures include overnight index swaps).

Significantly, its market share in euro denominated interest rate as measured by swaps notional outstanding was estimated by the exchange at 20% at the end of last year, having been 11% in December 2019 and 6% a year before. That is not to say there have not been significant headwinds as the exchange has sought to grow its presence. Last year saw a resurgence of volatility across markets as macroeconomic policy expectations shifted and the effects of continuing regulatory uncertainty around the post-Brexit framework hit activity.

“On the swaps side, 2022 was a challenging year on the one hand but global head of fixed income, funding and financing strategy and development at Deutsche Boerse and member of the executive board at Eurex Clearing also pointed to the successes we have had to date,” Graulich says. “Clearly our liquidity pool is still smaller than for example the LCH liquidity pool, but as volatility increased the positive result was that people stayed with us and liquidity provided by the banks was absolutely competitive compared to the liquidity provided to clients for LCH-cleared swaps. So, there has been a consequential increase in volumes compared to 2021.”

In figures released in January, Clarus Financial Technology estimated that the Eurex market share of euro denominated swaps, as measured by single-sided gross notional, held steady at 6.2% in 2022, compared to 93.8% for LCH.

“From a turnover perspective the growth trend has slowed compared to our main competitor, but this is a natural consequence of the client pool we have intentionally built through the years,” Graulich says. “Pension funds, asset managers, small and mediumsized banks traditionally have lower turnover but hold inventories with the CCP, in contrast to hedge funds and dealer banks that still do most of their business at LCH. In particular, the inter-dealer hedging business makes up two thirds of the market’s average daily turnover.”

The exchange intentionally targeted those clients because of their different risk profile and behaviour, and that has proved effective through the turbulence of last year.

“First and foremost, our objective is to get clients active on Eurex who are natural risk holders,” he adds. “That means directional exposure on the receiver or payer side. That is where we have continued to be a reliable source of liquidity.”

The next year promises to be pivotal for the exchange after a major regulatory obstacle shifted. The European Commission in December published the latest version of its European Markets Infrastructure Regulation (EMIR).

The updated rules include changes such as the mandatory opening of accounts with EU-domiciled CCPs and a requirement to set a minimum threshold for activity in those accounts for European firms. In the previous month, Eurex launched its own incentive program aimed at encouraging activity from clients that had set themselves up to clear but had yet to fully engage.

“The client activation program came out just before the EU announced its fresh legislative approach to promote clearing activities within the EU,” he said. “We have 600 clients and clearing members, but half of the accounts are not active yet. Having set up their contingency accounts with us they had been waiting for further guidance from Brussels. We hope that this clear signal from the European Commission that activity is expected within the EU, together with our incentive program, will create a catalyst to activate dormant accounts and grow activity with already active clients.

“The early indications are good –we have a good number of clients who have signed up already, and there is a significant pipeline of people actively considering it.”

As well as activating dormant accounts, the low thresholds and rewards on offer are expected to significantly increase buy-side participants at the CCP. Eligible clients can reap a €50,000 incentive reward once they start clearing OTC IRS, OIS, basis swaps and zero-coupon inflation swaps this year, with the registration period open until the end of March. That in turn will allow the exchange to expand its activities beyond that core client set over the medium to long term horizon.

“Once we have shifted a lot of risk and exposure from the ‘real’ end clients to Eurex, maintaining this fair balance between receivers and payers, we can start to develop an interdealer liquidity pool,” Graulich adds. “The clear focus in 2023 remains on activating those 300 accounts and onboarding another 100 to 150 that see the regulatory requirement to do something in the EU and choose to act.”

Outside those visible drivers for growth, there are technical indicators that reflect the increasing maturity and resilience of the market, according to Graulich. One example of this is the price differential between the two main euro denominated clearers for the same swap transactions (the Eurex-LCH basis).

The basis can create windows of beneficial pricing for one side of the trade flow, but in functioning markets should be evened out as participants seek to reap the benefits.

“As we have developed our swap clearing offering over the last five years, there have been occasions where there has been an observable widening in the Eurex-LCH basis at certain points,” Graulich says. “The nice thing about it, from my point of view, is that although it has moved out, it tightened again relatively quickly. In November/December we saw a dramatic example of this, and our data shows that participants benefited from it.”

Analysis by Graulich and his team published in late 2022 showed the basis was elevated at certain points in the second half of last year, with 10 year and 15-year swaps in particular peaking above 2.5 basis points in November. That opened the door for a different type of user to emerge and absorb the effect of that variance.

“Where there is a 2.5 basis point differential, with no fundamental reason behind it, then this is a great opportunity to arbitrage,” he adds.

“So, in our case, this has brought clients like hedge funds or other clients with a natural receiver position, to prefer doing this business with us because of their price advantage resulting from the basis. Banks came to us in October to explain why the basis was moving out, and we found that the profile we are seeing from the end users is fairly stable and, in many cases, close to a 50:50 payer-receiver profile cumulated across tenors. It is more than natural that the 30-year side is seeing more receiver than payer interest now, but even there it’s closer to 60:40, so a reasonable balance even at that long end.

“The belief is that some people just positioned to take advantage of the basis, and then certain players like hedge funds stepped in and they arbitrated until the basis came in again. This is a very healthy situation which has demonstrated that there is sufficient liquidity on the Eurex side to deal with temporary mispricing of swaps.”

The wider portfolio of interest rate products has been a significant factor in the way the exchange has demonstrated resilience in the past year.

“We have already built a 20% market share in euro denominated outstanding,” Graulich said. “That figure represents buy and hold accounts. Clients like pension funds are increasingly active on the fixed receiver side which is nicely balanced by the flow from the small and medium sized banks on the payer side. I think here our overall service portfolio plays a very important role in how we see the market developing.”

One key example of that interconnected dynamic has stemmed from the way pension funds have been squeezed for cash to fund their derivative positions. European authorities have pointed to the issue and are still debating the possibility of creating liquidity backstops to support users, but in the interim Eurex has seen a growth in demand for cleared repo services to meet ballooning cash variation margin needs. Graulich says the firm has a pipeline of 20 buy-side firms looking to be onboarded this year.

“Pension funds combine both products, interest rate swaps and cleared repo, for different purposes. They manage their interest rate risk with the swap product and their liquidity risk with the repo product,” Graulich says. “This sometimes goes together when we see a market environment that features both rising rates from a macro perspective and increased variation margin calls for receiver portfolios that pension funds typically hold. The cleared repo market allows these firms to source the liquidity they need to fund the variation margin required for their swap positions.

“Being able to have these two pools in the same place really differentiates us from other CCPs, who have a swap pool in one place and a repo product in another, so they are to some extent separated and you incur transition risk and lose netting efficiencies by using two separate legal pools.”

The demand for client cleared repo has driven overall repo volumes up more than half in 2022, year-on-year, to €144.4 billion in average outstanding volume last year.

Innovating to support the home of the yield curve

The German exchange identified an issue for clients in their collateral and cash management strategies – single security repo had to be collateralised and would tie up scarce resources at the time when clients might need them most.

It reacted in 2005 by creating general collateral (GC) pools that allow electronic money market trading in specific currencies collateralised by “baskets” of grouped central bank eligible collateral. Fast forward to today and Eurex covers 1,500 eligible securities across its baskets in five currencies through the solution.

“The cheapest-to-deliver GC pooling basket allows us to box the securities but still use them for funding purposes until the last day when the securities need to be delivered in the future,” Graulich says. “It addresses a long-standing issue we have observed in the market. With the rising rates we have indeed seen some traction and interest in using this product ahead of the next delivery date.”

That same innovative approach will apply to the problem currently plaguing customers – how to most efficiently manage margin requirements across products. The exchange has ambitious plans for extending the coverage of its clearing house margin netting and optimisation model (called Prisma).

“Cross-product margining has also increased after a long lead time, and we are now seeing requests to integrate repo margining into this ecosystem,” he added. “We have prioritised that in our mid-term roadmap starting in 2023 with the first step bringing repo margining into Prisma and then linking them to the futures in step 2 and eventually swaps in step 3. The great value it would generate for market participants was confirmed in many conversations over the last couple of months.”

These developments go alongside significant recent expansions in its traditional core futures markets to meet that ambition to create an autonomous and resilient European rates market.

Following customer demand, Eurex on January 23 launched its first euro short term rate (€STR) future, entering the battle for a European Libor alternative products. CME Group launched its contract referencing the rate in October. The move is only the first step in Eurex’s plans to develop the short term interest rate and fixed income product suite.

“In terms of new areas for growth, we have seen a shift of interest which has spurred the launch of our own futures referencing €STR, and there is certainly scope for further development of the short end of the euro-denominated interest rate product suite,” Graulich says.

“Similarly, the issuance of EU bonds has increased. I believe this is not a temporary program anymore, so we have been in intensive discussions with the EU Commission and market participants about a possible launch of a future on EU bonds to complement the futures we have on other European sovereign bonds.”