The Eurex-LCH Basis: a tale of known knowns and known unknowns

Since the ECB gave the first signals of a monetary policy tightening regime in the first half of 2022, there have been persistent pricing anomalies in some of the most liquid areas of the rates markets, including Euro interest rate swaps (IRS). A pricing anomaly very close to home is the Eurex-LCH basis (a CCP basis). 

The CCP basis in theory arises from an imbalance in dealers’ inventories at the two CCPs giving rise to initial margin costs, which are then passed down to clients in the form of higher pricing for one side of the trade and lower for the other. The Eurex-LCH basis is highly tenor-dependent. At Eurex, we regularly monitor the balance of fixed payers and fixed receivers amongst end-clients using a metric called the Portfolio Balance Indicator (PBI), which uses net DV01 by client as a proxy measure of exposure. The PBI has given Eurex confidence in the balance of the underlying portfolio structure at the different tenors. Even if not perfectly balanced for some tenors (e.g., 30 yr), the level of balance has at least remained stable or in most instances gradually improved.   

In recent months, however, the behavior of the Eurex-LCH basis at the different tenors has continued to test our conventional understanding. The Eurex-LCH bases at the different tenors have shown significant swings, despite relative stability in the respective PBIs. As an example, consider the 30yr tenor development below.

These anomalous movements are drawing close attention from the market and, understandably, large dealers and clients are looking to Eurex for explanations. The challenge we face is that a detailed analytical review of the dealer and client trading activity reveals no discernable aggregated trends over the recent months. We observe what can only be described as “random tactical positioning” amongst clients (and dealers). 

Historically we have seen a number of instances of short-term anomalous widening of the basis at the different tenors. These have mainly been event-driven, with reversion back to a ‘normal’ range after a short period, and in some cases a ‘new normal’ range. The reversion back to normal is due to the simple fact that the CCP basis is an opportunity ready to be taken. A positive Eurex-LCH basis should attract “fixed receivers” to Eurex with more competitive pricing and vice-versa for a negative basis. When the basis widens far enough, arbitrage opportunities arise from CCP basis swaps, even after factoring all-in costs. The faster these opportunities are taken, the faster the basis narrows. 

To encourage market participants to act quicker when the opportunities arise, we aim to bring much more transparency to the Eurex-LCH basis. We will provide more comprehensive breakdowns of Eurex’s client and dealer volumes, alongside improved disclosure of the PBI by tenor (see also this document for a sample). This will enable market participants to better-differentiate portfolio structure changes from market anomalies in their assessment of the Eurex-LCH basis. I would also encourage you to read a comprehensive educational discussion paper on the Eurex-LCH basis.