The Daily Collateral Cycle at LCH SwapClear

Central clearing works because the CCP constantly measures and collects margin from every clearing member to cover the risk it is carrying on their behalf. This is not a periodic exercise — it is a daily (and sometimes intraday) cycle that ensures the CCP always has sufficient collateral to cover the default of any single clearing member. Understanding this cycle is essential to understanding how the cleared derivatives market functions.

The cycle begins each evening when LCH runs its end-of-day pricing process for the SwapClear service. LCH constructs yield curves for each currency in which it clears swaps — GBP, USD, EUR, JPY, and others — using a combination of market data from trading activity, broker pricing, and reference rates such as SONIA fixings. These curves are used to value every swap in every clearing member's portfolio at the close of the business day.

LCH's pricing is independent — it does not simply use the prices that clearing members report. This independence is important because it ensures that a clearing member cannot influence the margin calculation by marking its portfolio favourably. LCH's end-of-day prices are the single source of truth for variation margin calculations.

For each swap, LCH computes the present value using its independently constructed curves. The difference between today's present value and yesterday's present value — adjusted for any cash flows that settled during the day — is the day's mark-to-market change. If the swap has moved in value in the clearing member's favour, the clearing member receives a variation margin payment. If it has moved against them, they owe variation margin to LCH.

Variation margin (VM) reflects the daily change in the mark-to-market value of the cleared portfolio. VM is always settled in cash — LCH does not accept securities for VM. This is because VM needs to be settled immediately and precisely; the value of a bond fluctuates, whereas cash is cash.

After end-of-day pricing, LCH calculates the net VM position for each clearing member — the aggregate of all VM gains and losses across their entire SwapClear portfolio. A clearing member with a net VM gain receives cash from LCH; a clearing member with a net VM loss must pay cash to LCH. The margin call is issued in the early morning, and settlement must be completed by 10am London time for the standard morning call window.

LCH also has the ability to issue intraday VM calls when market moves are sufficiently large to create material exposure. During periods of high volatility — such as the March 2020 COVID crash or the September 2022 gilt crisis — intraday calls can be very large and very urgent. Clearing members must have liquidity buffers capable of meeting unexpected large calls at short notice.

Initial margin is the collateral a clearing member must post to cover the potential future exposure of their portfolio — the loss LCH might suffer if the clearing member defaulted and LCH had to close out the portfolio over a defined close-out period (typically five days for SwapClear). IM is not about yesterday's moves; it is about the worst likely move over the next several days.

LCH uses a proprietary risk-based model to calculate IM for SwapClear. This model — known as PAIRS (Portfolio Approach to Interest Rate Scenarios) — uses historical simulation to determine the worst-case loss over the close-out period at a very high confidence level (typically 99.7% or higher). The result is an IM requirement calibrated to cover a severe but not catastrophic market stress event.

For bilateral (uncleared) derivatives, the industry uses a different model: ISDA SIMM (Standard Initial Margin Model). SIMM is a sensitivity-based model that calculates IM from the portfolio's risk sensitivities (delta, vega, curvature) across different risk factors and currencies. SIMM was developed by ISDA to provide a consistent, transparent, and industry-standard approach to bilateral IM calculation under the Uncleared Margin Rules.

IM at LCH can be posted in the form of eligible securities (government bonds) or cash. LCH applies haircuts to securities collateral to account for the risk that the collateral's value falls between the time of posting and the time LCH might need to liquidate it.

LCH publishes a schedule of eligible collateral for IM: the securities it will accept as IM collateral. Eligible collateral typically includes:

• Cash in major currencies (USD, EUR, GBP, JPY)
• G10 government bonds (US Treasuries, UK gilts, German Bunds, French OATs, Japanese JGBs)
• Some high-quality agency and supranational bonds

Lower-quality assets — corporate bonds, equities, most structured products — are not eligible as IM at LCH. This restricts the pool of assets a clearing member can use and is one of the drivers of demand for high-quality liquid assets (HQLAs) in the market.

Clearing members can substitute the collateral they have posted at LCH — replacing one eligible security with another — subject to LCH's substitution process. Substitution is operationally important for clearing members that need to manage which securities are tied up at the CCP versus available for other uses (repo, secondary market sales, other margin requirements).

The settlement of margin calls at LCH happens through TARGET2 (for EUR) and CHAPS (for GBP) — the real-time gross settlement systems of the eurozone and the UK. LCH is a direct participant in these payment systems. When a clearing member pays a margin call, the payment flows directly from the clearing member's account at the central bank to LCH's account.

The settlement window for the standard morning call closes at 10am London time. For the rare intraday call, LCH sets a specific deadline based on how urgently the additional margin is needed.

If a clearing member fails to meet a margin call by the deadline, LCH initiates its default management process. The default management process at LCH is highly structured and has been tested extensively through simulation exercises (known as "fire drills" involving clearing members).

The key steps are:

• Grace period: LCH allows a short grace period (typically 30 minutes) after the deadline before formally declaring a default.
• Default declaration: once a member is declared in default, LCH takes control of the member's SwapClear portfolio. The member's collateral (IM) is immediately available to LCH to cover losses.
• Portfolio hedging: LCH hedges the defaulter's portfolio using macro-level risk hedges to reduce the market risk of the portfolio while it prepares for auction.
• Default management group: a small number of non-defaulting clearing members form a Default Management Group (DMG) to assist LCH in understanding and managing the defaulter's portfolio.
• Auction: LCH auctions the defaulter's portfolio to the remaining clearing members. Members are incentivised to participate actively in the auction because a member that does not participate may have its own default fund contribution used first.
• Default fund usage: if the defaulter's IM is insufficient to cover losses from the default and portfolio close-out, the mutualized default fund is used — contributions from all clearing members. If the default fund is also exhausted, LCH has additional "skin-in-the-game" capital to call upon before considering any extraordinary assessments on remaining members.