LCH-JSCC basis turns negative on BoJ policy shift

A pricing gap between long-dated yen interest rate swaps cleared at Japan Securities Clearing Corporation and the same instruments cleared at LCH plunged into negative territory at the end of 2023, with the basis jumping fivefold in December alone. 

On December 28, the rate on 20-year pay-fixed yen swaps cleared at LCH was 4.625 basis points lower than the same contracts cleared at JSCC. Just four months earlier, instruments cleared in London had been 2.375bp higher than their Tokyo-bound counterparts, before converging to zero in late November. The negative basis has continued into 2024, with a gap of -3.375bp in early January. 

The reversal is thought to have been triggered by repositioning in London, with US hedge funds abandoning pay-fixed swap positions at LCH as the Bank of Japan edges closer towards ending its yield curve control (YCC) policy. This could have left LCH with an oversupply of receiver swaps. 

“I think what we saw is hedge funds reducing payer positions in the last part of 2023,” says Fabien Lanneluc, Crédit Agricole Corporate and Investment Bank’s co-head of trading for Asia-Pacific and the Middle East, and its head of credit, non-linear and repo trading for Asia. 

In December, the BoJ ditched its 1% cap on 10-year government bond yields but signalled it would stem any a large move in long-end rates by maintaining a reference rate set at the same level.

Lanneluc adds that the winding down of the BoJ’s YCC policy means it is less attractive for hedge funds to keep their long-end yen payer swap positions. 

“Before the July and October 2023 Bank of Japan (BoJ) meetings there was a narrative for international financial market players to try to build a payer position and at some point, BoJ would remove the yield curve control (YCC),” says Lanneluc. “But now, in a way, you can say that it already happened – there will be less big events that will make the long-term rate go higher, which is what hedge funds like." 

The theory is echoed by Tetsuo Otashiro, director of global policy and regulation / OTC derivative clearing services at JSCC in Tokyo, who says positioning of non-Japanese firms such as US hedge funds at LCH has begun to diverge from that of Japanese participants onshore.

“Basis can be developed by various factors. As one of the possible backgrounds this time, it is assumed that non-Japanese currency like US dollar, for longer tenor especially, has already been declining since the end of last year,” says Otashiro. “So participants with an access only to LCH – such as US customers – may possibly be more aggressively increasing their fixed receiving JPY swap as well. But a larger portion of JPY swaps globally is cleared in JSCC, which creates a robust price discovery function that reflects the perspectives of a wide range of investors at JSCC.”

A widening basis between CCPs typically reflects an imbalance of flows created by directional positioning at one or both clearing houses. 

The LCH–JSCC basis is often a reflection of a difference in preference for long interest rate positions between Japanese and overseas investors. 

US buy-side firms are unable to access clearing at JSCC through futures commission merchants due to the Japanese clearing house’s status as an exempt derivatives clearing organisation under US regulations. Instead, they clear their yen swaps at LCH. Meanwhile, Japanese institutions are required to clear receive-fixed swaps, which they use to hedge their loan books, at JSCC. 

The CCP basis reflects the increased funding cost of running directional positions and incurring initial margin at two clearing houses. 

While the LCH-JSCC basis typically bounces around in positive territory – meaning pay-fixed instruments are usually more expensive to clear at LCH than at JSCC – it’s not the first time the gap has turned negative. 

In March 2019, the basis between 10-year yen swaps cleared at LCH and JSCC hit a low of -5.265bp.  This event was attributed to US investors entering receive-fixed swaps in anticipation of yen rates following dollar interest rates lower. 

“It happened in the past, like in 2019, when the US dollar rates or euro rates were moving in the lower direction,” says Otashiro. “Based on our conversation with market participants back then, we understand that, irrespective of the Japanese context, participants such as US investment funds might have taken a view that Japanese yen rate market was also going on the same path.”

Yusuke Ikawa, a markets strategist at BNP Paribas in Tokyo, told Risk.net in late December that directional positions of Japanese institutions at JSCC could also be contributing to the basis. He says some banks have been positioning for higher yen rates by entering into asset swaps. These see traders buy Japanese government bonds and receive the Tokyo overnight average rate plus a spread.

“I think now domestic investors are also paying the swap,” says Ikawa.

He says domestic investors typically buy 20-year and 30-year asset swaps in anticipation of rate hikes as these offer the economics of a floating rate government bond. 

“That means the asset swap banks could be a driver of the paying on the JSCC swap, and that may cause the JSCC swap to be higher than LCH in this market and cause the LCH-JSCC basis to be tighter.”

JSCC officials do not rule out domestic activity as a contributing factor to the recent move in the basis, though they believe positioning at LCH is a more likely driver given JSCC’s larger share of longer-dated yen swap liquidity. 

“Our speculation is that the basis change in the longer tenor is mainly driven by LCH users and this will not be structural and possibly temporary because, in terms of DV01 for the longer tenors, we understand JSCC maintains a significant liquidity share of JPY swap clearing market and JSCC participants represent a wider range of global market views.” says Otashiro.

A spokesperson for LCH declined to comment. 

No room for arbitrage 

Movements in the LCH-JSCC basis have become a gold mine of arbitrage opportunities for participants that can access both clearing houses. In a negative basis scenario, this could see traders pay three-month Tona and receive fixed at JSCC, while receiving the floating rate and paying fixed at LCH. 

At the short end of the curve, arbitrage activity has often meant the basis between the two clearing houses is self-correcting, according to Crédit Agricole CIB’s Lanneluc. It is a different story at the long end, however.  

He highlights five-year tenors, where the basis hit 4bp on a number of occasions in 2023, but quickly corrected to 3bp.

“Whenever it will diverge [on long tenors] it's more difficult for actors to put arbitrage positions,” says Lanneluc. “If you do it in a swap format you need to have credit lines for the client up to 20 or 30 years, and they need to be able to trade it on their side. At five years it’s pretty simple to put in place but 20-year or 30-year, that’s pretty long. So not every bank and end user will be able to do it,” says Lanneluc.

A differential of at least 4bp is understood to be the minimum requirement for the arbitrage on a 10-year swap to be economical.  

While these opportunities are only available to those with access to both clearing houses, some banks have begun passing on the arbitrage to clients that cannot access one or both of the CCPs themselves, in the form of structured notes.