The AIG and Lehman debacles have convinced regulators globally that a central clearing counterparty is critical for the future of the credit default swaps market. But many market participants feel that the idea is flawed. Writer Michelle Price.
The collapse of insurance behemoth American International Group (AIG) on September 16 2008 was the biggest financial catastrophe never to happen, or so it was billed at the time. When the financial superpower experienced a paralysing liquidity shortage, leaving it unable to meet its obligations to its trading partners – with whom it had racked up a net notional credit default swap (CDS) exposure of $372.3bn – the US regulators galloped in to prevent what they feared would be a financial and economic apocalypse.
The near fatality of AIG, combined with the demise of Lehman Brothers, shone a light on a sizeable yet opaque over-the-counter (OTC) CDS market that had hitherto escaped regulatory oversight, convincing many that both regulatory and infrastructural change is urgently needed. Discussions on the matter have turned to the well-established central clearing counterparty (CCP) model, found to be successful in the stock, futures, commodities and a number of derivative markets. By enthroning a central clearing and, in time, exchange infrastructure, the obscure CDS market will become transparent, with information on pricing and risk exposures visible to all. In the event of a default, the CCP would absorb any collateral losses and fund the resetting of positions, thereby buffering the wider market and its participants from the systemic chaos of recent months.
Persuaded by this paradigm, the US authorities, led by the New York Federal Reserve, have vigorously campaigned for the creation of a CDS CCP facility, while Senator Tom Harkin, chairman of the Senate Agricultural Committee, has introduced a bill requiring OTC derivatives to be traded only on exchanges. In Europe too, plans are now afoot to set up a CCP infrastructure, in what has been presented as an open-and-shut case in favour of the long-lived model. But as market participants descend into the detail of the proposition, its suitability for the OTC CDS market is growing ever doubtful.
A tempting opportunity
For the clearing agents and global exchanges, of course, the clarion call for a central clearing infrastructure is good news. Recent market developments offer a tempting opportunity for such parties to take a large slice of the high volume that has so far remained all but beyond their purview. For the exchanges in particular, using their clearing businesses to secure a grip on the CDS marketplace is one strategy by which they hope eventually to promote the full on-exchange trading of such instruments.
Four major contenders are vying for this foothold, including CME Clearing, a joint-venture between the Chicago Mercantile Exchange and hedge fund monolith Citadel; Liffe, NYSE-Euronext’s futures and options subsidiary which has partnered with the London-based clearing provider LCH.Clearnet; Eurex, Deutsche Börse’s derivatives exchange; and ICE US Trust, a start-up founded by Intercontinental Exchange (ICE), the US futures and commodities exchange, in conjunction with The Clearing Corporation, a dealer-owned consortium in which ICE recently bought a major stake.
Both CME Clearing and NYSE-Euronext have gained regulatory approval and are operational while Eurex plans to go live by March. As a start-up venture, ICE US Trust, which declined to comment, lags behind although its strong dealer governance marks it out from its rivals as the most promising contender. CME Clearing and Eurex are in the process of courting dealer and buy-side stake holdings, although some parties believe that the predominance of Citadel in the governance of CME Clearing might deter other participants. CME believes it has an advantage, however, by consolidating its new service on its existing platform. “We’re not creating a start-up, or a separate clearing house, or one focused only on CDSs, that would therefore have concentrated risk profiles related to CDSs,” says Kim Taylor, managing director and president at CME Clearing. “We’ve tried to provide efficiencies to users of the clearing service,” she adds.
Eurex has taken the reverse approach, defining a new licence for credit clearing in order to avoid the “co-mingling of highly concentrated and different CDS risks within the existing business to ensure the market’s integrity”, says Uwe Schweickert, senior project manager in the strategy department of Eurex Clearing. Ms Taylor argues, however, that the CME model creates a more “capitally efficient” default fund by spreading the risk across a broader set of products. ICE US Trust, by contrast, will have to raise a hefty $2bn or more, which would be more costly for its members than raising an incremental $400m. In this regard, says Brian Yelvington, an analyst at CreditSights, the CME proposal is favoured by a larger number of parties. “But the same people will tell you that it is not going to happen because they’re going to have to trade where the liquidity is, which comes from dealers.”
The collapse of insurance behemoth American International Group (AIG) on September 16 2008 was the biggest financial catastrophe never to happen, or so it was billed at the time. When the financial superpower experienced a paralysing liquidity shortage, leaving it unable to meet its obligations to its trading partners – with whom it had racked up a net notional credit default swap (CDS) exposure of $372.3bn – the US regulators galloped in to prevent what they feared would be a financial and economic apocalypse.
The near fatality of AIG, combined with the demise of Lehman Brothers, shone a light on a sizeable yet opaque over-the-counter (OTC) CDS market that had hitherto escaped regulatory oversight, convincing many that both regulatory and infrastructural change is urgently needed. Discussions on the matter have turned to the well-established central clearing counterparty (CCP) model, found to be successful in the stock, futures, commodities and a number of derivative markets. By enthroning a central clearing and, in time, exchange infrastructure, the obscure CDS market will become transparent, with information on pricing and risk exposures visible to all. In the event of a default, the CCP would absorb any collateral losses and fund the resetting of positions, thereby buffering the wider market and its participants from the systemic chaos of recent months.
Persuaded by this paradigm, the US authorities, led by the New York Federal Reserve, have vigorously campaigned for the creation of a CDS CCP facility, while Senator Tom Harkin, chairman of the Senate Agricultural Committee, has introduced a bill requiring OTC derivatives to be traded only on exchanges. In Europe too, plans are now afoot to set up a CCP infrastructure, in what has been presented as an open-and-shut case in favour of the long-lived model. But as market participants descend into the detail of the proposition, its suitability for the OTC CDS market is growing ever doubtful.
A tempting opportunity
For the clearing agents and global exchanges, of course, the clarion call for a central clearing infrastructure is good news. Recent market developments offer a tempting opportunity for such parties to take a large slice of the high volume that has so far remained all but beyond their purview. For the exchanges in particular, using their clearing businesses to secure a grip on the CDS marketplace is one strategy by which they hope eventually to promote the full on-exchange trading of such instruments.
Four major contenders are vying for this foothold, including CME Clearing, a joint-venture between the Chicago Mercantile Exchange and hedge fund monolith Citadel; Liffe, NYSE-Euronext’s futures and options subsidiary which has partnered with the London-based clearing provider LCH.Clearnet; Eurex, Deutsche Börse’s derivatives exchange; and ICE US Trust, a start-up founded by Intercontinental Exchange (ICE), the US futures and commodities exchange, in conjunction with The Clearing Corporation, a dealer-owned consortium in which ICE recently bought a major stake.
Both CME Clearing and NYSE-Euronext have gained regulatory approval and are operational while Eurex plans to go live by March. As a start-up venture, ICE US Trust, which declined to comment, lags behind although its strong dealer governance marks it out from its rivals as the most promising contender. CME Clearing and Eurex are in the process of courting dealer and buy-side stake holdings, although some parties believe that the predominance of Citadel in the governance of CME Clearing might deter other participants. CME believes it has an advantage, however, by consolidating its new service on its existing platform. “We’re not creating a start-up, or a separate clearing house, or one focused only on CDSs, that would therefore have concentrated risk profiles related to CDSs,” says Kim Taylor, managing director and president at CME Clearing. “We’ve tried to provide efficiencies to users of the clearing service,” she adds.
Eurex has taken the reverse approach, defining a new licence for credit clearing in order to avoid the “co-mingling of highly concentrated and different CDS risks within the existing business to ensure the market’s integrity”, says Uwe Schweickert, senior project manager in the strategy department of Eurex Clearing. Ms Taylor argues, however, that the CME model creates a more “capitally efficient” default fund by spreading the risk across a broader set of products. ICE US Trust, by contrast, will have to raise a hefty $2bn or more, which would be more costly for its members than raising an incremental $400m. In this regard, says Brian Yelvington, an analyst at CreditSights, the CME proposal is favoured by a larger number of parties. “But the same people will tell you that it is not going to happen because they’re going to have to trade where the liquidity is, which comes from dealers.”
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