Clearing the way

IFR Derivatives 2009
12 min read

Dealers believe the arrival of CDS clearing this year will transform the marketplace, just as ISDA’s release of the 1999 credit derivatives definitions unleashed the potential of credit default swaps a decade ago. Progress has already been made and a roadmap for additional improvement has been drawn, but where the industry is headed is not entirely clear. Jean Haggerty reports.

Uncertainty looms large in the CDS market. Not all of this uncertainty is regulatory: Richard Metcalfe, global head of policy at the International Swaps and Derivatives Association, said regulators should pay as much attention to the quality, quantity and timeliness of OTC derivatives market data they receive as they do to OTC reform, to ensure clarity over where the industry really stands. Yet the headline-grabbing debates have centred on regulation. The industry is trying to push past uncertainty here, to plot a new, more durable future. Yet for the time being, uncertainty is likely to continue.

According to ISDA’s mid-year 2009 market survey of privately negotiated derivatives, released last month, the notional amount outstanding of credit derivatives decreased by 19% in the first six months of the year to US$31.2trn from US$38.6trn. Over the preceding twelve months, credit derivative notional amounts decreased by 43% from US$54.6trn at mid-year 2008.

ISDA claims the reduction in CDS outstanding highlights the progress made implementing operational enhancements, in particular in portfolio compression.

But the issue that has really captured the imagination is central counterparty (CCP) clearing. Work first began on creating a CDS clearing mechanism in late 2006. Even without a regulatory impetus, dealers were attracted to the idea because it would free up capital by reducing counterparty credit risk exposure. It promised reduced operational costs, back office efficiencies and scalability.

According to Bank for International Settlements figures, bilateral netting of OTC derivative positions reduces counterparty credit risk exposure by about 85%. The introduction of central counterparty clearing for CDS should only serve to reduce OTC-related counterparty credit risk exposure further. That is why ISDA has been petitioning the EU for the past five years for a directive to bolster the recognition of bi-lateral netting across all EU member states. Some market participants have called for a Basel Committee-type summit to address interoperability issues arising from the diversity of OTC derivatives and CCPs.

Provinciality reigns

No such summit is currently planned, although the European Central Bank has called for at least one CCP clearing facility for OTC credit derivatives to be located within the euro area.

"Particular priority will be given to the use of euro area infrastructures for clearing credit default swaps denominated in euro, which will be closely monitored by the Eurosystem in the coming months," the ECB said in a recent report reflecting the views of national central bank regulators and the European Commission.

The fragmentation of OTC CCPs into European and US spheres will destroy opportunities to net positive against negative positions, according to Darrell Duffie, professor of finance at Stanford Graduate School of Business. Clearinghouses that are capable of operating in various regions and that have the support of major dealers can reap the benefits of collateralisation and netting across institutions.

As a group, dealers claim to be product agnostic, stressing competition among OTC CCP providers is paramount. Yet competing regulatory agendas have already plagued the CDS market’s CCP experiment.

In Europe, participants have said politics, not just market forces, have driven the decision about whether to use Eurex or ICE. For example, some of the smaller German players have been encouraged to use Eurex’s CDS CCP by their local regulator.

Bayerische Hypo- und Vereinsbank and Nomura International act as clearing members for Eurex’s CDS CCP and, according to Eurex, more than 20 customers are still in simulation.

ICE’s European CDS CCP venture, ICE Clear Europe, lists Bank of America, Barclays, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, Royal Bank of Scotland and UBS as clearing members.

Eurex initially seemed to be in the stronger position to capitalise on the desire for a euro-zone solution, but it has had slow start. It saw the first single-name CDS cleared in late August, but by mid-September Eurex Credit Clear had only cleared transactions with a notional value of €85m in index CDS and €5m in single-name CDS.

ICE Clear Europe, which like Eurex Credit Clear debuted in late July, had already cleared more than €204bn (notional value) across 2,000 European CDS index transactions by mid-September.

Both ICE Trust and ICE Clear Europe expect to introduce single-name CDS clearing for certain, liquid CDS index constituents this autumn. Eurex is exploring plans to offer OTC equity derivatives and interest rate derivatives CCP solutions.

Well-worn criticism

The obvious risk to having a single CCP for OTC derivatives is the concentration of operational risk on that CCP. "But would you rather have more sources of systemic risk or fewer?" Duffie asked. "A case can be made for varying from the common wisdom, by putting all of your eggs in one basket and watching the basket like a hawk."

The question of interoperability must also be met head-on. “It would be crazy to have non-interoperability between [clearinghouses],” said the head of credit trading at one US bank in London. Product fungibility and portability are essential for achieving the industry’s interoperability goals, he said. For both buy-side and sell-side participants it would make risk managing open OTC derivative positions easier and more efficient. CCP providers and dealers will have to work towards this goal together.

Some interoperability issues can be overcome, especially where major dealers have an economic stake in a CCP. But some dealers have warned interoperability between clearinghouses is a pipedream that has been elusive in other markets, for example the European equity markets. Why should it be any different now? Differences in risk models, guarantee funds and risk ratios will all conspire to inhibit interoperability, they warn, while regulators will only be able to push so far.

The counterargument is that cooperation would drive volumes for all competitors, as the ability to net positions for like products between clearinghouses encouraged firms to send more flow to be cleared, said Kevin McPartland, senior analyst at TABB Group in New York.

Earlier this year, major CDS market participants told the New York Federal Reserve they would have a roadmap for offering buy-side clients access to CDS CCPs by December 15. The plan is to provide frequent buy-side users access through a dealer clearing member, unlocking greater transparency and reducing counterparty risk.

A big concern for the buy-side is position portability. “If a buy-side firm's clearing broker was to default, how easily can those positions be moved to another broker?” said McPartland. The ability to switch brokers within a clearinghouse would be welcome, but “it would be ideal if this was also possible between clearinghouses.” He conceded this still looks some way off.

During its first six months of operation, ICE Trust had cleared more than US$2trn (notional) across 22,000 transactions in North American CDS indices. It launched CDS clearing operations in the US in March and now has 13 clearing members. But the war is not yet won. While barriers to entry clearly exist, later CCP arrivals will have the benefit of other vendors’ developmental experience. Some may look to find a niche.

LCH.Clearnet believes its established OTC interest rate derivatives clearing service, SwapClear, gives it invaluable experience that will translate into CDS, according to Simon Grensted, managing director of business development at LCH.Clearnet in London.

CME Group plans to launch both US and European CDS CCPs and is said to be sizing up possible OTC cross-asset class clearing opportunities. Originally, CME Group and its CDS CCP partner, Citadel Investment Group, planned to offer CDS trading and clearing, though now the CDS trading platform idea has been dropped.

“Both buy-side and sell-side participants have expressed an interest in continuing to execute their CDS transactions the same as they do today, but with the added benefit of central counterparty clearing,” said Terry Duffy, executive chairman of CME Group. CME and Citadel will now focus solely on offering CDS clearing services, though they declined to comment further on their product plans.

With AllianceBernstein, BlackRock, BlueMountain Capital Management, the DE Shaw group and PIMCO now all buy-side founding members, and several sell-side participants also looking to get onboard, CME’s CDS CCP offering cannot be discounted.

But its European CDS CCP plans are less advanced, having not yet received UK FSA approval to become a recognised clearinghouse.

New pledges

Fifteen large derivatives dealers, in a letter sent to the Federal Reserve Bank of New York on September 8, committed to new target levels for expanding central clearing for CDS and OTC interest rate derivatives.

“[Dealers] agreed to this because it is easy to do," a market participant in London remarked. The industry also hopes its actions will stave off outside regulatory interference.

The dealers committed to submitting 95% of new eligible trades (calculated on a notional basis) for clearing by October. Tabb Group estimated that at the time of the letter only about 14% of dealer to dealer CDS indexes are currently cleared, and less than 3% of total outstanding notional CDS is cleared.

Dealers also collectively committed to clearing 80% of all eligible CDS trades (calculated on a weighted average notional basis) from October onwards. They promised a new series of performance metrics reports aimed at addressing both new transactions and the outstanding trade population on a monthly basis.

“We will review the performance metrics and targets contained in this letter with the global regulators on a regular basis to ensure that the metrics and targets demonstrate the industry commitment to increased clearing of OTC transactions,” the letter said.

The advancement of OTC cross-asset class CCP models may satisfy US Secretary Timothy Geithner’s calls for broad use of CCPs in OTC derivatives markets. Yet questions remain regarding which types of OTC he envisages being cleared. Regulators are still being given plenty of latitude when designating derivatives as standardised – a prerequisite for CCP clearing.

Market participants believe the dealers should decide which derivatives to standardise and clear centrally, minimising the risk of bad incentives or unintended consequences. They insist they are motivated to do it: standardisation as the industry currently understands it will make products more fungible, said Paul Hamill, a director in Credit Trading at Barclays Capital in New York. This should broaden accessibility and solidify the product's legal certainty, making CDS more attractive from a flow stand point. This would be welcome: while the number of real money CDS clients has edged up recently, the market has lost hedge fund clients, while some banks have scaled back.