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Transaction bankingSeptember 28 2010

CME struggles to find path to CDS clearing

The Chicago Mercantile Exchange has struggled to establish itself in credit default swap clearing against stiff opposition. However, it sees plenty of opportunities, starting with the launch of new trading platforms and the growth of business and partnerships overseas. Writer Geraldine Lambe
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As the financial crisis unfolded in 2008, many believed it would herald wholesale change at investment banks. As the dust settles, however, it is in trading and clearing that some of the most seismic shifts - and the biggest business opportunities - have taken place.

The near collapse of Bear Stearns and the bankruptcy of Lehman Brothers highlighted the counterparty risks associated with credit default swaps (CDS) - the contracts that offer insurance against banks, companies and governments defaulting on debt. By the time it became clear that US insurer AIG had been brought to its knees by selling such insurance on $446bn of bonds, the US regulators had had enough. It was time to bring these opaque over-the-counter (OTC) derivatives into the light, and to force as many transactions as possible into central clearing. Almost overnight, a huge business was created and market participants rushed to create the necessary infrastructure.

The Chicago Mercantile Exchange (CME), which has an existing clearing business for products such as interest rate futures and commodities, partnered with a Chicago hedge fund, Citadel, to design an electronic exchange and CDS clearing house. This posed a direct threat to the OTC trading dominated by the world's largest banks.

The CME's rival, IntercontinentalExchange (ICE), took a more bank-friendly route. It partnered with 10 of the biggest US banks, acquiring the banks' own clearing house, Clearing Corp, and renamed it ICE Trust. To lock in the banks' CDS clearing volumes, ICE agreed to split future profits from the clearing business 50:50.

Banks have opted for the model that does not tread on their toes, and ICE has become the dominant player. Between its launch in March 2009 and September 2010, it cleared $12,000bn of CDS contracts. Following the lukewarm reception by dealers of the execution element of its offering, the CME eventually launched a clearing-only model in December 2009. But, despite pressure on dealers from buy-side clients to clear through the CME and not solely through ICE Trust, between the CME's launch and June 2010, it cleared only $192m of CDSs.

CME chief executive Craig Donohue acknowledges that ICE got the jump on the futures giant with CDS, but he believes there is still a lot to play for. For one thing, the dealer-to-client business has yet to really get going.

"Obviously, dealers have embraced working with ICE to create a narrowly focused dealer-to-dealer facility. We have a balanced clearing facility that meets the needs of both the dealer and buy-side communities. ICE may have taken the lead in CDS, but almost all that business is dealer-to-dealer; there isn't much clearing in the dealer-to-client segment, and that will be an important focus for us."

More importantly, says Mr Donohue, it is still early days for the CDS market and a lot can change, particularly as the legal requirements become clearer. "Regulators are still defining what will constitute a standardised swap contract that can be cleared, and what will constitute a swap execution facility," he says. "This business is only just beginning and, from our conversations with partners on the street, it is clear there is still a substantial opportunity for us, particularly in the dealer-to-client segment of the market, but also in the dealer space. Additionally, we are well positioned for clearing interest rate swaps, where we have a very significant presence in the exchange-traded business."

Challenge from an upstart

The battle with ICE is not the only fracas on the CME's radar. ELX, an upstart futures exchange launched last year and backed by banks including Barclays Capital, Credit Suisse, Goldman Sachs and Morgan Stanley, wants to allow its customers to be able to take out a position in contracts known as 'exchange of futures for futures' (EFFs) and unwind them on the Chicago Board of Trade, a CME unit on which interest rate futures are traded. The introduction of this kind of fungibility - the ability to open a position on one exchange and close it on another - could challenge the CME's virtual monopoly in the trading of US futures contracts.

The CME has so far refused to allow such trades. It says this is nothing to do with the challenge posed by ELX, but is based on Board of Trade rules, which do not permit exchange-for-futures transactions, deeming them to be 'wash' or 'fictitious' trades. However, the CME's defence of its territory was dealt a blow in August when the US Commodity Futures Trading Commission (CFTC), rejected the CME's claim that the ELX futures contract was illegal.

Now that the CFTC has backed ELX, will the Board of Trade unwind EFF positions? No, says Mr Donohue. He denies that the CFTC has backed ELX. The regulator was "placed in a position of having to respond to the issues raised by ELX" and has an ongoing review, "at least half of which has yet to be completed", he says. "There is no requirement that we facilitate these transactions just because a competitor exchange would like us to. And if you look at the latest CFTC correspondence, it makes it clear that the Commodity Exchange Act neither prohibits nor mandates the facilitating of these kinds of transactions."

Even if the CFTC is reviewing the issue, it still leaves the CME disagreeing with its regulator on a fundamental issue. Mr Donohue robustly defends the CME's position. "For several decades, we have adopted rules and provisions that have helped to improve liquidity, and to ensure that the vast majority of transactions executed in the treasury futures market are done openly and competitively, with immediate price reporting and price dissemination. That is how we have built an extremely successful and liquid market that benefits market users and has low transactional and frictional costs," he says. "The ELX model allows for 'non-competitive transactions', away from the central transparent marketplace, and for which there is not timely price reporting or price dissemination.

"If ELX wants to create liquidity in its own products, and to do so by offering a different market model and market structure - that involves less transparency and less centralised and open trading - then that's its prerogative," adds Mr Donohue. "We don't feel it is in the best interests of our market or the liquidity that we provide to allow market participants to establish positions that could be transferred into our clearing house non-competitively. We think that's within our right and our obligation - given our rules, which have been approved by the CFTC - to determine."

New ventures

Such battles aside, the CME sees plenty of opportunities in the new landscape that is emerging, including other new ventures that are jostling for position. In July, five Chicago-based trading houses launched a new exchange that will offer trading in interest rate swap derivatives closely modelled on the current OTC rate swaps. These products will be cleared by CME Clearing.

The new platform, Eris Exchange, hopes to benefit from the regulatory push towards trading swaps on exchanges. The five firms - Getco, DRW Trading, Infinium Capital Management, Chicago Trading Company and Nico Trading - are market makers in equities, options and bonds, and they hope to grab some derivatives business from the Wall Street firms that dominate the OTC space.

Eris will offer trading in interest rate swaps that have been designed as futures contracts but are economically equivalent to the OTC interest rate swaps that are currently traded between dealers and sold to corporates, asset managers and hedge funds. "Essentially, the product can best be viewed as a synthetic alternative to a plain vanilla interest rate swap, which can be traded and cleared as a futures contract," says Mr Donohue. "We are hoping that there will be a number of different product offerings and execution facilities in both swaps and swap futures, and we are well positioned to get the clearing business - especially given our critical mass in the interest rate area."

It is too early to say how successful the platform will be, not least because it is still unclear what the exact rules will be on swap trading and swap clearing. Eris is also an untried product going up against a very established market. "People are accustomed to trading swaps rather than trading swap futures, so it remains to be seen how readily people will adopt an alternative. But there are certainly some very smart people behind it," says Mr Donohue.

The CME has an ambitious global strategy. It aims to increase volumes both through organic growth and through partnerships with foreign exchanges in emerging markets. In March, the CME deepened ties with Bolsa Mexicana de Valores, the operator of Mexico's MexDer futures exchange. A few weeks previous to this, the CME had expanded its alliance with BM&F Bovespa, the Brazilian exchange, after the latter increased its stake in the CME to 5%. The CME also owns 5% of Bovespa. The pair plan to develop a new cross-asset trading platform.

Mr Donohue says such equity investments and partnerships enable the CME to extend trading around the clock and to reach new clients. It also makes trading much easier for clients: before the Bolsa Mexicana partnership, for example, CME clients that wanted access to MexDer's products had to open a local account in Mexico.

"The partnerships give us order routing linkages and enable us to cross-list products, or to host foreign products on Globex [the CME trading platform]," he says. "This is a smart way for us to reach new customers more easily, and also puts us in a good position to sell our core products in foreign exchange, commodities and metals, and to a certain degree our interest rate and equity products."

The CME is also aggressively building its Asian hub in Singapore. It has strong links to the city state, having been active there for three decades. It helped to create the Singapore Exchange, launching the mutual offset system, which offers Asian customers the ability to trade eurodollars and more recently Nikkei and other futures contracts in both Singapore and the US. Users can also transfer positions between the Singapore and CME clearing houses.

It is known that Singapore is keen to become an Asian hub for derivatives clearing. Many believe it hopes to poach business from Europe and the US as regulation reshapes the global market. However, with the US and Europe regulators moving almost in tandem, this may be more difficult to achieve. According to reports, the Monetary Authority of Singapore (MAS) is discussing ways of expanding its clearing capacity, possibly by allowing international derivatives clearing houses to compete with the two Singapore exchange clearers. Some have suggested that the MAS has approached the CME and London's LCH.Clearnet.

Mr Donohue will only say that the CME will continue to have a valuable and productive relationship with the MAS. "Obviously, you can take from the fact that we have a significant hub in Singapore - and the fact that we are increasingly locating sales and marketing people there - that we are very supportive of Singapore," he says.

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