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.”
Regulatory Row
To some extent, the emerging regulatory regime will help to determine which proposition prevails, although this is more a political than a practical issue. In the US, for example, three separate regulators, the Fed, the Securities Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), are fighting to assert control over the CDS market. To make matters worse, each agency leans towards a different entity: the Fed has played midwife to the ICE US Trust proposal while the CME Clearing falls, as with its existing commodities business, under the jurisdiction of the CFTC. The SEC, meanwhile, is more likely to favour an on-exchange proposition akin to the cash equities markets, which would put NYSE-Euronext ahead. None of which, however, may be relevant for long if the new administration overhauls the US regulatory system, as President Barack Obama has suggested is necessary.
Richard Metcalfe, head of policy at the International Swaps and Derivatives Association (ISDA)
If the US landscape seems a little confused, US regulators are at least “pushing on an open door”, says Richard Metcalfe, head of policy at the International Swaps and Derivatives Association (ISDA): in Europe, on the other hand, relations between the regulators and the dealers are fraught. In November, both the European Commission (EC) and the European Central Bank (ECB) called on derivative dealers, exchanges and clearers to commit to establishing what the EC ominously called a “European solution” to the CDS problem, with a concrete industry-led proposal for a European clearing structure demanded by the end of December. Not only has this deadline passed without success, but at the time of writing Brussels has failed to secure even a notional commitment to a European CCP from a sufficient proportion of the dealer community, which is strongly opposed to fragmenting the CDS market across trans-Atlantic lines.
In the European context, Eurex, as the only contender both based and regulated in Europe, would likely be the favourite. But many key parties, in particular ISDA, believe that the creation of a specifically European CCP is an ineffective response to what is a truly global market. “We’d be in favour of the regulatory approach to CDSs being a global one,” says Mr Metcalfe. “We would look for international consistency of approach as the derivatives industry is more cross-border than other markets.” Although broadly supportive of the move to centrally clear CDS contracts, many dealers are likewise campaigning for a global solution. Brussels officials are concerned, however, that the EC would possess limited powers to intervene should a global US-based clearing house run into difficulties. Furthermore, a single clearing house, in so much as it would concentrate all contracts in one proverbial basket, could increase systemic risk, to say nothing of the crassly anti-competitive nature of such a proposition.
London Pull
There is no practical reason why a global solution could not be located in Europe because, as Simon Grensted, managing director, LCH.Clearnet observes, it is London, not New York, that is the true home of the CDS market. It is instructive to note, however, that the dealer community finds it easier to resist the demands of the EC than those of the Fed, says one source close to the EC. Certainly, the EC is debilitated by the forthcoming European parliamentary elections in June which render any legislative action largely impossible in the short term. If the demands of the Fed are more compelling, it makes sense for any US-based solution to assume a global scope: almost by definition, a European solution will not be a global one.
Nevertheless, the ECB’s requirements for a European CCP is, in the words of Mr Grensted, “ineluctable” and, although the regulators are unlikely to mandate dealers to sign up to the model, says the CME’s Ms Taylor, they could deploy capital rules in order to penalise trades that are not cleared. Yet the long-term material success of any enforced European CCP may not be so easy to control, says Mr Yelvington. “If you have two different regimes there will be a market preference for one or the other: banks will simply trade out of their US entity if that is a better solution for them. The EC could find itself in a position where there is an entity set up elsewhere, which everybody uses, and the EU is left effectively with a shell.”
Dealer community
It should come as no surprise that there is a palpable lack of enthusiasm among the dealer community to further the cause of CDS clearing, not least because the associated up-front and ongoing costs that such an entity will entail would be considerable, in addition to the losses that dealers will take as part of the structural shift in the intermediation model. For most dealers, it is not the infrastructural costs associated with connecting to one or multiple CCPs that is so unappealing, but rather the considerable collateral they will be forced to contribute to the CCP’s default fund and the additional risk-related variation margin they will have to post against their portfolio on an ongoing basis. The value proposition of any CCP rapidly erodes once dealers are forced to connect to more than one and to replicate many of these costs in multiple locations.
In many respects, however, this is not the biggest concern for the dealers: a CCP, and worse still, an exchange, will expedite the narrowing of CDS spreads, as well as divesting the dealers of the perks that intermediation brings. It has become well-known, for example, that prime brokers use the collateral that buy-side clients pledge to them as an additional and often-critical source of funding. If CDS trades are cleared centrally, brokers will not be able to demand this collateral or control client funds to the same degree. Moreover, their capacity to differentiate their service by offering preferential collateral rates will be dramatically reduced, directly diminishing the role of the broker as an executor of trades, argues Stephen Bruel, an analyst at TowerGroup. Hedge funds may also be less likely to opt for the more profitable customised CDS contracts if they cannot be cleared, reducing dealer commissions further.
System at large
This last point is especially pertinent, not merely for the dealer’s wallet but for the financial system at large. In a recent report published by inter-dealer broker ICAP, Mark Yallop, the firm’s chief operating officer, raised concerns that the increasing standardisation of CDS contracts as a result of building out a CCP and trading infrastructure would serve to mitigate their primary function: to hedge risk. “Exchange contracts very rarely provide a perfect hedge for actual economic risk,” he wrote, while “OTC contracts can hedge risk precisely”. By enforcing the standardisation of contracts, a central clearing and trading infrastructure may in fact reduce the capacity of traders across the market to properly hedge their exposure. In the past, such unhelpful standardisation killed off FX platform FXMarketSpace and respective attempts by Eurex and CME to trade credit default futures, Mr Yallop points out: this may yet kill off any hopes of a CDS exchange.
This problem is reflected in the somewhat limited scope of the respective CCPs’ initial offerings. In the first instance, only a small number of contracts will be cleared, with index-CDS, based on the Markit iTraxx credit index family, traded first. The CME is the only contender offering to clear single-name CDS contracts from the outset. Market-watchers, including Axel Pierron, senior vice-president at analyst house Celent, believe illiquid and complex contracts may never be cleared. “There are so many different elements in a CDS contract that I think we are far from anyone producing a full solution,” he says.
Axel Pierron, senior vice-president at analyst house Celent
LCH.Clearnet, a self-confessed conservative firm, also believes that the risk attached to clearing single-name contracts demands prohibitively high levels of capital. In the wake of multiple bank failures, “it has become very difficult for a risk manager to model the perception of risk for some of these single names”, says Mr Grensted.
Risk model
Numerous dealers are also concerned that under a mutualised risk model, the more reputable players with stronger balance sheets will have to pay for or subsidise weaker players with a less rigorous approach to counterparty risk. Since the CCP acts as the counterparty to each trade, it is possible that many players trading on a multi-lateral basis will be even less conscientious about their counterparty risk than the crisis has shown them to be historically. This is particularly concerning for many dealers as the variation margin charged on trades relates only to the risk of the dealer’s positions, and not to the counterparty. Any CCP must offer a compelling method of assessing the credit-worthiness of counterparties. Controversially, counterparty risk under the ICE US Trust proposal is reportedly to be assessed by the credit ratings agencies, whose shortcomings have contributed to current problems in the market. If the successful CCP gets it wrong, however, a default could destroy the entire entity.
For this reason, there is a growing belief that the determinism that has characterised much of the regulatory debate on the future of the OTC derivative market is misplaced: unlike stocks or futures, CDSs are not based on a single key measure or parameter that can be easily standardised, and the vast collateral requirements of any entity wishing to offer a comprehensive service could well preclude its existence. According to Mr Pierron, however, it is the CCP providers that have the ear of the regulators and who, in turn, have helped to shape the debate: this being the case, regulators may end up with a solution that suits themselves but not the market.
