Central Clearing of Derivatives Could Help Prevent "Too Bigger to Fail"

With the market evolving for central clearing of credit default swaps and regulators pushing for more transparency and reduction of counterparty risk, exchanges are eyeing new opportunities for central clearing and electronic trading of OTC derivatives contracts. Chris Edmonds, CEO of the International Derivatives Clearing Group, spoke with WS&T Editor-at-Large Ivy Schmerken about the value of central clearing in the interest rate derivatives markets.

WS&T: The market is evolving for the central clearing of credit default swaps. The Obama administration is shaking up the status quo and is pushing for legislation that will require standardized OTC derivatives contracts that will trade on exchanges or electronic trading platforms, and ultimately go through central clearinghouses. What do you think of these developments and how do they change your outlook for the business?

Edmonds, IDCG: Certainly, what the administration has outlined really removes uncertainty in the marketplace. That uncertainty is: Do we really have to do it? Is it a "nice to have?" Is it something that we will have to focus on sometime in the future, or do we have to dedicate our resources toward compliance today? For IDCG it is right in our sweet spot. We provide everything the Treasury proposal has called for. We are certainly very supportive of the proposed legislation.

WS&T: The interest rate market in OTC derivatives is the largest derivatives asset class. Since interest rate swaps are traded over the counter, the market is largely opaque and participants bear a great deal of the counterparty risk. How will central clearing of interest rate swaps bring transparency to the market?

Edmonds: The interest rate market is actually the second-largest market, after FX, but it is still a massive market, some 15 times larger than the current CDS market, so it is a material asset class that the world needs to face. At the end of the day the perception of central clearing and what it provides is really around value. And the value of how we are pricing this risk is the same for all market participants, whether you are the smallest firm on the block or the largest firm. What you get is the same mark-to-market curve.

In the bilaterally managed world that is not always the case. There are instances when you enter into a transaction with counterparty A, with the same product and all of the contract specs the same at one price, and then you enter into an offsetting contract with counterparty B at a different price. In a central counterparty world that transaction means you have a flat position. In a bilateral world you have two positions, and at the end of the day those two positions could be marked widely differently. There is so much subjectivity in a bilateral agreement. The value proposition of central clearing takes the valuation curve and makes it the same for everyone.

WS&T: What is the relationship between the Nasdaq OMX Futures Exchange and IDCG?

Edmonds: We, IDCG, operate under a regulatory contract from the CFTC [Commodity Futures Trading Commission]. One of the products we use in the listed products is [providing] clients the ability to trade off-exchange and then submit those in for clearing through a novation process called transitory EFS, or exchange future for swap.

Under the regulatory construct you have to have a designated contract market, or DCM. Nasdaq OMX Futures Exchange is a DCM. So instead of re-creating a DCM, as we were creating a clearinghouse, or designated clearing organization (DCO) under the CFTC, we decided to partner with one of our sister companies under the Nasdaq umbrella. We will list our contracts there and provide the clearing mechanism and credit mitigation for those contracts. This [was done] specifically for regulatory issue(s) and it works well because it was a Nasdaq holding and we didn't have to worry about what we were creating or who we were doing business with. We all operate under the same [Nasdaq] flag.

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