Mandatory Clearing for CDS, No Surprise

It was reported last week that dealers are backing a mandatory central clearing counterparty or CCP model for credit derivatives to avoid an alternative plan to move trades onto an exchange.Dealers are agreeing to support the CCP initiative pushed by federal regulators to fend off an alternative plan, which is to bring the credit instruments onto an exchange, the report in the Financial Times said. In addition to accept mandatory participation in a central clearinghouse, major CDS dealers are accepting the inevitability of margining and oversight by the Securities and Exchange Commission, the Reuters article said.

I'm puzzled by this revelation since I assumed that dealer participation in a CDS clearinghouse was a done deal, but I guess not. With the current method of bilateral clearing exposing the entire financial system to systemic risk, and exposing institutions and hedge funds to the perilous fortunes of Bear Stearns, Lehman Brothers and American International Group, I assumed there was agreement on the need to insert a clearinghouse to remove the counterparty risk in the event of a default.

Also, all of the clearing initiatives that have emerged are in some way connected to an exchange. For starters, Intercontinental Exchange acquired The Clearing Corporation (CCorp), whose investors are nine major CDS dealers, and formed a New York-registered trust company to accelerate the CDS clearing initiative. CME Group, operator of the world's largest futures exchange, is adapting its existing CME Clearinghouse to accommodate credit default swaps and has teamed up with Citadel Derivatives Group to develop an electronic execution platform. Global futures exchange operators NYSE Euronext (Liffe) and Eurex, have emerged as the main contenders to offer central clearinghouses for CDS in Europe. Kevin McPartland, senior analyst at TABB Group in New York, said that regulators could allow multiple clearing models to operate. "It would be pretty unprecedented to mandate the use of a particular provider," says McPartland, who then adds, "Anything can happen."

So exchanges appear to be involved in each of these central clearing house initiatives. Evidently dealers want to continue trading these instruments over-the-counter (OTC) - via voice brokerage with dealers involved as intermediaries -rather than submit these trades to an exchange. Is it possible to submit OTC derivatives for clearing to an exchange-backed clearinghouse house, without trading the instruments on that exchange? I guess so.

"There are well established mechanisms to trade these products," said Kim Taylor, managing director & president of the CME Clearinghouse in an interview last week. "People can continue to trade with voice or chat or email," said Taylor with respect to CME's CDS clearinghouse initiative. "There's a small number of trades that are already executed electronically any of those trades are eligible to be submitted to the clearinghouse," said Taylor. "Any trades that are open positions on the members books will be able to submitted to the clearinghouse and be converted into the cleared products," said CME's Clearinghouse President. While CME's partner Citadel is working on execution platform that will electronically trade credit default swaps and indices, that's "optional," according to Taylor.

If dealers are compelled to move their trades onto an exchange, that will lead to more transparency in pricing and more confidence in the marketplace which has been threatened by fears over counterparty risk. Why is that so bad? I understand that dealers have resisted moving their OTC credit derivatives contracts onto an exchange. This will cause their profit margins to go down because the contracts will be homogenized into more vanilla structures and the method of pricing credit default swaps will be transparent to everyone. Credit derivatives have been a moneymaker for large banks at time when they have written off hundreds of billions of dollars in losses from CDOs and mortgage-related securities.

But moving credit derivatives onto an exchange will lead to higher volumes and more electronic trading and pave the way for straight through processing. The theory is that dealers will make-up in transaction volume what they are losing from transparency. This is a pattern that has been repeated in other OTC instruments.

But dealers probably have no choice but to back this regulatory centralized clearinghouse mandate. Relying on dealers to handle bilateral clearing for complex derivatives is no longer viable in the current environment.

One source tells me that dealers bought into CCorp. last year thinking it was a 2011 or 2012 issue. In other words, they could put the need for the central clearinghouse on the backburner. But now it's on the fast track again. Both ICE and CME said they would go live by end of November, said McPartland of Tabb Group.. "I understand that the regulators were fast tracking the application process to get things up and running quickly," he says.I'm puzzled by this revelation since I assumed that dealer participation in a CDS clearinghouse was a done deal. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio