CDS clearing

From Riski

Jump to: navigation, search
Derivative processing costs

See also Credit default swaps, CDS confirmation, CFTC, Derivatives, Regulatory harmonization and ***House derivatives 2009***


Global clearing oversight

CPSS-IOSCO working group for central counterparties

Source: CPSS-IOSCO working group on the review of the recommendations for central counterparties, International Organization of Securities Commissions (IOSCO), July 20, 2009

"The Committee on Payment and Settlement Systems (CPSS) and the Technical Committee of the International Organization of Securities Commissions (IOSCO) have set up a working group to review the application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties to clearing arrangements for over-the-counter (OTC) derivatives. The recommendations, which were developed by the CPSS and the IOSCO Technical Committee, set out standards for risk management of a central counterparty.

In recent years, there have been coordinated efforts by the public and private sector to improve bilateral clearing and settlement arrangements for OTC derivatives transactions. More recently, several existing, newly established, and proposed central counterparties (CCPs) have sought to provide central clearing and settlement services for OTC credit default swap (CDS) transactions, interest rate swaps, and other asset classes of OTC derivatives."

IOSCO principles for securities settlement

Assessment methodology for “Recommendations for Securities Settlement Systems” November 2002, International Organization of Securities Commissions

"Securities settlement systems (SSSs) are an increasingly important component of the domestic and global financial infrastructure. It is for this reason that the Committee on Payment and Settlement Systems (CPSS) of the central banks of the Group of Ten countries and the Technical Committee of the International Organisation of Securities Commissions (IOSCO) established the Task Force on Securities Settlement Systems in December 1999 to develop recommendations for the safety and soundness of SSSs.

In November 2001 the CPSS-IOSCO Recommendations for Securities Settlement Systems were published. The November 2001 report sets out and discusses 19 recommendations for SSSs that identify minimum standards that SSSs should meet. The recommendations are designed to cover systems for all types of securities, for securities issued in both industrialised and developing countries, and for domestic as well as cross-border trades.

These recommendations have been included in the Key Standards for Sound Financial Systems highlighted by the Financial Stability Forum. The CPSS and the Technical Committee of IOSCO encourage national authorities responsible for the regulation and oversight of SSSs to assess whether markets in their jurisdiction have implemented the recommendations and to develop action plans for implementation where necessary."

BIS - Central counterparties for OTC derivatives

We can think of the organisation of derivatives markets as taking one of three forms (Table 1).

The first, the bilateral OTC market, is a fully decentralised market in which participants trade – and clear their trades – directly with one another.

The second is an OTC market with decentralised trading but with centralised clearing through a CCP.

In the third type, an exchange-based market, both trading and clearing are centralised through an exchange that is typically linked to a CCP. As the last type of market organisation is well known, we focus on the first two.

Bilateral OTC market

In a bilateral OTC market, participants trade directly with one another, either electronically or via telephone. The management of counterparty risk – the risk that the person or firm on the other side of the transaction will fail to live up to what is contractually agreed – has two components: collateral and bilateral netting.

In the collateral component, the parties limit counterparty risk by requiring the daily posting of collateral reflecting the mark to market changes in the value of the contracts.

Collateral agreements can be customised to reflect the contracting parties’ assessment both of the riskiness of the position and of each other’s credit quality. The posting of collateral implies that actual counterparty exposures are smaller than market values would suggest.

Surveys conducted by the International Swaps and Derivatives Association (ISDA) indicate that roughly two thirds of OTC derivatives exposures are collateralised and that the estimated amount of collateral in use at the end of 2008 was approximately $4 trillion, of which almost 85% was cash (see ISDA (2009)).

The second component of managing counterparty risk, bilateral netting agreements, helps reduce collateral requirements. The ISDA margin survey cited above indicates that virtually all large banks rely on some form of bilateral netting agreement to control counterparty exposures. In many cases, bilateral netting agreements allow for netting across different contract types.

BIS statistics on OTC derivatives suggest that the impact of bilateral netting is substantial: at end-2008, the gross market value of all OTC derivatives was $33.9 trillion.4

However, after one accounts for bilateral netting agreements, the gross credit exposure came to $5 trillion at end-2008.5 Combining this information with the estimated $4 trillion in collateral implies that uncollateralised OTC derivatives exposure at the end of 2008 came to about $1 trillion.

Bilateral OTC markets have a number of advantages.

First, they facilitate the creation of new financial instruments at a relatively modest operational cost.

Second, bilateral OTC markets allow customers to tailor products to their individual needs.

Nevertheless, in order to facilitate transactions, derivatives contracts have in many cases become more standardised. For example, over the years, interest rate swaps and foreign exchange derivatives have become highly standardised through voluntary industry initiatives. One can think of the variation in standardisation across various contracts as both intrinsic to the variation across the contracts themselves, reflecting how amenable they are to standardisation, and as a reflection of how “evolved” the contracts are.

Their decentralised nature, combined with the heterogeneity of the instruments traded, naturally makes bilateral OTC markets less transparent than their centralised counterparts.

Information on prices and quantities in bilateral OTC markets is much more difficult to come by. Also, in many bilateral OTC markets, market-makers play an important role as intermediaries, profiting from price discrimination among their customers – one possible explanation for the absence of voluntary post-trade price transparency.

That said, many derivatives (including CDS) are increasingly traded on bilateral OTC markets featuring electronic platforms that provide efficient access to real-time pretrade prices, at least for more liquid instruments.

Central counterparty

In an OTC market with a CCP, trading itself continues to take place on a bilateral basis. Once a trade agreement is reached, however, it is transferred, or “novated”, to the CCP: the single contract between the two initial counterparties is replaced by two new contracts between the CCP and each of the two parties.

This structure brings with it a number of benefits. First, as the counterparty for all trades, the CCP can net multilaterally, thereby facilitating the reduction of both counterparty and operational risks.

Netting on a multilateral basis is done by summing each participant’s bilateral net positions with those of the other participants to arrive at a multilateral net position. The resulting multilateral net position is the bilateral net position between each participant and the CCP.

The available data indicate that multilateral netting of new CDS trades reduces gross notional exposures by approximately 90 percent. As more counterparties start using the CCPs, the benefits could be even larger.6

A second benefit from concentrating all outstanding derivatives positions of the participating buyers and sellers in a CCP is that it improves and simplifies the management of counterparty risk, as well as increasing the efficiency of collateral management.

In addition, a CCP will also ensure consistent marking to market, margining and exposure evaluation across its participants.

One crucial characteristic of a CCP is that it mutualises credit and market risk, spreading it among all of its participants. But the capacity of a CCP to absorb risk is determined by the equity capital injected by its members, who own it; the margin it collects; and the practice of marking positions to market.

Existing derivatives CCPs generally collect an initial margin from its members to cover potential future exposure in the event that a clearing member defaults.

This initial margin, which is a form of collateral, is typically delivered either in cash or in the form of securities that have high credit quality and can easily be sold.

As a rule, the CCP will reject new trades from a member whose initial margin is no longer sufficient. In a manner similar to bilateral arrangements, CCPs control risk by marking positions to market and requiring that a variation margin be paid and received each day.

In periods with high volatility, positions may be marked to market intraday to limit the size of uncollateralised exposures."

Banque de France on CDS settlement

"...Given the specific risk profile of CDS, the risk management systems of clearing houses need to be adapted in order to take into account the lower liquidity level of this type of products and the asymmetric risks borne by the clearing house vis-à-vis the protection buyer and seller. At the European level, the ESCB-CESR5 recommendations applicable to clearing houses adopted in June 2009 have integrated the adaptations that are needed to take account of the specific risks involved in the clearing of OTC derivatives. Within the G10 framework, work is underway to adapt the risk management standards applicable to clearing houses, which up until now have not made any distinction between the different types of cleared products to the specificity of the clearing of OTC derivatives.

The development of these services also implies major operational changes for clearing houses. These have to integrate the use of new types of infrastructures, such as the “central registry” for CDS contracts set up by DTCC (“Depository Trust & Clearing Corporation”)6 , which acts as “central registry” for credit derivatives contracts.

Lastly, giving clearing houses access to central banks’ credit operations is essential to facilitate the management of sudden and important liquidity needs that may result from the default of one of their members. As mentioned by the ECB Governing Council on 18 December 2008 and re-asserted on 16 July 2009, it is thus important that – given their potentially systemic importance – clearing houses processing euro-denominated credit derivatives be set up within the euro area in order to ensure their efficient access to credit in central bank money. LCH.Clearnet SA and Eurex Clearing AG, two euro area clearing houses, have announced two projects concerning the provision of clearing services for credit derivatives; the later was launched on 30 July 2009..."

Australian clearing/settlement facility annual assessment reports

As part of the conditions of a granting a licence to operate a financial market or clearing and settlement facility, the licensee must supervise the market in accordance with Part 7.2 of the Corporations Act 2001.

Under the Coporations Act, ASIC must assess, at least once every year, whether a licensee has adequate arrangements to supervise its market.

UK Lords raise questions over clearing houses

  • Source: [ Lords raise questions over clearing houses] Financial Times, March 31, 2010

Clearing houses cannot be supervised by European Union authorities because the EU does not have the financial resources to bail out a large clearing house that runs into difficulties, a report by the upper house of the British parliament said on Wednesday.

The House of Lords report was published as debate escalated over how clearing houses should be regulated and supervised in the wake of the financial crisis...

...The European Commission, in its proposals on OTC derivatives reform, has suggested that a pan-European body such as the planned European Securities and Markets Authority (ESMA) be granted powers to authorise CCPs to operate in the EU and that it may be given supervisory power over them as well.

However, in its report, a committee of the Lords chaired by Baroness Cohen of Pimlico, said the “political reality” was that the cost of any failure of a financial institution, including a CCP, would be borne by the government of an EU member state in which the CCP was situated.

“We recognise that the absence of any cross-border fiscal burden-sharing arrangements for failing financial institutions means that supervision of CCPs at EU level is probably unrealistic,” the report said..."

US oversight of CDS clearing

Mitigating conflicts of interests under Dodd-Frank

Through November 22nd, the CFTC accepted and posted public comments on the proposed rules for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities Regarding Mitigation of Conflicts of Interest.

The industry responded with more than 100 comments to the proposed rules, including submissions from the buy- and sell-sides, exchanges, clearinghouses, Congressmen, MTFs and other parties.

Though there was a diverse group of respondents to the proposed rules, consistent themes throughout the comments favored flexibility for innovation and preserving liquidity. PDFs of each of the responses are available via this link, but shortcuts to several highlighted comments include:

More than 50 public comments for the SEC’s proposed rules on ownership limitations and governance are also available online via this link.

The Lynch amendment on clearing house ownership rules

As dealers and legislators feud over reform of the over-the-counter derivatives market, at least one innocent bystander – New York-based post-trade utility the Depository Trust & Clearing Corporation (DTCC) – has been caught in the crossfire. At the end of February, DTCC staff travelled to Washington, DC to voice their concerns.

At issue is an amendment offered by Massachusetts congressman Stephen Lynch on December 9, which was included in the House version of reform when it passed two days later. The rule would prevent dealers from collectively owning more than 20% of any derivatives clearing house – an attempt to stop the industry hampering progress towards greater use of clearing and a swipe at dealer-backed ventures such as IntercontinentalExchange's Ice Trust and Ice Clear Europe. But it could also catch the DTCC, which regularly shakes up its ownership based on how much members use its services – if one of these periodic reviews resulted in more than a fifth of the DTCC's shares being in the hands of dealers, the consequences could be dire.

"It is impossible to know what would happen," says a clearing industry insider. "DTCC shares are not publicly traded so it might theoretically mean it has to go public, and then completely rebalance the ownership. But the DTCC is also a monopoly, which is only tolerated because it is a user-owned utility, so going public would leave it subject to the usual antitrust laws. To say it is a catch-22 would be an understatement. In theory, it could prevent it fulfilling its charter and put it out of business." One London-based banker is sympathetic. "It is a technical thing, but a real pain for them. It is one thing having a go at banks but the consequence of this amendment is that it is now sweeping up a utility as well," he says.

A spokesman for the DTCC confirms concerns have been raised in Washington, DC but refuses to comment further.

The Lynch amendment specifies that dealer ownership would be restricted only for a "derivatives clearing organisation that clears swaps", which would seem to rule the DTCC out – although it clears a vast swathe of the cash markets, it does not at this point handle swaps business. That apparent exemption hasn't been enough to calm the DTCC's fears, though.

The point could eventually be rendered moot. The impression gathered on the DTCC's Washington trip is that the Lynch amendment has few backers in the Senate, where three different committees are drawing up their own reform bills – which will need to be compressed into a single document before finally being reconciled with the House version. If none of the Senate bills contains a Lynch-type rule, it would be more difficult for the amendment's backers to force it into the final reconciled bill.

"It is tough to say anything definitive, but people are saying there doesn't appear to be a champion. There isn't anyone out there saying ‘I want this to take place, I want Lynch language'," says the clearing industry source.

Until the final bill appears, however, the uncertainty remains – and the notion of restricting dealer ownership of clearing houses has its supporters. Across the Atlantic, an advisory note published on February 11 contains even stronger language than the Lynch amendment, calling for dealers to be barred from sponsoring clearers. The note is for politicians who will vote on the European Union's own OTC reforms. On March 1, Moody's Investors Service released a report that argued the ban on dealer ownership would help tackle systemic risk by making it less likely clearers would compete for business by reducing margin requirements.

Revised petition from the CME Involving CDS

The Commodity Futures Trading Commission is requesting public comment on a revised petition submitted by the Chicago Mercantile Exchange (CME) in connection with credit default swaps (CDS) cleared by CME.

Protests over limits for bank-ownership of clearing houses

A proposed amendment to the US financial reform bill that would limit bank ownership of derivatives clearing houses has been met by a wave of criticism from financial market participants.

The US House of Representatives is expected to vote today on the passing of the Wall Street Reform and Consumer Protection Act of 2009, which is intended to regulate risk across the financial system. The bill is subject to as many as fifty proposed amendments, of which the most contentious is that advocated by Republican senator Stephen Lynch to limit bank ownership of clearing houses.

While Lynch has been drumming up support for the measure in the House, big banks and clearing houses have lined up to decry the proposal.

In a statement published Thursday, TradeWeb CEO Lee Olesky says: "Any significant form of restriction on the ownership of execution platforms and clearing houses is concerning. Aside from being anti-competitive, it is unclear how such a proposal could benefit market participants. Attempting to limit the types of entities that could invest capital in companies that provide these innovative solutions is bad public policy and counter-productive for the evolution of the market."

Similar sentiments have been expressed by a host of other market particpants and industry lobby groups, including LCH.Clearnet, FXAll, Nyse Euronext, Sifma, Isda and the FIA.

With the largest US derivatives clearing houses owned by exchanges rather than banks, the amendment has been criticised for encouraging protectionism and closing down competition.

"Its acknowledged purpose is to knock out one set of competitors while promoting the private business interests of another," FIA president John Damgardwrote wrote in a letter to congressional lawmakers earlier this week. "The amendment conflicts with the public interest in fair and open competition."

In an interview with Bloomberg, Lynch tried to play down the outcry, stating that the amendment won't be applied to existing businesses like LCH.Clearnet, but rather to new entities created to clear over-the-counter derivatives.

Report to the Supervisors of OTC Dealers

Report to the Supervisors of the Major OTC Derivatives Dealers on the Proposals of Centralized CDS Clearing Solutions for the Segregation and Portability of Customer CDS Positions and Related Margin

June 30, 2009

This Report is part of ongoing industry efforts to enable customer access to CDS clearing solutions, an initiative described in the letter delivered to the Federal Reserve Bank of New York on June 2, 2009 from certain sell-side and buy-side institutions:

It is our goal to achieve buy-side access to CDS clearing (through either direct CCP membership or customer clearing) with customer initial margin segregation and portability of customer transactions no later than December 15, 2009.

The legal and regulatory analysis to achieve buyside access will be completed and delivered to supervisors by June 30, 2009. A joint buy- and sell-side group coordinated through IBOC initiated the analysis. If through the analysis we confirm or determine that regulatory and/or legislative changes are required to accomplish buyside access to CDS clearing with customer initial margin segregation and portability of customer transactions, we will seek assistance from supervisors.

In connection with the foregoing, strategic commercial review will be performed by individual institutions which will consider, among other things, tax, legal, regulatory, risk management, interoperability among existing CCPs, implementation, and ongoing operational costs, capital, margining and compliance implications.

Subject to the strategic commercial review, dealers who provide customer clearing services in the ordinary course of their businesses, agree to provide clearing services through CCPs that have

  • (i) broad buy-side and dealer support and
  • (ii) a commitment to develop viable direct and indirect buy-side clearing models

In addition, the market needs to accomplish several work streams including the roll out of Restructuring Credit Event Protocol (small bang) and of single name and index clearing for the U.S./Europe and build out of operational infrastructures industry-wide.

This Report is organized as follows:

We first set forth a brief “executive summary” of the Group’s analysis of the U.S. CCPs and the European CCPs.

In the executive summary, we summarize our views of each CCP’s proposal and highlight particular issues that may need to be resolved. (The summary is subject in its entirety to the more detailed analysis that follows it.)

Next, we discuss legislative and regulatory proposals that may help to enhance the customer protection regime for CDS clearing customers.

We then set out a general framework for the analysis of customer protection issues, with a particular focus on issues relating to the segregation and portability of positions and related margin.

With that framework in place, we consider the specifics of each CCP’s response, summarizing the CCP’s proposals and highlighting what we perceive to be some of the advantages and disadvantages, as well as any unresolved legal, regulatory and operational issues, surrounding each CCP’s customer protection framework, in each case to the extent within the scope of this Report.

New York Fed's oversight related to CDS clearing

Industry letter on OTC clearing March 1, 2010


  • AllianceBernstein
  • Bank of America-Merrill Lynch
  • Barclays Capital
  • BlackRock, Inc.
  • BlueMountain Capital Management LLC
  • BNP Paribas
  • Citadel Investment Group, L.L.C.
  • Citi
  • Credit Suisse
  • Deutsche Bank AG
  • D.E. Shaw & Co., L.P.
  • DW Investment Management LP
  • Goldman Sachs & Co.
  • Goldman Sachs Asset Management, L.P.
  • HSBC Group
  • International Swaps and Derivatives Association, Inc.
  • J.P.Morgan
  • Managed Funds Association
  • Morgan Stanley
  • Pacific Investment Management Company, LLC
  • The Royal Bank of Scotland Group
  • Asset Management Group of the Securities Industry and Financial Markets Association
  • Société Générale
  • UBS AG
  • Wachovia Bank, N.A.
  • Wellington Management Company, LLP

Identical versions of this letter have been addressed directly to the heads of the primary supervisory agency (each, a Supervisor) of each of the regulated signatories, including:

  • Board of Governors of the Federal Reserve System
  • Connecticut State Banking Department
  • Federal Deposit Insurance Corporation
  • Federal Reserve Bank of New York
  • Federal Reserve Bank of Richmond
  • French Secretariat General de la Commission Bancaire
  • German Federal Financial Supervisory Authority
  • Japan Financial Services Agency
  • New York State Banking Department
  • Office of the Comptroller of the Currency
  • Securities and Exchange Commission
  • Swiss Financial Market Supervisory Authority
  • United Kingdom Financial Services Authority

Sixth industry meeting Jan 17, 2010

The Federal Reserve Bank of New York hosted a meeting today of major market participants and their domestic and international supervisors to discuss efforts to improve the infrastructure supporting the over-the-counter (OTC) derivatives market. Today’s meeting is the sixth such meeting with industry participants at the New York Fed.

“The industry must undertake a major transformation to bring significantly greater levels of transparency to these markets. Increasing the amount and quality of market information available to participants, regulators and the public is critical to the work of shoring up the stability and efficiency of the financial system,” said William C. Dudley, president of the Federal Reserve Bank of New York.

Market participants provided an update on developments in the OTC derivatives market and agreed to further improvements to support the overall goals of reducing risk and increasing transparency, including:

  • Expand central clearing for interest rate and credit derivatives: Market participants agreed to increase central clearing of transactions that are currently eligible to be cleared as well as to extend the range of products that are eligible for central clearing.
  • Expand regulatory reporting on OTC derivatives transactions: Market participants will provide regulators with enhanced analysis and reporting to help identify and target opportunities for improvements to increase clearing and standardization.
  • Improve risk management for non-cleared derivatives transactions: Market participants reaffirmed their efforts to formalize best practices for managing the risks of non-cleared OTC derivatives, including collateralization practices.

Market participants agreed to detail their next steps and commitments for addressing these priorities in a letter to regulators by March 1.

The New York Fed will continue to work with domestic and international regulators to encourage further improvements and transparency in the OTC derivatives infrastructure and market.

List of attending institutions

Comments by ISDA:

The International Swaps and Derivatives Association, Inc. (ISDA) today commented on the continuing progress of major member firms in their initiatives addressing further improvements to the privately negotiated derivatives industry infrastructure.

ISDA and its members continue to be committed to the delivery against industry goals in three key areas:

-- Strengthening and diversifying counterparty risk management through increased use of clearinghouses by extending their use to a greater number of individual market participants and product types;

-- Improving transparency by building and using trade repositories for interest rate, CDS and equity derivative transactions; and

-- Further strengthening the operational infrastructure of the privately negotiated derivatives business.

"With the direct input of the supervisory community, we have made significant progress in each of these areas and are determined to make more in the near future in line with ongoing commitments," said Eraj Shirvani, Chairman of ISDA and Head of Fixed Income EMEA at Credit Suisse. "We look forward to working constructively with the New York Fed and other policymakers on these initiatives."

In a January 14 meeting with supervisors, the industry outlined its accomplishments in the following areas:

-- Meeting clearing targets in respect of new and pre-existing eligible trades;

-- Achieving buy-side clearing;

-- Delivering on a range of collateral management targets, including portfolio reconciliation and dispute resolution procedures;

-- Establishment and go-live of trade repositories -- the industry interest rate trade repository has recently gone live and an equity derivatives repository is in build-out phase; and

-- Radically reducing, and in some product areas eliminating, confirmation backlogs.

ISDA and the industry have undertaken to deliver a further commitment letter to supervisors on March 1, 2010, extending and building upon prior commitments.

Industry letter to NY Fed President Sept. 8, 2009

"We are writing to inform you of our commitment to increase the usage of central counterparties for clearing, which we believe will significantly reduce the systemic risk profile of the OTC derivatives market. We have set the following initial performance targets as a demonstration of that commitment. We will increase these target levels, which are the first set for central clearing, as we improve our clearing capabilities.

For Interest Rate Derivatives:

  • Each G15 member (individually) commits to submitting 90% of new eligible trades (calculated on a notional basis) for clearing beginning December 2009. The G15 members (collectively) commit to clearing 70% of new eligible trades (calculated on a weighted average notional basis) beginning December 2009. The G15 members (collectively) commit to clearing 60% of historical eligible trades (calculated on a weighted average notional basis) beginning December 2009.

For Credit Default Swaps:

Each G15 member (individually) commits to submitting 95% of new eligible trades (calculated on a notional basis) for clearing beginning October 2009. The G15 members (collectively) commit to clearing 80% of all eligible trades (calculated on a weighted average notional basis) beginning October 2009.

Furthermore, we will issue performance metrics that address both new transactions and the outstanding trade population on a monthly basis. The first report will be issued on the 10th business day of October 2009 and will be in respect of September 2009, and for each month thereafter, the relevant report will be issued as part of the monthly metrics we currently report.

We will continue to work with the regulators to explore means by which we can look to improve submission levels and clearing yields. 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.

G15 members commit to actively engaging with CCPs and regulators globally to broaden the set of derivative products eligible for clearing, taking into account risk, liquidity, default management and other processes.

The G15 members also commit to work with eligible CCPs and regulators globally to expand the set of counterparties eligible to clear at each eligible CCP taking into account appropriate counterparty risk management considerations, including the development of buy-side clearing. Of course, successful expansion of the sets of eligible products and counterparties is necessarily dependent on several factors, including ensuring proper risk management, CCP capabilities and business choices, regulatory treatment and decisions of non-G15 firms. We commit to work actively with our supervisors and other regulators to remove any of these impediments to our efforts.

  • Bank of America-Merrill Lynch
  • Barclays Capital
  • BNP Paribas
  • Citigroup
  • Commerzbank AG
  • Credit Suisse
  • Deutsche Bank AG
  • Goldman Sachs & Co.
  • HSBC Group
  • International Swaps and Derivatives Association, Inc.
  • JP Morgan Chase
  • Morgan Stanley
  • The Royal Bank of Scotland Group
  • Société Générale
  • UBS AG
  • Wachovia Bank, N.A.

NY Fed meeting Oct. 10, 2008

"The Federal Reserve Bank of New York today will host a second meeting to discuss industry progress toward the creation of a central counterparty for credit default swaps (CDS).

Today’s discussion will include representation from four potential CDS central counterparties: Eurex, NYSE Euronext, CME Group/Citadel and IntercontinentalExchange/The Clearing Corporation.

The Federal Reserve does not endorse any of these specific proposals but is seeking to accelerate market adoption of central counterparty services. Also participating in the meeting are representatives of major dealers, buyside firms, the U.S. Securities and Exchange Commission, the Commodity Futures Trading Commission and the European Central Bank.

The Federal Reserve expects any central counterparty for credit default swaps to satisfy the CPSS-IOSCO Recommendations for Central Counterparties, as articulated in the Federal Reserve Policy on Payments System Risk, in addition to any other statutory and regulatory provisions that may apply to it."

Joint agency MOU on central clearing and CDS markets

"...The Fed, Commodity Futures Trading Commission and Securities and Exchange Commission signed memorandum of understanding today that they said will provide consistent oversight of the clearinghouses and the credit-default swap market. The group laid out guidelines they said would provide more public information on potential risks and also lessen the chance of systemic losses...

...Chicago-based CME, Intercontinental Exchange and NYSE Euronext are vying for control of a global market that could generate as much as $400 million in revenue a year, Keefe Bruyette & Woods analyst Niamh Alexander estimates.

"Bringing transparency to this market is vitally important," SEC Chairman Christopher Cox said in a statement today. "The virtually unregulated over-the-counter market in credit-default swaps has played a significant role in the credit crisis."

The accord signed by the Fed, the CFTC and the SEC "establishes a framework for consultation and information sharing" for the new entities, according to a statement.

No Central Authority

Regulators were driven to sign the accord because there's no central authority for the market, or for the operators of the clearinghouses.

CME is regulated by the CFTC. Intercontinental Exchange has set up its clearing plan as a special purpose banking entity within the state of New York that would be regulated by the Fed. Intercontinental agreed last month to buy Chicago-based Clearing Corp., which is owned by nine major banks. Eurex is part owned by Deutsche Boerse AG.

The agreement between the Fed, the CFTC and the SEC, while not altering their oversight mandates, seeks to ensure consistent rules for clearinghouses that fall under the domain of one or the other. It also would give the SEC better access to market data to police market fraud and manipulation. The SEC hasn't had access to broad market data, hampering its policing ability, Erik Sirri, head of the SEC's trading and markets division, said in an interview last week.

Dealers shutting out buy-side on clearing

Despite regulatory calls for buy-side clearing of credit derivatives, few client trades are being cleared.

In June 2009, major dealers made a commitment to the Federal Reserve Bank of New York to give dealer clients access to clearing for credit default swaps (CDS) in the US by December last year. The December 15 deadline was met by both the Chicago Mercantile Exchange (CME) Group and Ice Trust, the credit derivatives clearing arm of the Atlanta-based Intercontinental Exchange. Both firms are vying to clear CDSs in the US.

What was done in December for CDS was manual and not something that could be operationally sustained on a day-to-day basis.

However, work to make central clearing an operational success is still far from complete, suggest market participants. "What was done in December for CDSs was manual and not something that could be operationally sustained on a day-to-day basis," says one source close to the matter.

Dealers say aspects of the services are not properly automated or scalable, and are not part of the day-to-day workflow of clients at the moment.

"Buy-side clearing of trades isn't really happening. You might have a couple of little outliers where they've done a few trades to say they did it, but it's definitely not pumping numbers through like on the dealer-to-dealer side," says one New York-based banker at a large prime broker.

Although dealer clients, particularly hedge funds, put pressure on the New York Fed to make buy-side clearing available, many of are now taking a wait-and-see approach, says Christian Erickson, New York-based global chief operating officer of prime brokerage at UBS. "In December last year, there was a handful of transactions cleared just to test the pipes and for clients to be able to say ‘yes, we can centrally clear over-the-counter derivatives'. The take-up since then has not picked up a lot of steam. I would say for most of our clients, it's primarily been a wait-and-see approach," he says.

CME Group and Ice Trust insist their services are automated and fully scalable, but admit clearing is at an early stage. CME Group had cleared $47 million in CDS notional across series 12 and 13 of the Markit CDX investment-grade indexes by April 15. The exchange declined to reveal how much of this volume consisted of dealer-to-client trades. On April 9, Ice Trust reported it had cleared $490 million in buy-side CDS notional.

"We had a pilot launch for CDSs, and we met the mandate and successfully cleared business for buy-side clients. That was the pilot launch and we are still working on a public launch," says Sunil Cutinho, Chicago-based director of clearing solutions at CME Group. The company does not yet have a date for the full launch, he adds.

"It's fair to say buy-side clearing is not currently a core part of anybody's day-to-day workflow," admits Peter Barsoom, chief development officer at Ice Trust in New York. Nonetheless, he suggests the reasons for the lack of volume are more straightforward. These include uncertainty over derivatives regulation, which looks likely to compel market participants to clear certain trades, as well as the narrow set of products offered by clearers. At the moment, Ice Trust only offers buy-side clearing for index CDSs, limiting the margin efficiencies that can be obtained by clearing trades. "With the launch of single-name CDSs for buy-side participants, expected in the coming months, we'll have the ability to provide more effective margin benefits across both indexes and single names," he says.

In a letter to the New York Fed on March 1, dealers committed to work with central counterparties to remove the remaining obstacles to buy-side clearing of credit derivatives. While the launch of central clearing represented a "significant milestone", it noted it was "preliminary and requires further substantial work to effectively implement".

Some dealers believe the ability to clear buy-side CDS trades on a day-to-day basis could be six months or a year away. "All of the central counterparties are optimistic about the timelines on which they can develop things like new products and services. And the history of this business is that it takes a lot longer to come to market with something than initially anticipated," says the source.

CME talks with Goldman Sachs, Morgan Stanley on swaps

"- CME Group Inc. is in talks with banks including Goldman Sachs Group Inc. and Morgan Stanley to join a credit swap clearinghouse after signing Pacific Investment Management Co. and BlackRock Inc. as members.

Dealers have met with CME officials at least a dozen times in the past two months to discuss clearing in the $27 trillion credit-default swap market, people familiar with the discussions said. Pimco, BlackRock, AllianceBernstein Holding LP, BlueMountain Capital Management LLC and D.E. Shaw & Co. are joining the venture, now owned by CME and Citadel Investment Group LLC, according to a CME statement today.

“I have to give a lot of credit to the CME for staying the course because it didn’t look very good for them for a long time,” said Darrell Duffie, a finance professor at Stanford University. Early plans to offer execution of credit swaps on CME’s system “gave pause to the dealers” because it would cut into how they make money on the trades, he said.

CME and Citadel, both based in Chicago, have yet to process a trade. U.S. and European regulators have prodded banks to set up clearinghouses for over-the-counter derivatives such as credit-default swaps because risks tied to the contracts complicated efforts to resolve a financial crisis last year as Lehman Brothers Holdings Inc. went bankrupt and American International Group Inc. required a government bailout.

Morgan Stanley hosted a meeting Sept. 9 at its New York headquarters, in which banks and customers discussed access to credit-default swap clearing for dealer clients, said the people who asked not to be identified because the talks were private.

In June, the Federal Reserve Bank of New York and banks agreed to a Dec. 15 deadline to offer dealer customers access to clearinghouses.

Wellington Asset Management Ltd., BlackRock, Moore Capital Management LP, Pimco and AllianceBernstein were among the asset managers that attended the Sept. 9 meeting, one of the people said. Several of the firms expressed their preference for CME, the person said.

Goldman Sachs, Deutsche Bank AG, Morgan Stanley, JPMorgan Chase & Co. and Barclays Plc also attended the meeting, the person said. UBS AG and Credit Suisse Group AG, both based in Zurich, also are among the banks negotiating with CME, the people said.

Spokesmen for the banks and asset managers either declined to be interviewed or didn’t return telephone calls.

“We continue to work closely with both buy- and sell-side participants on our solution,” CME spokesman Allan Schoenberg said. He declined to comment on any details of bank discussions.

Clearinghouses, financed by their members, reduce the effects of defaults by spreading the risk across all member firms. They also provide access to prices and market positions to regulators.

Intercontinental Exchange Inc., based in Atlanta, has cleared more than $2 trillion of credit-default swap trades since March with its ICE Trust clearinghouse. ICE Trust is also working to give access to bank customers to meet the December deadline. The clearinghouse, which has a profit-sharing arrangement with its bank members beginning next year, has said its customer clearing service will be available next month.

While discussions with dealers have advanced, none of the banks have committed to use CME. One barrier outlined in a June 30 report to U.S. and European regulators is that CME’s framework requires that transactions be handled through bank units known as futures commission merchants. Dealers don’t now trade credit-default swaps through those units, meaning they would have to invest in risk management and processing systems to deal with CME’s clearinghouse.

“It’s going to take the cooperation of the dealers” for CME to succeed, Stanford’s Duffie said.

Wall Street banks dominate trading in the market. Dealer- to-dealer credit-swap trades accounted for $21.5 trillion, or 80 percent of existing trades as of Sept. 11, according to New York-based Depository Trust & Clearing Corp., which runs a registry that captures most trading.

A potentially larger hurdle for CME is a concern among dealers that it has the discretion to block banks from tapping a default fund that would be a backstop in the event of a failure by a swaps dealer, according to people familiar with CME’s clearing structure.

One solution may be the creation of a separate default fund for the clearinghouse’s members that gives the banks more control over how the funds are used, the people said.

Interest in CME’s credit-default swap clearing picked up in July after the New York Fed-led group set the mid-December deadline. Theo Lubke, the New York Fed official responsible for the central bank’s efforts to curb risks in the credit-swaps market, has said he wants an alternative to ICE, at least initially.

“A competitive environment, at least in the short run, is beneficial,” Lubke said in an interview in July. “We don’t want the first mover to be the winner just because they’re the first mover.”

Asset managers also have told the banks they want an option that was seen as more independent from the dealers than ICE, one of the people familiar with the discussions said.

CME’s plan for backing credit-default swaps will only offer clearing services for the contracts and will no longer give users the option to execute trades on its electronic system developed by Citadel, the CME statement said.

CME and Citadel gained U.S. approval in March to offer clearing of credit-default swaps.

Intercontinental continues to seek support from both the dealers and asset managers for its plan to allow bank clients to clear through its credit-swaps clearinghouses in New York and London. Frankfurt-based Eurex also is vying for the credit derivatives clearing business in Europe and had an open interest of 90 million euros ($132 million) of trades as of Sept. 17.

ICE Trust last week said it will make it easier for bank customers to access its clearinghouse starting next month, offering hedge funds and swaps investors direct access by trading through a member bank without the fund needing a prior written credit agreement with its trading partner that were created by the International Swaps and Derivatives Association.

Broker-dealers have vested interests in clearers

"...Another debate is over which clearing platforms or exchanges should be used. JPMorgan, Goldman Sachs, Bank of America, Citigroup, Morgan Stanley and other banks will begin sharing profits next year from the credit-default swap clearinghouse ICE US Trust LLC.

While the banks have an interest in supporting that initiative, they’re expected to lobby to remove any requirements that the contracts be executed on exchanges because that would cut them out of making a profit on the trades, according to lawyers working for the banks.

“The broker-dealers are happy to clear as much as they can because they do have a vested interest in the clearing companies that they’re clearing these products through,” said Aite Group’s Zubulake.

Chicago-based CME Group Inc., the world’s largest futures exchange, would be a logical place to clear interest-rate swaps because it already clears Eurodollar futures, which are often used as a hedge for rate swaps, Zubulake said. He doubts that will happen though.

“They don’t want to clear an interest-rate swap through the CME because they don’t own the CME,” Zubulake said.

Paul Gulberg, a colleague of Peabody’s at Portales Partners, said the most likely outcome is legislation requiring that trades be reported and, in some cases, cleared. He said it’s “not very likely” the law will force derivatives onto an exchange or an electronic facility."

Fannie and Freddie to centrally clear swaps

"...Fannie's and Freddie's regulator seems intent on changing course regardless of the political winds. Martha Tirinnanzi, chairman of the FHFA's clearinghouse working group, said at an industry conference in March that Fannie Mae and Freddie Mac are "going to central clearing" even if current legislation that includes clearing mandates doesn't pass.

There were $342 trillion of interest-rate swaps outstanding as of June 2009, according to the Bank for International Settlements. Fannie Mae and Freddie Mac have more than $2 trillion of interest-rate swaps on their books, according to public securities filings. Market experts say that share, while under 1%, is among the biggest if not the biggest held by any participant.

A number of exchanges are now vying for Fannie's and Freddie's clearing business, including Nasdaq OMX Group Inc. and CME Group Inc.

J.P. Morgan officials favor the use of a London-based clearinghouse, LCH.Clearnet Group Ltd., according to people familiar with the matter. LCH, in which several U.S. banks including J.P. Morgan are stakeholders, has been the most active clearer of the derivatives, according to firm data.

Meanwhile, in recent months, the agency has been running tests with the International Derivatives Clearing Group, or IDCG, a clearinghouse operator majority-owned by Nasdaq. It also has been testing the systems of LCH.Clearnet and CME.

The FHFA is likely to select more than one exchange, according to a person familiar with the matter.

Some see the IDCG as a front-runner, since its clearing system has been operational since early 2009. A number of large brokerage firms have signed on to its platform, including Newedge USA LLC and MF Global Holdings Ltd..."

New York Fed’s Lubke said to be joining private sector

Theo Lubke, who led the Federal Reserve Bank of New York’s effort to curb risk in the private derivatives market, plans to leave the central bank, according to a person familiar with his decision.

Lubke, 43, has been reassigned as a senior vice president working on internally focused special projects at the bank while he seeks a private-sector position, said the person, who declined to be identified because the move hasn’t been made public. Stacy Coleman, a vice president at the bank, has replaced Lubke on derivatives matters, the person said.

In 2007, Lubke was appointed to his former role by Timothy Geithner, now Treasury Secretary, who was then president of the New York Fed. The central bank has pushed for changes in the credit-default swap market since 2005, when Geithner became concerned that an explosion of trading was threatening the ability of banks and regulators to manage and monitor risks that posed a threat to the financial system.

The $32.7 trillion credit swap market complicated efforts to resolve the financial crisis when market users and regulators couldn’t easily determine how interconnected banks had become from using the contracts. They were also used to replicate pools of mortgages that banks created to sell to investors, in what was known as synthetic collateralized debt obligations. Losses from synthetic and other types on CDOs have totaled more than $114 billion since the third quarter of 2007, according to Bloomberg data.

New York Fed spokesman Jeffrey Smith declined to comment.


Lubke led efforts that pushed credit swaps dealers to begin moving trades through clearinghouses after the September 2008 collapse of Lehman Brothers Holdings Inc., one of the biggest dealers in the market. Amid meetings between regulators and the industry following Lehman’s collapse, Chicago-based Clearing Corp., owned by credit-swaps dealers, agreed to sell itself to Intercontinental Exchange Inc., which has since cleared $11.5 trillion of the contracts through Aug. 27.

“He spearheaded the effort for the Fed and worked with academics and market participants to get the full story,” said Brian Yelvington, head of fixed-income strategy at broker-dealer Knight Libertas LLC in Greenwich, Connecticut, who spoke at a Chicago Fed symposium this month on derivatives clearing. “Theo has done a tremendous job at gathering information from all participants in the OTC markets regarding how best to strengthen the markets.”

Lubke’s new assignment was designed to avoid conflicts of interest while he negotiates with potential private-sector employers, the person said. The move by Lubke, who has worked for the central bank for 15 years, was effective yesterday and announced within the bank on Sept. 10, the person said.

CDS utilities

Clearing and systemic risk

$1 bln rev potential for clearinghouses

Morgan Stanley said it expects central clearing of over-the-counter (OTC) derivatives to provide a $1 billion (619.7 million pounds) revenue opportunity for clearinghouses starting in 2012.

"We expect significant levels of standardized OTC derivatives to be centrally cleared in two-to-three years, driven by changes in legislation and regulation, decreased tolerance for counterparty risk post-Lehman, increased demand for transparency and reduction of systematic risk," Morgan Stanley said.

About 60 percent of total OTC derivatives outstanding will be centrally cleared in two-to-three years compared with the current level of 20 percent, it said.

"The clearing revenue opportunity is global and will be partially dependent on in which region contracts are traded and which clearinghouse clears it," Morgan Stanley said.

Central clearing, in which a clearinghouse stands between the two parties to a trade and assumes the risk of a default, is seen by U.S. and European regulators and legislators as key to reducing risks of derivatives due to the maze of exposures the contracts create between firms.

Last week, the U.S. House of Representatives approved a section of the reforms bill that would impose regulation for the first time on the $450 trillion over-the-counter derivatives market, including credit default swaps (CDS).

The global CDS market is worth about $26 trillion and has been under scrutiny as governments push the wider derivatives market through central clearinghouses.

IntercontinentalExchange Inc (ICE.N), the derivatives exchange operator, has already taken the lead in clearing CDS, as governments push to install central counterparties in the private market blamed for exacerbating the financial crisis.

CME Group Inc (CME.O), the world's largest derivatives exchange operator, also began clearing U.S.-based credit derivatives from Tuesday.

Industry infrastructure being repurposed

A 'Hybrid' of Existing Systems

"The new OTC world is really a hybrid of old and existing derivatives systems," observes Stephen Li, a director in prime brokerage at Barclays Capital. "A lot of the CCPs are leveraging existing derivatives third-party affirmation systems to get the trading into clearing."

For example, London-based Markit Partners acquired Swapswire, the leading electronic trade affirmation and confirmation service for interest rate swaps, and has renamed it Markit Wire. Through a joint venture with the Depository Trust and Clearing Corp. (DTCC), Markit also operates MarkitServ (formerly DerivServ), an affirmation and confirmation service for credit derivatives.

DTCC also operates the global repository for credit derivatives, the Trade Information Warehouse. ICE Trust's ICE Clear platform leverages the ICE Link (formerly known as T-Zero) messaging service, and CME Clearing obtained its OTC derivatives clearing service, CME ClearPort, in its acquisition of Nymex.

"There's been an effort to leverage existing frameworks within the industry," says Li, who points out that the existing affirmation services "were critical in getting to the first cut of clearing in December." "This is the quickest way to market for [the CCPs]," he adds.

Meanwhile, Bloomberg has built a trade-screen confirmation service, VCON (for voice confirmation), that automatically affirms both sides of OTC derivatives trades and can route them to multiple CCPs. "The buy side can use VCON to route the trade details over to MarkitServ," says George Harrington, Bloomberg director of credit trading.

"If you were doing a CDS trade, you may choose to clear that trade through a facility like CME or ICE," Harrington explains. "Or it will be a bilateral, non-cleared trade, and [the brokers] will legally execute that trade at MarkitServ or Market Wire for interest rate swaps."

In addition to Bloomberg, Tradeweb, which provides straight-through processing for OTC derivatives trades, could provide connectivity into the CCPs, while futures technology providers such as SunGard, which offers the GMI trading system for futures, also are contenders.

Competitive Cooperation

Some of these third-party providers, however, are competitors with the affirmation services; yet they all must cooperate to bridge the gaps into the CCPs. For instance, LCH.Clearnet has to be accessible on Markit Wire for interest rate trades to get to clearing, according to Li. "There is talk that other systems might pipe into Markit Wire to get to LCH.Clearnet," he notes.

A system such as Bloomberg can get into ICE Link to then connect with ICE Clear, the clearing system at ICE Trust, according to Li, who notes that Bloomberg is used heavily by the buy side for accessing the dealers' prices on OTC derivatives and for its daily messaging services. But some buy-side firms, Li adds, may see Bloomberg as costly because of the terminal fees.

According to Pete Axilrod, DTCC managing director, new business development, "The existing technology is very good," and technology changes aren't necessary to accomplish central clearing of OTC derivatives. Ninety-five percent of all credit derivatives trades are confirmed electronically and processed in real time via MarkitServ, he contends. "The bulk of the trades that are cleared leverage our infrastructure. MarkitServ is a provider of electronic confirmations [in credit derivatives] and can send trades to multiple CCPs."

But what happens if a credit derivatives trade is executed bilaterally by the buy side with a dealer and is not eligible for central clearing? "If it's a bilateral trade, it can be directed to a repository," says Axilrod. "And if it's a cleared trade, it can be directed to the appropriate CCP and to the [Trade Information Warehouse]."

According to Mark Cox, director of clearing solutions at CME Group, "The assumption is that market participants will execute their trades as they do today, in bilateral markets. Clients negotiate their OTC derivatives trades bilaterally with their counterparties and then affirm their trades on an existing, established third-party trade affirmation platform or directly on CME ClearPort to allow participants to send trades to us."

But DTCC's Axilrod is concerned that some of the exchanges/clearinghouses, including CME Clearing, are rolling out their own front ends. "I know that exchanges are promoting their own front ends," he says. "In my mind that is just complicating everything because then you have to hook up to multiple front ends. But there are providers that will hook you up that are agnostic to where you want to clear."

ICE dominates CDS clearing

Intercontinental Exchange Inc., owner of the largest credit-default swap clearinghouse, started guaranteeing trades between banks and clients such as hedge funds a day before a U.S. deadline to improve the $26 trillion market.

The ICE Trust clearinghouse became the first to process customer trades after receiving U.S. regulatory approval, Atlanta-based Intercontinental said today in a statement. Ten hedge funds and asset managers conducted testing before today with the 12 dealers who are ICE Trust clearing firms, the company said.

“The collaboration of the buy-side and dealer community played a key role in the successful development and launch of customer clearing,” Dirk Pruis, president of ICE Trust, said in the statement.

Regulators in the U.S. and Europe pushed the financial industry to improve market structure and reduce systemic risk after last year’s bankruptcy of Lehman Brothers Holdings Inc., one of the largest credit-swap dealers, froze trading and cost investors hundreds of millions of dollars.

Clearinghouses, which are capitalized members, increase stability in over-the-counter derivatives markets such as for credit swaps because they lessen the effect of a default by sharing that risk among the membership and use daily margining procedures to keep accounts current. They also allow regulators to see market positions and prices.

Same-Day Clearing

Since its inception in March, ICE Trust has only been open to banks. Investors have demanded the protections of clearing to avoid the risk of counterparty default such as with Lehman Brothers. ICE Trust said its new system will segregate customer margin payments and allow that money to be transferred in the case of a dealer default. It will also allow trades to be cleared on the same day they are executed, according to the company.

In June, the Federal Reserve Bank of New York and banks agreed to a Dec. 15 deadline to offer dealer customers access to clearinghouses. ICE Trust faced delays in starting customer clearing after saying in July it would begin customer clearing in October. It still needed regulatory approval as of Oct. 2 when it said it would begin the service this month.

ICE Trust didn’t disclose which bank customers are participating in its clearing services. It quoted executives from AllianceBernstein Holding LP, D.E. Shaw & Co. and BlueMountain Capital Management LLC, among the largest users of the CDS market, in a Sept. 8 statement about customer clearing for credit swaps.

Role of Swaps

Credit-default swaps were created initially as a way for banks to hedge their risk from loans. They became popular vehicles for hedge funds, insurance companies and other asset managers to speculate on the quality of debt or the creditworthiness of companies because they were often easier and cheaper to trade than bonds.

On Dec. 11, the U.S. House of Representatives voted to tighten rules for derivatives and create powers to break apart healthy financial firms that threaten the economy in the wake of last year’s financial crisis. The Senate is expected to take up the measure early next year.

Lawmakers voted to create a Consumer Financial Protection Agency, expand oversight of hedge funds and build a $150 billion industry fund the government would use to take apart failed systemically risky firms.

Clearing in Europe

An amendment to the bill limits bank ownership in new clearing or execution services to 20 percent. Firms in existence with bank stakes exceeding 20 percent as of Jan. 1, 2010, would be exempt unless they change their ownership structure.

In a separate statement today, Intercontinental said its European clearing service started processing credit-swap trades on the debt of individual companies, or so-called single name contracts.

London-based ICE Clear Europe will, in the first phase of single-name credit default swap clearing, guarantee debt of European utility companies, the exchange said. Nomura Holdings Inc. and BNP Paribas SA have joined ICE Clear Europe as credit- swap members, the exchange added.

The two credit-swap clearinghouses have guaranteed more than $4.3 trillion of the transactions since March, the company said today. ICE Trust accounts for over $3.1 trillion of that figure.

Intercontinental competitor CME Group Inc., the world’s largest futures exchange, has yet to clear a trade in the credit swap market. The Chicago-based exchange has said it plans to be ready by tomorrow to guarantee trades in indexes and single-name contracts. Eurex, Europe’s largest futures market, is also competing to back the trades with its clearinghouse.

Frankfurt-based Eurex has processed five trades as of Dec. 10, according to its Web site.

ICE Clear Europe receives limited CFTC registration as DCO

"The Commodity Futures Trading Commission issued an Order on Friday, January 22, 2010, granting ICE Clear Europe Limited (ICE Clear Europe) registration as a derivatives clearing organization (DCO) pursuant to Section 5b(b) of the Commodity Exchange Act. ICE Clear Europe is a private limited company organized under the laws of England and Wales. Pursuant to an order that the Commission issued on July 23, ICE Clear Europe has operated within the United States as a multilateral clearing organization. ICE Clear Europe clears energy-based contracts and credit default swap contracts on European reference entities. As a registered DCO, ICE Clear Europe is authorized to clear futures contracts, options on futures contracts, commodity options and over-the-counter derivative contracts."

CME clears first credit swap

"CME Group Inc., the world’s largest futures market, guaranteed its first credit-default swap with its clearinghouse as a Federal Reserve deadline to improve the $27 trillion market expires.

The trades cleared today were between a bank and a client, spokesman Michael Shore said in an e-mail. The Chicago-based exchange has struggled to attract bank business to process trades as competitor Intercontinental Exchange Inc. has guaranteed more than $4.3 trillion of the contracts with its two clearinghouses since March.

“It’s a huge leap forward,” said Paul Hamill, a director in credit trading at Barclays Capital in New York, who said his bank was the first to clear a credit-default swap trade through CME’s system. “It makes it more transparent, more robust and reduces systemic risk.”

In June, the Federal Reserve Bank of New York and banks that dominate the market set today as a deadline to offer dealer customers access to clearinghouses. Atlanta-based Intercontinental Exchange processed its first bank customer swap trade yesterday, according to the company.

Regulators in the U.S. and Europe pushed the financial industry to improve market structure and reduce systemic risk after last year’s bankruptcy of Lehman Brothers Holdings Inc., one of the largest credit-swap dealers, froze trading and cost investors hundreds of millions of dollars.

Clearing Procedures

Clearinghouses, which are capitalized by their members, increase stability in over-the-counter derivatives markets such as for credit swaps because they lessen the effect of a default by sharing that risk among the membership and use daily margining procedures to keep accounts current. They also allow regulators to see market positions and prices.

The CME Group clearing could increase transparency in the market because the company is not restricted from distributing prices for the trades it processes.

“We are not working with Markit” and will internally create prices at CME Group and with CMA Datavision, which CME Group owns, said Laurent Paulhac, managing director of OTC products and services for CME Group.

A Justice Department investigation is examining whether London-based Markit Group Ltd., which provides derivative and bond data to more than 1,500 customers, sought to retain ownership of the pricing data that is created when trades are processed by a clearinghouse, a person familiar with the probe said in August.

Markit Indexes

Markit owns indexes and price data for credit swaps contracts and releases trading prices at the end of the day. Prices recorded from the trades processed by Intercontinental Exchange’s ICE Trust clearinghouse are available only through Markit, according to ICE Trust’s Web site.

A Markit spokesman didn’t immediately return a call for comment.

Bloomberg LP, the owner of Bloomberg News, competes with Markit in selling information to the financial-services industry. Markit is among the contributors of data that appears on the Bloomberg terminal.

The Barclays trade, Hamill said, was tied to the Markit CDX North America Investment Grade Index Series 13, a benchmark used to hedge against losses or to speculate on the creditworthiness of 125 companies including General Electric Co.’s finance arm, Caterpillar Inc. and retailer Wal-Mart Stores Inc.

CME Group’s clearing plan followed months of meetings with dealers over how the system will work. Citadel Investment Group LLC, AllianceBernstein Holding LP, BlueMountain Capital Management LLC, D.E. Shaw & Co., Pacific Investment Management Co. and BlackRock Inc. committed to the service in September..."

CME to launch CDS clearing with eight major dealers

"The agreements with Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan, Morgan Stanley, and UBS, pave the way for the CME to take on rival InterContinentalExchange in the nascent CDS clearing market.

The dealer founding members join the buy-side founding members, AllianceBernstein, BlackRock, BlueMountain Capital Management, Citadel, the DE Shaw Group and Pimco.

In addition, Bank of America Merrill Lynch, Nomura Group, and Royal Bank of Scotland will become CDS clearing member firms and intend to participate in the pre-launch programme which kicks off on 15 December.

The arrival of larger dealers to the CME platform marks a victory for the Chicago-based exchange and its fund management clients which had complained of being frozen out of the market by the broker-backed ICE venture.

Since launch in March, ICE claims to have cleared some $4 trillion in notional CDS contract value at its US clearing house. However, the effort has faced mounting criticism from the buy-side community and regulators.

In June, Bluemountain capital COO turned up the pressure by accusing major derivatives dealers of "filibustering" to protect their oligopoly by deliberately withholding their support from the exchange-backed CME-led alternative. This in turn forced the dealers to promise regulators that they would offer buy-side market participants access to all viable clearing credit default swap solutions by 15 December."

BME to take on DTCC with trade repository plan

"Spanish bourse Bolsas y Mercados Españoles (BME) has announced plans to create a trade repository for over-the-counter (OTC) financial instruments, in a move that will pit the European exchange operator against the US-based Depository Trust and Clearing Corporation (DTCC).

BME says the proposed repository will meet the European Commission's objectives of providing an EU-centric data warehouse for OTC derivatives contracts.

The Madirid-based bourse says the project is expected to be completed by the second quarter of 2010 and will cater for a wide range of financial instruments, including bilateral securities lending, bank loans or credit claims as well as OTC derivatives whose underlying assets are fixed income, equities, currencies, commodities or others.

"The new service will initially be provided in Spain although it has a clear international orientation," says the bourse in a statement. "The system can in the future be shared with other markets or implemented by BME in other countries."

Such a move would put the BME up against the DTCC's Trade Information Warehouse, the utility-based service which currently holds most of the world's OTC products."

Markit and DTCC to Launch MarkitSERV

"Markit and The Depository Trust & Clearing Corporation (DTCC) today announced the September 1st launch of MarkitSERV, a new company that will combine the two organisations’ electronic trade confirmation and workflow platforms to provide a single gateway for over-the-counter (OTC) derivative trade processing.

The strategic partnership was first announced in July last year, subject to completion of due diligence, regulatory filings and approval by relevant global regulators. Due diligence is now complete and MarkitSERV has received regulatory approval from the U.K. Financial Services Authority and the U.S. Department of Justice.

Jointly owned by DTCC and Markit, MarkitSERV will combine the DTCC Deriv/SERV and Markit Wire trade confirmation platforms to cover all major asset classes including credit, interest rate, equity and commodity derivatives. It will connect multiple market participants and execution venues to downstream processing platforms such as DTCC’s Trade Information Warehouse for credit default swaps (CDS). It will also connect to various central counterparty platforms for interest rate swaps and CDS, in collaboration with the DTCC Trade Information Warehouse.

...MarkitSERV will comprise the Markit and DTCC flagship trade processing services for affirmation, confirmation, novation, allocation and reconciliation. These include Markit Wire, Markit Trade Manager, Markit Tie-Outs and Markit PortRec in addition to the DTCC Deriv/SERV matching and confirmation engine, MCA Xpress and novation consent service.

MarkitSERV will rationalise costs by removing the need for users to connect to numerous, asset-class specific trade processing systems. Instead, clients will be able to use their existing connectivity to access a wider variety of combined services. The new company will be industry-governed and will have a global presence, including offices in London, New York and Tokyo.

Markit’s data and valuation services, and DTCC’s Trade Information Warehouse, life-cycle event processing and centralised settlement and payment netting services will remain part of the respective parent companies."

DTCC automated matching and confirmation services

DTCC Deriv/SERV LLC provides automated matching and confirmation services for over-the counter (OTC) derivatives trades, including credit, equity and interest rate derivatives. It also provides related matching of payment flows and bilateral netting services.

Deriv/SERV's customer base, which includes dealers and buy-side firms from more than 35 countries, is the market's largest post-trade service provider for OTC derivatives. In 2008, Deriv/SERV processed a record 10.1 million transactions.

Since its establishment in 2003, Deriv/SERV has been an important driver in increasing electronic confirmation rates, thereby reducing the risks and costs associated with labor-intensive, paper-based processing. More than 90% of credit derivatives traded globally are now confirmed through Deriv/SERV, up from 15% in 2004.

DTCC in 2006 launched Deriv/SERV's global Trade Information Warehouse, the market's first and only comprehensive trade database and centralized electronic infrastructure for post-trade processing of OTC derivatives contracts over their lifecycles, from confirmation through to final settlement. Initially servicing credit derivatives, this global infrastructure solution, which was developed in close collaboration with leading dealers and buy-side firms, is designed to be extended to accommodate interest rate, equity and other OTC derivatives in the future.

Services include:

  • Credit Default Swaps Matching and Confirmation
  • Equity Derivatives Matching and Confirmation
  • Interest Rate Derivatives Matching and Confirmation
  • Payment Calculation and Bilateral Netting
  • Trade Information Warehouse

US clearing groups

Government approvals related to ICE and CME


The SECs approval for ICE's request to be exempted from rules that would prevent it clearing CDSs was the third government action granted to Intercontinental in one week. On March 3, its proposed acquisition of Clearing Corp., a Chicago clearinghouse owned by eight of the largest dealers in the credit-default swap market, was approved by the Federal Trade Commission and the Justice Department. On March 5, the Federal Reserve Board, which oversees the clearinghouse, granted a request for ICE to begin clearing.

Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS AG, received $39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.’s cash on hand and a 50-50 profit-sharing agreement with Intercontinental on the revenue generated from processing the swaps.

SEC spokesperson John Nestor stated "For several months the SEC and our fellow regulators have worked closely with all of the firms wishing to establish central counterparties... We believe that CME should be in a position soon to provide us with the information necessary to allow the commission to take action on its exemptive requests."

Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH.Clearnet Ltd. Only the NYSE effort is available now for clearing after starting on Dec. 22. As of Jan. 30, no swaps had been cleared by the NYSE’s London- based derivatives exchange, according to NYSE Chief Executive Officer Duncan Niederauer. [1]

CME and Citadel turn CDS JV into clearing-only service

CME Group and Citadel Investment Group have halted their plans to develop an electronic trading platform, known as CMDX, for credit default swaps and instead are refocusing their efforts on providing clearing-only services for the nearly $27 trillion CDS market. CME plans to announce the launch of a clearing pilot program in the weeks ahead, according to the company issued release.

While Citadel remains a founding member of the newly restructured CDS initiative, CME is bringing in other buy-side founding members, which include: AllianceBernstein, BlackRock, BlueMountain Capital Management, the D.E. Shaw group and PIMCO. In addition, a number of sell-side participants are in the process of becoming founding members.

CME's and Citadel's original intent was to introduce CMDX as an electronic platform for trading for trading CDS, but evidently that didn't gain acceptance by the industry's major CDS players. "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," stated Terry Duffy, executive chairman, CME Group, in the release.

CME executives emphasized that CME is committed to bringing stability and transparency to the CDS market and that the increasing collaboration of founding members from both the buy and sell side would make its offering the strongest and most effective CDS clearing solution.

Key features from the CMDX joint efforts will be carried forward in the clearing-only services, including state-of-the-art book and legacy trade migration facilities. CME's clearing service will support a range of Markit CDX indices and liquid single name CDS at launch. CME Clearing also supports trade entry through its CME ClearPort platform, enabling connectivity from any trading platform.

However, Finextra pointed out that CME's stiffest competition will come from The InterContinentalExchange (ICE), which began clearing CDS contracts in March through ICE Trust. ICE acquired The Clearing Corp. (CCorp.), giving it the support of major broker dealers and it has already cleared $2 trillion worth of CDS contracts.

ICE Clearing House member requirements

Members of the Intercontinental clearinghouse will have to have a net worth of at least $5 billion and a credit rating of A or better to clear their credit-default swap trades. Intercontinental said in the statement today that all market participants such as hedge funds, banks or other institutions are open to become members of the clearinghouse as long as they meet these requirements.

A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded, participants are exposed to each other in case of a default. A clearinghouse also provides one location for regulators to view traders’ positions and prices.

ICE's CDS clearing tops $3 trillion

IntercontinentalExchange Inc's (ICE.N) U.S. and European credit derivatives clearinghouses have handled more than $3 trillion in notional contract value in the seven months since the U.S. clearinghouse was launched.

ICE said on Monday it has cleared $2.3 trillion in U.S.-based credit default swaps since March, and 514 billion euro ($750 billion) in Europe-based CDS since the launch of the European clearinghouse in July.

ICE competes with CME Group Inc (CME.O) and Deutsche Boerse's (DB1Gn.DE) Eurex unit in the race for share of the new market. CME Group has said it will start testing its long-awaited CDS clearinghouse this week.

Governments and regulators on both sides of the Atlantic have pushed for central counterparties, or clearinghouses, in the $26 trillion CDS market in order to curb possible widespread impact from the default of a single, major player.

CDS are contracts that insure against debt default, and allow traders to bet on credit quality.

Atlanta-based ICE cleared $91 billion in CDS last week in the United States, and 136 billion euro in Europe. The company said it expects regulatory approval to clear single-name U.S. contracts later this month.

ICE shares were up 2.7 percent at $93.78 on the New York Stock Exchange, while CME fell 0.5 percent to $291.30 on the Nasdaq.

LCH.Clearnet lobbying to gain clearing privilege in the US

European clearing

"Derivatives exchange NYSE Liffe and London-based clearing house LCH.Clearnet have shelved their central clearing service for credit default swaps (CDS), having processed no trades since it was launched in December last year.

The exchange officially suspended the CDS contracts offered for clearing (series 8, 9 and 10 of the Markit iTraxx Europe investment grade, Crossover and Hi-Vol CDS indexes) on July 29 following a month-long review of the service.

An official at the exchange told Risk Liffe would consider venturing into the CDS market again, but declined to elaborate.

Atlanta-based IntercontinentalExchange (Ice) and Frankfurt-based Eurex have both begun clearing CDS contracts. Ice cleared $1.67 trillion of trades in the US between March 9 and August 7, and has cleared €37.93 billion in Europe since launching a regional service on July 29.

Eurex, which launched its platform on July 30, has cleared two trades worth a combined €75 million. A clearing initiative by the Chicago Mercantile Exchange has yet to get off the ground despite receiving regulatory approval.

In an interview with Risk in January, Ade Cordell, Liffe's director of over-the-counter services, presciently said there would not be enough business to sustain four clearing ventures. "The market will decide which platform or platforms they want to use. I wouldn't be surprised if four gets whittled down to three pretty quickly, and three may well go to two."

Cordell anticipated Liffe’s platform would attract volumes because it targeted buy-side firms. However, those firms are typically reliant on banks for clearing services, meaning their dealers would also need to sign up to the central counterparty. But the dealers have converged on to Ice’s platform, and Eurex’s to a lesser degree."

As of today, credit default swaps (CDS) relating to European entities and indices based on these entities will start clearing through central counterparties regulated in the EU. This will reinforce financial stability by ensuring better risk management for European CDS, and comes in response to Commissioner McCreevy's call to reduce the risks inherent in this market (see SPEECH/08/538 ). CDS are financial products designed to insure the buyer against losses caused by a credit event (e.g. a default) affecting a given entity, and until now had been managed bilaterally between buyer and seller.

Internal Market and Services Commissioner Charlie McCreevy said: "Back in October 2008, I called upon the industry to reduce the risks inherent in the credit default swaps market, in particular by moving the clearing of these contracts onto a European central counterparty (CCP). The financial crisis highlighted a number of problems in the credit default swaps market, especially where transparency, market concentration and risk mitigation were concerned. Clearing through central counterparties is key to improving risk management and to increasing the stability of the financial system. I am pleased that the extraordinary efforts by the industry and service providers have made it possible that two European CCPs are starting to clear these products now, with a third aiming to launch its service by the end of the year. The existence and the use of more than one CCP is essential for the proper development of a safe and competitive environment."

In response to the Commission's call for central clearing of credit default swaps (CDS), ten major dealers committed to clear CDS on European reference entities, and indices based on these entities, through one or more central counterparties (CCPs) established and regulated in the European Union by 31 July 2009. The Commission has set up a working group, involving dealers, the buy-side (e.g. banks, insurance companies and funds), CCPs and supervisors, to monitor the orderly roll-out of this commitment.

The Commission welcomes the fact that, through the International Swaps and Derivatives Association (ISDA), dealers have developed the standards necessary to allow central clearing for European CDS, in particular standards for the treatment of the restructuring credit event incorporated in the so-called "Small Bang" Protocol, to which the vast majority of market participants has already adhered. The Commission also welcomes the considerable efforts made by the CCPs to implement these standards so as to offer a solution by the set deadline. Two European CCPs (ICE Clear and Eurex Clearing) have already obtained the necessary regulatory approvals and are now offering their services while a third (LCH.Clearnet SA) is expected to follow by year end. The Commission, therefore, expects that, as of today, dealers will live up to their commitment and will start using all available CCPs for all eligible trades.

The Commission will monitor the migration of the CDS onto CCPs and will take account of the progress made by market participants in the CDS area when formulating its policy orientations for over-the-counter (OTC) derivatives in general. The Commission intends to publish these policy orientations by the end of October 2009, as announced on 3 July in its Communication on "Ensuring efficient, safe and sound derivatives markets" ( IP/09/1083 ). To this end, the Commission is currently running a public consultation and will also organise a high-level conference entitled "Derivatives in crisis: Safeguarding financial stability" on 25 September.

Since CCPs constitute an essential post-trading infrastructure, high supervisory standards are indispensable to ensuring that CCPs have in place proper risk management procedures. However, in order to be able to offer their services on an EU-wide scale, central counterparties had to undergo multiple scrutiny and to obtain multiple authorisations. In view of the Recommendations[www.ecb.] recently agreed by the Committee of European Securities Regulators (CESR) and the European System of Central Banks (ESCB) and with regard to a proper functioning of the single market, the Commission will consider ways to facilitate this process along the lines announced in its Communication of 27 May on European financial supervision ( IP/09/836 ).

Background Clearing is the process by which obligations arising from a financial security are managed over the lifetime of the contract. Until now, credit default swap (CDS) trades – like most over-the-counter (OTC) financial derivatives – are predominantly cleared bilaterally between two contracting parties. A Central Counterparty (CCP) is a service providing clearing at central market level. The CCP steps into the middle of each trade, so as to become the buyer to every seller and the seller to every buyer. From its central position, the CCP's main business is therefore to manage the risk in that market.

More information is available.

"Under pressure from the Eropean Union, banks in Europe will start processing complex financial contracts known as credit default swaps through a central clearing house by the end of July, EU regulators said today.

Swaps offer insurance against securities for lenders worried about a borrower's ability to pay them back. The unregulated $60 trillion market lost its main central clearing house to handle the deals with the September collapse of U.S. investment bank Lehman Brothers.

Clearing manages who is liable for losses and a central counterparty becomes the buyer and seller to every trade in order to manage the risk in the market. For swaps, many deals were done by buyers and sellers directly and in private without clearing, a practice regulators view as risky.

The swaps can lead to huge financial exposures when companies go bankrupt unexpectedly, as three Icelandic banks did last year. They are commonly used contracts to insure against the default of financial instruments such as bonds and corporate debt. But they also are bought and sold as bets against defaults, even by parties that do not own the security in question.

Frustrated by the financial industry's failure to plug the gap left by Lehman and agree on a clearing house by the end of last year, the European Commission threatened that regulators would step in and set up their own system in Europe.

Two EU-based clearing houses are now operational — ICE Clear and Eurex Clearing — and another, LCH.Clearnet SA should follow by the end of the year, the EU executive said.

Regulators said they expected "that as of today, dealers will live up to their commitment and will start using all available central counterparties for all eligible trades."

They said they would monitor how many deals were moving to the European clearing houses and would publish new ideas on regulating over-the-counter derivatives in October.

Credit default swaps played a prominent role in the credit crisis that brought the downfall of Lehman Brothers Holdings Inc., a government rescue plan for giant insurer American International Group Inc., and Merrill Lynch & Co.'s sale to Bank of America Corp.

The huge volume of credit default swaps sold by AIG, for example, coupled with rising levels of defaulted mortgage and other debt, threatened the company's existence and prompted the government to spend $150 billion to bail it out to avoid a catastrophic collapse. If AIG were to fail, the losses would spread to the companies and investors who bought the swaps.

Eurex sets launch date for CDS counterparty

Swiss-German derivatives exchange Eurex says it will launch a European counterparty clearing system for credit default swaps at the end of the month.

The new entity, Eurex Credit Clear, will be operational by 27 July and ready to start live clearing of European iTraxx indices and European single name CDS on 30 July 2009.

Confirmation of the launch date comes a day after IntercontinentalExchange committed to kick-start its European offering later this month.

Eurex Clearing says it has developed a "CDS-specific state-of-the-art risk management model".

Implementation has been supported by deploying application modules from Calypso Technology and the platform has been in production testing with 20 market participants since the end of the first quarter.

Eurex board member Thomas Book says: "The key challenge in developing Eurex Credit Clear was to design and build a new risk management solution specifically to meet the unique risk characteristics of CDS. This new service significantly strengthens our clearing capabilities with a sound, reliable and flexible engine to deliver central clearing initially for credit derivatives and subsequently also for further OTC-traded asset classes."

Japan to build OTC CCP

Japan to build CCP for OTC derivatives trading

Japan Securities Clearing Corporation (JSCC) has announced plans to develop a central clearing counterparty for interest rate swaps and credit default swaps.

The JSCC, in association with the Tokyo Stock Exchange, has set up a working group to design detailed CCP functionality for managing risk in OTC derivatives trading.

The establishment of the group follows the March release of a specially-convened study group on post-trade processing of OTC derivatives trades. This concluded that the JSCC should co-ordinate operational procedures including the establishment of a robust risk management process, IT systems, and business analysis with the aim of launching a fully-fledged clearing service in the first half of next year.

The JSCC says it will work with foreign clearing operators already active in Japan to ensure a harmonised approach and minimal disruption to existing procedures.

The study group report concluded: "In accordance with the current common practice of using the CCP function of LCH.Clearnet's SwapClear for interest-rate swap trading by foreign financial institutions, the opinion was expressed that cooperation with LCH.Clearnet would be required when a clearing institution in Japan is introduced for the clearing of interest-rate swap trading."

Earlier this week, the Reserve Bank of Australia rejected the option of building its own domestic CCP and instead said it would encourage international central counterparties to extend their product coverage to the Australian market.


Personal tools