Mixed reception for derivatives clearing
By Paul J Davies and Jeremy Grant
Published: April 22 2008 17:54 | Last updated: April 22 2008 17:54
Antonio Zoido, chief executive of Spain’s Bolsa y Mercados Espanoles, seemed frustrated at a recent London conference.
As the world’s regulators struggle with how to bring more transparency to the over-the-counter derivatives markets, why were they not studying the exchanges, such as his?
“I haven’t heard anyone say ‘Hey, why don’t we pay some attention to the organised markets?’ I find myself a little isolated.” Mr Zoido said, making the point that exchanges provide price discovery even in market turmoil. Yet he is by no means isolated. Exchanges are falling over each other to persuade anyone who may be listening that their model of on-exchange clearing could be one way to reduce unwanted counterparty risks associated with the bilaterally-negotiated OTC derivatives markets.
The beauty of organised exchanges, they say, is that a clearing house steps in and takes on the counterparty risk, rather than forcing each participant to carry extra risk capital on their balance sheet to guard against default by the opposing side in a transaction.
On Tuesday, the CME Group, the largest US futures exchange, could not resist mentioning how its record first quarter earnings illustrated “the benefits of the exchange model for managing risks in diverse global markets”.
The question is, what role can, and should exchanges play in the OTC credit markets?
Gerald Corrigan a former president of the New York Federal Reserve, suggests thinking about “some sort of automated clearing house”, especially for credit default swaps (CDS) contracts, where valuation and risk issues are still fraught.
The first problem is that OTC contracts are far from standardised, in contrast to on-exchange products that are cleared through an exchange’s clearing house. They are often specially tailored by two parties to meet a specific requirement.
Pascale Scatozza, senior product manager for BNP Paribas Securities Services, says: “I think the initiative is good in the sense that the industry needs to have a central system for the clearing of these products. The only issue I see is that we are in the OTC derivatives world so each contract is different, it’s a bilateral agreement between two entities.”
Second, bank’s prime brokerage businesses already make a lot of money from clearing bilaterally negotiated OTC products and would likely resist any move by exchanges to move too far into their territory.
Liffe, the derivatives unit of NYSE Euronext, has since 2005 offered an OTC clearing service for equity derivatives known as “Bclear”.
The CME will next quarter launch its first foray into clearing of OTC interest rate swaps under an umbrella OTC clearing service known as Clearing 360.
That may help explain the emergence of an initiative from Chicago, where a group of investment banks, including Goldman Sachs and Deutsche Bank, are developing a system that would allow institutions with strong capital bases and credible trading histories to clear trades in the CDS markets with a central counterparty.
The plan would use The Clearing Corporation, once briefly clearer for the ill-fated attempt by Eurex, the Frankfurt-based derivatives exchange, to take on the Chicago Board of Trade’s Treasury bond futures in 2002.
The Corporation is in talks with The Depository Trust & Clearing Corporation, which clears and settles all US stock trades, about offering common customers of the two institutions central counterparty guarantee services. The DTCC already brings some expertise to the project, having started automatic matching of CDS trades in 2003 under its DerivServ unit – taking advantage of an increasing desire of OTC participants to outsource the back office matching and trade confirmation functions.
The reaction to the idea of a central clearing house among credit derivatives players beyond the group of dealer banks involved in the initiative has been mixed, however, with some highly sceptical about its workability or likelihood of success.
The International Swaps and Derivatives Association, a powerful lobby group for the interests of the OTC derivatives industry, has in the past opposed any centralised clearing for these markets.
However, ISDA’s position seems to have mellowed somewhat and while the body is still not likely to support the initiative, it will not actively campaign against it. Robert Pickel, chief executive of ISDA, says that it is not clear there is a problem in need of a solution, let alone whether that solution is centralised clearing.
He says the industry has grown up with the protection of the ISDA Master Agreement: the overriding contract common to all OTC derivatives that governs collateral arrangements and the cancelling out, or netting, of directly equivalent or mirrored exposures.
“What we’ve constructed in the ISDA Master Agreement is an alternative to clearing and could be a complement to it,” Mr Pickel says. He says the protections it gives are real, effective and fully tested.
Some ISDA members are more strongly opposed to central clearing, in part because it could take liquidity from participants who are denied access, or because it would concentrate all counterparty risk in a single entity.
Tom Jasper, chief executive of Primus, a company that exists only to sell default protection on mainly corporate credit says that OTC markets have served derivatives well for more than 20 years and should not be dismantled in a hurry.
Mr Jasper says he is sceptical, warning those involved to beware of unintended consequences. “We have to be sure we’re solving the problems we set out to solve and that we are not creating other problems further down the track,” he says.
The business model of Primus and a number of other similar players relies on not having to post collateral, while according to analysts ordinary non-financial companies who buy or sell credit protection for hedging purposes also do not post collateral. This aspect would be likely to exclude such players from a centrally cleared market.
Other traditional debt investors, particularly some of those who do not currently use credit derivatives to a great degree, see merit in the scheme.
Dan Fuss, vice-chairman of Boston-based Loomis Sayles, says centralised clearing would reduce counterparty risk by creating an entity that was supported by the 10 or 12 different banks behind it. This would be an improvement for most investors who trade credit derivatives with probably only three to five different counterparties, he says.
Copyright The Financial Times Limited 2008 |
