Why did it take a financial crisis and regulatory whipping to bring the CDS market to embrace central counterparty clearing? Some people in the market clearly thought change would cost them money. Either they were right, and it will, or they were wrong, and the market is about to get more efficient. Vishala Sri-Pathma tries to find out which it is.
Intercontinental Exchange endured months of work and negotiations to reach the point on March 9 when it could put its efforts to lead central counterparty clearing of credit derivatives into high gear. The exchange was delighted to clear $7bn of CDS in its first few days of operation.
However, even the best laid plans are no guarantee that anything is going to work out in what is an entirely new initiative for this huge market, whose notional principal is now estimated at around $28tr.
As Jeff Sprecher, ICE’s chief executive, puts it: “We don’t know exactly what we will find when we get to the end of the thread we’ve started pulling here.”
Kevin McPartland, a senior analyst at research firm Tabb Group in New York, has tried to predict what ICE and the other exchanges and clearing houses will find at the end of that thread.
McPartland first points out that CDS notional principal outstanding has not declined so steeply (from some $60tr in 2007) because the product has gone out of fashion, but because of trade compression – the process of netting offsetting positions.
He then forecasts that revenues from central clearing, electronic trading and existing trade migration in the CDS market will grow at a compound annual rate of 12% to reach $174m in 2011. This is based on assumptions, including that 55% of outstanding CDS contracts will have migrated to a central clearing house by then.
Whether that estimate is optimistic or conservative, no one knows. But nearly all agree that a substantial part, though not the whole, of the CDS market, will be centrally cleared within a few years. The more standardised index and liquid single name instruments will come first; more tailored contracts later or not at all.
Analysts at Morgan Stanley, for example, say that not all corners of the market will be converted, and a fairly large chunk of the legacy market will remain, at least in the medium term.
‘Heel,’ say regulators
One reason for the consensus on this is that regulators have made it perfectly clear that is what they want.
The Federal Reserve Bank of New York has set the pace all along in pushing the industry towards CCP clearing. In Europe, Charlie McCreevy, EU internal market commissioner, browbeat the banks until he got what he wanted – a deal in late February in which the industry, speaking through the International Swaps and Derivatives Association and the European Banking Federation, agreed to clear “eligible EU contracts”, otherwise described as “certain CDS which are systemically relevant” on a CCP in the EU by the end of July.
The European Parliament and European Council have started a process to draft a law to force CCP clearing on the market, so as to be ready to pass it into law if the industry looks like backsliding. Even if the industry lives up to its promises, the EU may impose a wide-ranging statutory code of practice on the derivatives market.
Hitting a brick wall
So much is clear. Try and dig deeper than that into CDS clearing, however, and you quickly encounter rocky ground. Many market participants seem either not to know, or not to want to reveal, the answers to basic questions.
These include: precisely which contracts can be and will be centrally cleared; which can’t, and why; how CCP clearing will change the economics of the market; and whether there will be any improvement in transparency alongside the measures to deal with counterparty risk.
Richard Metcalfe, senior regulatory adviser and head of global policy at Isda, has been close to the action.
He is keen to remind participants in the debate of the great value he believes credit default swaps add to financial markets. He also hammers home the point that the CDS market has continued to function robustly in the face of financial catastrophe – and although he doesn’t say this, without central counterparty clearing.
“In the real world, CDS play an important role in the growth and function of the global economy,” Metcalfe says.
But although Isda is the guardian and champion of the over-the-counter derivatives market, Metcalfe is not wedded to the past. In fact, he embraces CCP clearing, saying that, in the present climate, it is “the solution to everything”.
CCP will, he reckons, restore confidence in the CDS market, while enabling banks to free up capital.
“We are confident that policymakers and market participants will find their efforts [to establish CCP] have been rewarded,” he says.
Metcalfe, then, believes the big dealers will benefit financially from CCP, at least as far as capital requirements are concerned, because they will be able to net off positions to the greatest extent possible, and only capitalise the residual position.
James Higgins, head of credit at interdealer broker GFI Group in New York, also feels that banks will benefit, despite the initial cost in terms of margins: “Revenue may be an issue, but banks will have to think about liquidity and if they want maximum revenue in future, liquidity is an important factor.”
All in good time
But this confidence that banks will be better off in the new regime is a little perplexing. If Metcalfe and Higgins are right, then why did it take months – even years – of regulatory cajoling to get the industry to move towards CCP clearing?
Perhaps it was only natural. New ideas that involve collective action can often take a long time to be adopted, even when everyone stands to benefit from them.
Metcalfe advances one explanation. “Sufficient volume in standardised contracts, which only occurred around 2005-2006, was around the time that plans for CCP were being sketched out,” he says. “The public inauguration of central counterparties came only after Lehmans went down. But firms were looking at this on a voluntary basis before – individuals have to remember that it takes months to implement – it is a long process.”
One weakness in this argument is that there are a great many exchange-traded derivatives in which volume is slight – products do not need to have huge volume to be cleared or even traded on exchanges.
Isda had also completed the most important work on creating the necessary standardisation for the CDS market to function efficiently by 2003, with the publication of its Credit Derivatives Definitions, designed to be used with trade confirmations using the 2002 Isda Master Agreements.
Happy just to be like I am
Others argue that banks in fact preferred the status quo. For years, they negotiated and transacted CDS bilaterally over the counter and enjoyed healthy profit margins in a market with minimal regulation.
Transparency was not high on anyone’s agenda. In fact, the lack of any centralised trade data or price quotation system appeared to be an advantage, helping dealers and investors to execute large trade orders without hindrance.
Small wonder that while the cogs of CCP were put into motion in 2003, they only gained momentum in the last 12 months, under extreme regulatory pressure.
McPartland believes that the delays in introducing CCP have more to do with profit margins than with complications of implementation. “Clearing will at least in the short term mean that banks will be making fewer profits due to margins so the incentives aren’t as clear cut as they are for the exchanges,” he says.
What seems to have brought about a change of heart for many was the collapse of Bear Stearns, the monoline bond insurers, Lehman Brothers and AIG. Although the outcome in each case was different, all these events brought home that big derivatives players – to which every other player on the street was heavily exposed – could go down.
The realisation that default of a major counterparty was not a remote possibility concentrated minds on the potential benefits of CCP – notably the assurance that trades would be fully margined and pre-collateralised in a more complete, rigorous, standardised and automatic way than in the OTC market.
“The OTC market seems to better serve the characteristics of the CDS market, particularly pre-Lehman, when counterparty risk was unheard of, and defaulting certainly was not something that bothered them,” says one broker in New York. “The ramifications of the collapse of Lehman Brothers and Bear Stearns presented to the market the very real risk of counterparties defaulting.”
Another broker in New York argues that before these events, central clearing was not high on the priority list as it did not seem to add that much value from a bank’s perspective. “The market was liquid before, no one worried about risk or unwinds, so CCP had no value then,” he says. “The change in thinking happened after Lehmans went down, with players being forced to get out of contracts and having to face residual risk.”
Brokers still speak out
Reinforcing the impression that there was active opposition to CCP clearing – and therefore that some players at least believed that they stood to lose from it – is the fact that some are still willing to criticise aspects of it.
James Davies, head of trading at Trayport, the UK electronic trading software company taken over by GFI in January 2008, believes the economies of the market will be distorted heavily if clearing houses do not “remain neutral”.
“If the exchanges open this up to everyone of course it is not going to be good for banks, because they want to protect their revenue,” he says. “Market makers are not going to be too keen either if it’s just single name CDS being traded [in the OTC market].”
Icap highlighted what it saw as the flaws of CCP in a white paper published in November 2008. “An exchange solution needlessly grants the exchange a monopoly on trade execution, usually accompanied by restricted access to clearing, which thereby leads to increased trading costs and risk and diminished flexibility,” the paper said.
“Increased trading costs and risk” – quite a way from the benign picture of CCP painted by the regulators, exchanges and now Isda.
Icap believes that although tighter regulation is certainly necessary, the authorities may make the wrong diagnosis if they do not look closely at how the market works.
Interdealer brokers are particularly concerned about maintaining what they call fair and open competition in trading.
“Rather than rushing to develop new infrastructure,” the Icap paper said, “better and more extensive use should be made of the tremendous capabilities of the existing OTC market infrastructure, which has been battle-tested and shown to operate very effectively, even at moments of severe market stress.”
Having apparently lost that battle, Icap seems to have decided that if you can’t beat ’em, join ’em. It emerged at the beginning of February that it was considering bidding for LCH.Clearnet, one of Europe’s leading derivatives clearing houses and the first to open its doors to CDS.
Rival brokers GFI and Tullett Prebon are said to be in on the plan, too, though they have not confirmed it.
Buying a clearing firm would be one way for the brokers not to go hungry if their traditional OTC hunting ground is colonised by the clearers and exchanges.
Dangers of rushing
The brokers say they are concerned not just about their own interests, but that the market itself should not be damaged.
“CCP will improve the market,” says Davies at Trayport, “making it more capital-efficient and eliminating systemic risk. But there is a good reason why this hasn’t happened before and that is because the divisions in OTC are not accidental. CDSs are complicated instruments with a lot of variables. I’m not entirely sure how confident exchanges can be to support it. For example, they haven’t considered wide bid-offers and the importance of voice brokerage. A voice barrier is needed in a CDS market,” Davies says.
The brokers are also worried that moving the secondary market on to exchanges will chip away at their natural advantage of direct access to market players.
“That’s why we’re coordinating together... it’s really quite phenomenal how we’re working on the same side,” says Davies – referring to the three big brokers’ financing of a media campaign by the Wholesale Market Brokers’ Association to defend OTC markets.
“We all feel that exchanges are making the most noise in the market, but they haven’t necessarily considered how all aspects of OTC can be transferred across,” says Davies.
Specific points made by the CCP-sceptics are that central clearing does not remove risk but transfers it to the clearing house; that all CCP participants are exposed to each other, but may not know the extent of that exposure; that participant defaults may affect the guarantee fund of other participants; and that a single clearing entity could come to control the market, making it a monopoly that could keep prices high.
Another issue they raise is transparency. A price quotation system similar to that used for stocks could flow from CCP, but no one seems to have much idea what is planned.
The Depository Trust and Clearing Corp, which clears most CDS at the moment, without acting as a central counterparty, began posting fuller data on contracts in its trade warehouse in January, but this may not be enough to satisfy regulators.
“They will have to come up with a way of showing prices in a prompt manner,” says Higgins at GFI. “With the single names and indexes this will be relatively easy as they are more standardised, but with the more tailored contracts it will be quite a challenge.”
Hopes and fears
Exactly who will benefit and who will lose from CCP clearing, it may be too early to determine. Many firms are reticent about it, and none want to put numbers on it.
Certainly there is widespread hope that the new regime will lead to a more efficient, well ordered market; equally, plenty of people fear that costs will rise, profitability will be drained, subtleties of the market be crushed.
For good or bad, though, CCP is going ahead. For the exchanges, a lot is riding on the project. Trading revenues are down amid deteriorating equity and interest rate markets. They see clearing CDS and other OTC derivatives as a new source of cash. ICE spent $625m buying Creditex, a CDS trading platform central to its clearing effort, while the CME Group teamed up with hedge fund Citadel.
Banks will have to shoulder the costs of hooking up with the clearing houses at a time of severely constrained budgets. Some question the need for multiple providers, but acknowledge that the market, not regulators, will decide how many survive.
The determination of European policymakers to have a separate clearer for the region, both to ensure risks are not concentrated in a single US clearer and to gain a supervisory window on market activity, ensures that for the time being, there will be at least two providers – even if they belong to the same group.
And players should not forget that the process of establishing CCP could still be long and tedious. Craig Donohue, CME Group’s chief executive, compares the changes in clearing with the shift from floor to screen-based trading in derivatives on exchanges. “This is a secular shift that will take years to accomplish,” he says. “It is a marathon, not a sprint.”