The battle to offer central clearing of index and single name CDS by the European Commission’s July 31 deadline is heating up.
The first wave of contenders includes NYSE Liffe, Eurex and Intercontinental Exchange, the out-and-out winner so far in the US market for clearing CDS. Eurex and ICE plan to be ready for action in Europe by July 31.
This means that firms are likely to have a choice of two or three central counterparties (CCPs) with which to clear CDS – even though in the US, they have so far shunned the choice available and only used ICE’s solution.
In a deal with EU internal markets commissioner Charlie McCreevy in February, firms in the European CDS market, acting through two industry bodies, promised to adopt central counterparty clearing for large parts of the market by July 31.
NYSE Liffe’s Bclear system, already well established for equity derivatives, has been able to clear CDS since December for European and US customers but has yet to clear a single trade. Liffe says the project is under review but won’t comment further.
Considering that Bclear’s CDS product has failed to take off, and that the US market has directed all its clearing business to ICE since March, ignoring the CME’s offering, the odds might appear to be stacked in favour of ICE capturing the European business too.
ICE said it had cleared $1.3tr of CDS index contracts since the launch of its dedicated US clearing house in March, and was on track to introduce the European equivalent.
The exchange said there was no specific launch date for European clearing but it was “working towards the July 31 deadline”.
However, Eurex is still determined to press ahead. “We are aiming to be ready by the end of July in line with the industry’s commitment,” said a spokesperson for the exchange in Frankfurt.
Eurex is testing its clearing platform with 23 members participating in a simulation. The spokesperson said they included “all the big sell-side banks” and other banks.
Eurex will begin by clearing the three European iTraxx indices and individual constituents of the iTraxx Europe index, which contains the most creditworthy companies.
Bclear’s tough experience
Bclear went through similar tests in February. Ade Cordell, director of OTC clearing at Liffe, told Futures and Options World at the time: “We have about 30 members looking at CDS on our platform. Of those, close on 90% are going through a new product approval process.”
Cordell said virtually all the top CDS dealers were among those 30 institutions.
At that stage Liffe expected Bclear to clear its first CDS contract by the end of March.
The exchange will not say why that did not happen, but two reasons present themselves.
The first is that a dozen of the biggest CDS dealers have signed up as institutional backers of ICE’s solution, so they may have a financial incentive to make that platform succeed — essentially keeping clearing in the family.
Cordell said this could have delayed the uptake of Bclear’s offering and said Bclear was more likely to gain early traction in the dealer-to-customer business.
A second possibility, advanced by a senior derivatives banker in London, is that the market did not like the fact that Liffe uses the same default fund at its clearing house, LCH.Clearnet, for CDS and for ordinary futures.
“There is a distinct division between the risk profile of CDS and futures and options,” the banker said. “It needs to be ringfenced for the protection of market participants.”
The puzzling thing about this view is that one would expect the bankers at leading dealers, who understand both the CDS and futures and options markets, to place their confidence in the risk modelling systems used to manage the central counterparty’s risks. If that is done right, it should not matter whether the default funds are mingled.
However, for whatever reason, it is the case that the solution which has succeeded – ICE Trust US – has a separate default fund just for CDS, while those that have not won a following – CME’s and Liffe’s – use a single default fund for both CDS and other cleared derivatives.
Eurex is following ICE in using a separate default fund just for CDS. Eurex says there are reasons for its confidence. “The first is: we have a central counterparty,” a Eurex spokesperson said. “Bclear didn’t have one.” (Bclear uses an external CCP, LCH.Clearnet, while Eurex runs its own, Eurex Clearing.)
“Second, we build on the existing market infrastructure, which means we have a link into the DTCC trade warehouse.”
So far the CDS market has been using Depository Trust and Clearing Corp, the US clearing house, for trade recording and matching, though DTCC does not act as a CCP. The DTCC link could make it easier for banks to adopt Eurex Clearing as a CCP.
“We are going to use the OTC specifications for pure OTC index CDS contracts and thus we are working on an agreement with Isda to use their data,” the Eurex spokesperson said. “Using the existing market infrastructure makes it less costly and the sell side can utilise their built-up infrastructure and don’t have to invest into a totally new system.”
Two more players
There are at least two other potential competitors for CDS clearing in Europe.
CME Group in London said it was awaiting approval from the UK Financial Services Authority to launch its European clearing house. However, Kim Taylor, president of CME Clearing, said in June it was unlikely to hit the July 31 deadline.
Meanwhile, a spokesperson for LCH.Clearnet in London said the clearing house was “still committed” to launching CDS clearing in December.