Derivatives Clearing Gives Congress Fits

The Challenge Congress is working on legislation for OTC derivatives reform, but there is still no agreement on mandatory clearing of standardized instruments or on how exotic instruments will be handled.

Why It's Important: "Central clearing is all about reducing systemic risk," says Kevin McPartland, senior analyst at TABB Group, explaining that central clearing of OTC derivatives results in reduction of the counterparty risk that exists in bilateral transactions between two dealers. Adds Joe Trentacosta, board member of the International Securities Association for Institutional Trade Communication (ISITC), "It definitely reduces the buy-side risk to the counterparties in the sense that margin is now being posted to a central exchange versus directly with a counterparty." Operationally, central clearing allows for added efficiencies, such as a reduction in margin requirements and cross-margining of listed and OTC derivatives, Trentacosta says. It also would bring transparency into pricing of OTC derivatives, an opaque market that is virtually exempt from federal regulation.

Where the Industry Is Now: Major futures exchanges (InterContinental Exchange, Eurex and CME) have rolled out central counterparty facilities (CCPs) in the U.S. and Europe for plain vanilla credit default swaps and CDS indices. CME even scrapped its CMDX electronic trading initiative with Citadel to focus on clearing. NYSELiffe and London-based clearing house LCH.Clearnet, however, shut down their CDS clearing business in September. Experts predict that CCPs will clear plain vanilla derivatives, but that they will not clear exotics, which will continue to be cleared bilaterally through the dealers and reported to a central repository.

"Obviously all of this requires the brokers to be derivatives clearing members. That is still in its very infant stage," says ISITC's Trentacosta. Buy-side firms also are figuring out how central clearing will work. "They don't like a single entity seeing all of their positions," Trentacosta explains.

Focus in 2010: A key focus will be on finalizing derivatives reform bills in the House and Senate and passing legislation for President Obama to sign. Two different bills were passed in the House Financial Services and Agricultural committees that need to be reconciled, and the U.S. Senate has said it will take up derivatives reform by the end of this year.

Another focus in 2010 will be securing buy-side support and pushing firms to submit their trades through the derivatives clearing members. But in order for clearing to take off, exchanges need software to provide pre-clearing checks and reconciliation mechanisms.

"The exchanges don't have the infrastructure, and clearly the clearing members are not ready to invest hundreds of millions to do it," says Gerard Rafie, SVP of product management at Calypso Technology, which is working with Eurex and two other major exchanges on a central clearing initiative. "It's not enough for the clearing firm (i.e., broker-dealer) to jump in and start clearing. Exchanges will need systems to calculate Net Present Value, Value at Risk, margin and interest payments on long-term swap contracts. ... The methodology is more complex."

Industry Leaders: Global futures exchanges are the major players in OTC derivatives clearing -- namely ICE Trust, CME Clearing House and Eurex Clearing. Nasdaq OMX entered the CCP space with International Derivatives Clearing Group (IDCG), partly owned by BNY Mellon, to clear interest-rate swaps, while CME and Eurex also are targeting interest-rate swaps. Meanwhile SwapClear, owned by LCH.Clearnet, controls 50 percent of the interest-rate swaps market currently. Another key player is DTCC Deriv/Serv, a matching facility for credit derivatives trades that now is part of MarkitServ, which was formed in July 2009 with MarketPartners. DTCC's Trade Information Warehouse is a top contender to become the central repository for OTC derivatives trades, and TriOptima won a bid to develop a repository for interest rate derivatives.

Technology Providers: There are a lot of vendors selling reconciliation products and other post-trade systems to address workflow. Top players include Calypso Technology, TriOptima, Omgeo and SmartStream, as well as Summit Systems and Murex in the risk space.

Price Tag: There are no estimates for the cost of building an OTC derivatives clearing infrastructure. But experts say software packages from the vendors range from $50,000 to $100,000 and are not onerous to implement. Yet buy-side firms are slow to act. "The buy side needs to know what the clearing members are going to charge for the business," says ISITC's Trentacosta. "[If] they don't know how much it's going to cost, it's hard for the buy side to gauge [how much it should invest in solutions]."

Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio