In the new world of swaps trading, there is a debate brewing on how to reduce the risks before the trade is accepted for clearing. That debate flared up at Tabb Forum’s Fixed Income 2012 event on Tuesday, when panelists discussed the topic of “Getting A Trade Done: from SEF to Clearing.”
Buy and sell side firms on the panel explained that until a trade is accepted for clearing by one of the clearinghouses (i.e., CME, ICE Trust, or LCH.Clearnet) either the FCM (futures commission merchant) or the buy side firm holds the risk.
“Certainty of clearing is at the top of the list or amongst challenges or pain points for the participants to get on board here and the models are pre-trade acceptance and the post-trade guarantee,” commented the panel’s moderator Paul Rowaday, senior analyst at Tabb Group.
An FIA working committee focusing on certainty of clearing is examining both models, according to panelists. Once derivatives clearing rules are finalized, the mandate for clearing is expected to take effect in Q3 of this year.
In the post-trade model, the trade is executed between the parties and submitted to the clearinghouse. Then,the clearinghouse has to run checks and has to verify the trader is within his limits for clearing, according to Randall Costa, managing director at Citadel and CIO of Citadel’s technology group, who spoke on the panel. In addition, the clearinghouse has to ascertain that the clearing member won’t tip its credit limits at the other venues.
In the pre-trade execution/clearing model, the counterparties are not allowed to trade unless they pass a filter at the SEF. This is known as the “ping model” since the SEF will need to use messaging technology to contact each FCM and clearinghouse. Before the trade is displayed and negotiated, the SEF has to check whether the client has a credit limit with the clearinghouse and with the FCM. If the client has exceeded its credit limit, then the clearinghouse will say No, said Costa.
“What everyone is trying to solve for is that until the trade is accepted for clearing there is still bilateral risk between the two counterparties to the trade,” observes Jim Rucker, chief operations, credit and risk officer at MarketAxess, an electronic trading platform for corporate bonds, high yield credit derivatives that plans to register as a SEF. “What the new model is meant to do is to place the clearinghouse in the middle, so there is no risk between these two counterparties. That all works once the trade is accepted for clearing,” emphasizes Rucker, in an interview today.
One of the reasons that industry participants, especially the FCMs, are interested in the pre-trade acceptance is that they feel this model could help reduce the chances of trade breakage. “As an FCM we care that there are no breakage costs after the trade is executed,” said Hester Serafini, managing director and global head of credit fixed income prime brokerage clearing at Deutsche Bank, on the panel. This can happen if an FCM doesn’t have enough capacity at the clearinghouse and has too many trades, said Serafini. “I would say as an FCM our preference would be for the pre-trade check and pre-trade certainty because we know the SEFs are going to check with us.”
But other panelists felt that the pre-trade/ping model was going to be more onerous to implement since it would require infrastructure between the SEFs, dealers, FCMs and clearinghouses. “I think that realistically pre-trade is far more complicated,” argued Ron Levi, COO at GFI Group, pointing out that his firm would need to connect to several FCMs and each clearinghouse. Levi also cautioned that there is a theoretical argument that pre-trade filtering could cut down on liquidity.