Buy-side firms navigating the world of OTC derivatives clearing will find that trades must be submitted to the new central clearing counterparties (CCPs). This means that a buy-side firm must rely on its brokers for connectivity or face the expensive and time-consuming task of building connectivity to the individual CCPs.
But to which CCPs should they connect? ICE Trust and CME Clearing have emerged for credit default swaps. Or how about LCH.Clearnet's SwapClear, the major interest-rates swap clearing service? All three began to offer the buy side access to their clearing platforms this past December. But the buy side is left to wonder how this all will shake out and who will win the most market share.
Alternatively, buy-side firms could rely on their executing brokers, prime brokers and, potentially, new swap execution facilities, such as Bloomberg or Tradeweb, that will also have connections into the CCPs. But whatever route they choose, buy-side firms will discover that there is a tangled web of third-party affirmation and confirmation services, messaging service intermediaries, and clearinghouses that are enmeshed in the market structure of processing OTC derivatives and that are necessary to bridge the gaps toward central clearing.
A 'Hybrid' of Existing Systems
"The new OTC world is really a hybrid of old and existing derivatives systems," observes Stephen Li, a director in prime brokerage at Barclays Capital. "A lot of the CCPs are leveraging existing derivatives third-party affirmation systems to get the trading into clearing."
For example, London-based Markit Partners acquired Swapswire, the leading electronic trade affirmation and confirmation service for interest rate swaps, and has renamed it Markit Wire. Through a joint venture with the Depository Trust and Clearing Corp. (DTCC), Markit also operates MarkitServ (formerly DerivServ), an affirmation and confirmation service for credit derivatives. DTCC also operates the global repository for credit derivatives, the Trade Information Warehouse.
ICE Trust's ICE Clear platform leverages the ICE Link (formerly known as T-Zero) messaging service, and CME Clearing obtained its OTC derivatives clearing service, CME ClearPort, in its acquisition of Nymex.
"There's been an effort to leverage existing frameworks within the industry," says Li, who points out that the existing affirmation services "were critical in getting to the first cut of clearing in December." "This is the quickest way to market for [the CCPs]," he adds.
Meanwhile, Bloomberg has built a trade-screen confirmation service, VCON (for voice confirmation), that automatically affirms both sides of OTC derivatives trades and can route them to multiple CCPs. "The buy side can use VCON to route the trade details over to MarkitServ," says George Harrington, Bloomberg director of credit trading.
"If you were doing a CDS trade, you may choose to clear that trade through a facility like CME or ICE," Harrington explains. "Or it will be a bilateral, non-cleared trade, and [the brokers] will legally execute that trade at MarkitServ or Market Wire for interest rate swaps."
In addition to Bloomberg, Tradeweb, which provides straight-through processing for OTC derivatives trades, could provide connectivity into the CCPs, while futures technology providers such as SunGard, which offers the GMI trading system for futures, also are contenders.
Some of these third-party providers, however, are competitors with the affirmation services; yet they all must cooperate to bridge the gaps into the CCPs. For instance, LCH.Clearnet has to be accessible on Markit Wire for interest rate trades to get to clearing, according to Li. "There is talk that other systems might pipe into Markit Wire to get to LCH.Clearnet," he notes.
A system such as Bloomberg can get into ICE Link to then connect with ICE Clear, the clearing system at ICE Trust, according to Li, who notes that Bloomberg is used heavily by the buy side for accessing the dealers' prices on OTC derivatives and for its daily messaging services. But some buy-side firms, Li adds, may see Bloomberg as costly because of the terminal fees.
According to Pete Axilrod, DTCC managing director, new business development, "The existing technology is very good," and technology changes aren't necessary to accomplish central clearing of OTC derivatives. Ninety-five percent of all credit derivatives trades are confirmed electronically and processed in real time via MarkitServ, he contends. "The bulk of the trades that are cleared leverage our infrastructure. MarkitServ is a provider of electronic confirmations [in credit derivatives] and can send trades to multiple CCPs."
But what happens if a credit derivatives trade is executed bilaterally by the buy side with a dealer and is not eligible for central clearing? "If it's a bilateral trade, it can be directed to a repository," says Axilrod. "And if it's a cleared trade, it can be directed to the appropriate CCP and to the [Trade Information Warehouse]."
According to Mark Cox, director of clearing solutions at CME Group, "The assumption is that market participants will execute their trades as they do today, in bilateral markets. Clients negotiate their OTC derivatives trades bilaterally with their counterparties and then affirm their trades on an existing, established third-party trade affirmation platform or directly on CME ClearPort to allow participants to send trades to us."
But DTCC's Axilrod is concerned that some of the exchanges/clearinghouses, including CME Clearing, are rolling out their own front ends. "I know that exchanges are promoting their own front ends," he says. "In my mind that is just complicating everything because then you have to hook up to multiple front ends. But there are providers that will hook you up that are agnostic to where you want to clear."