Clearing the name of derivatives

Credit derivatives have taken a lot of blame for the current crisis, but centralised clearing could help to revive the market.

On the weekend of September 13, 2008, when then-New York Fed president Timothy Geithner called a special meeting to discuss the future of Lehman Brothers, nobody knew how the bank's failure would affect other market participants. It was impossible, during the course of a weekend, to figure out the complex web of bilateral bets the bank was involved in.

In the end, the effect of Lehman's bankruptcy on the credit derivatives market was much bigger than the losses on those contracts alone. Market participants started looking at each other with heightened scepticism and the market seized up, causing a cascade of losses through the banking system that is still not even close to being resolved. But the problem at Lehman, say many specialists, was not about the product itself -- i.e. the over-the-counter (OTC) credit derivatives.

Indeed, a note issued by ING shortly after Lehman's collapse pointed the finger at regulators for letting Lehman go under. "Authorities misjudged the effects of Lehman and underestimated the power and volume of CDS [credit default swaps]," said Jeroen van den Broek. "It's not the product that's to blame; it's the false estimation by the authorities."

True or not, regulators have turned their attention to the problems in the credit derivatives market and have settled on centralised clearing as the most effective tool in mitigating runaway counterparty risk. It is an elegantly simple solution that shifts this counterparty risk to a central agency underwritten by the market participants themselves -- instead of taxpayers, which, as the present crisis has demonstrated, is the reality of the existing regime.

It is perhaps surprising, given that it took a crisis to get people talking, that there is almost universal support for central clearing. "There will be a lot of benefit coming from the regulatory world," says Bernard Dan, president of MF Global and former head of the Chicago Board of Trade. "Some view the regulatory scrutiny as negative, but frankly I think it's going to be well-balanced and in the case of OTC could be significant. If it improves integrity of pricing that's good and if it helps to mutualise risk because of centralised clearing that's great."

At the moment, OTC derivatives are agreed by counterparties on a bilateral basis, creating a fiendishly complex puzzle of trades that depends on both parties trusting each other to be in business when the contracts mature. In a centrally cleared system, the trades are still agreed bilaterally, but they would then be processed through the central clearing house, which would charge a fee. All of the participants capitalise the clearing house by contributing to a so-called default fund. If a counterparty goes bust, this fund is used to meet its obligations.

Beyond the obvious benefit of guaranteeing trades, a cleared system has two important advantages: first, the product itself stays the same, offering the same degree of flexibility and liquidity, and, second, it creates transparency about the exposure that counterparties have. In the case of Lehman or Bear Stearns, the Fed could have seen at a glance what would have happened if those names had gone into default.

Even if Lehman had been allowed to go under, it would not have caused a centrally-cleared credit derivative market to seize up. Pierre Gay, Asia-Pacific chief executive at Newedge, a broker owned jointly by Calyon and Societe Generale, estimates that volumes in the credit derivatives market, although difficult to gauge accurately, are about 85% down on a year ago. "If clearing happens it will really boost the market for sure," he says. "And we are really pushing for it to happen, because we think it offers a very good opportunity for our business."

Some progress has already been made. On April 1, in a meeting at the Federal Bank of New York, 22 central banks and regulators met with a host of market participants to discuss plans for revamping the OTC credit derivatives markets, and centralised clearing emerged as a key part of their plans. They will detail their next steps in a letter to regulators by May 29.

Two clearing houses are already up and, kind of, running. London's Liffe set up a system in partnership with Anglo-French outfit LCH.Clearnet on December 22, but has yet to actually start clearing trades. The first to do that was the system set up by Intercontinental Exchange, or Ice, a US futures market based in Atlanta.

Ice US Trust launched on March 9, guaranteeing bilateral trades on Markit's North American CDX indices, and by the end of the month it had cleared 399 transactions with a total notional value of $45 billion. Others are getting in on the act too. The Chicago Mercantile Exchange won approval in March to launch its own clearing house and Eurex, a derivatives market jointly owned by the German and Swiss exchanges, has plans to set up a similar system to Ice, in which the clearer shares revenues with a number of big dealers.

The proliferation of competing clearing houses has caused some to worry about a race to the bottom, with clearers reducing the fees they charge to attract business and, in doing so, reduce the capital cushion that is the whole point of a centrally cleared system.

Marcus Schueler, a managing director at Markit, says that such concerns are overblown because the dealers have a vested interest in the soundness of the system. "If they are in any way concerned about it they wouldn't participate, because in the end they would lose money," he says.

But the competition among the different groups means that it will be some time before the market for centrally cleared credit derivatives takes off. There is also a risk that the slew of initiatives will lead to national regulators calling for their own local clearing systems.

Japan, perhaps unsurprisingly, is already making moves designed at setting up a separate clearing house of its own. The Japan Securities Clearing Corporation, majority-owned by the Tokyo Stock Exchange, aims to start clearing CDS and interest-rate contracts by 2010. A working group that includes most of the major dealers in the Japanese market is studying the idea.

Schueler is not sure it makes sense. "If you're looking at liquidity on Japanese CDS, it's probably not worth creating a separate clearing house," he says. But he also concedes that the situation in Asia is quite different to the market in Europe. In any single European market, Italy for example, the biggest local player probably does not have better coverage in the CDS market than a global dealer such as Goldman Sachs or J.P. Morgan. In some Asian markets, particularly Japan, that is clearly not the case.

Central clearing is not a magic bullet that will remove risk from the market. And, in fact, it would have worked a lot better if the system had been set up before the banks' reputations were so badly damaged -- as the sponsors, their credibility is key to the operation of any clearing initiative.

But, because it is something that can be achieved cheaply, using technology, systems and knowhow that already exist, and because it enjoys broad support, it is by far the best solution for helping banks reduce their exposure to credit derivatives. And it will do so without affecting the functioning of the market.

This article first appeared in the April issue of FinanceAsia magazine.

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