Its no secret that CME is one of the few firms in contention to be a major interest rate swap and CDS clearinghouse. This is a promotional video from CME that I make a quick cameo in, talking about the eventual growth in demand for swaps as the industry gets past the short term pain of change and benefits from the efficiencies of the new model. Its also worth noting that today CME announced its latest swaps clearing numbers. You can also view this video at CME.com.
I recently spoke with John McPartland, a Senior Policy Adviser at the Chicago Fed (and no, we can’t seem to find a direct relation although it seems there must be one somewhere). Here we discuss the implications of MF Global on the clearing model going forward; was it simply fraud or does it point out flaws in the current system.
MF Global and the Euro crisis have made people think about counterparty risk again. Counterparty risk concerns are good for clearing, and Swapclear US is all over it. Here are I talk to its US head Dan Maguire about their enhanced functionality, success to date and the “fun” Dan had living through Lehman.
A few months back we put out a research piece on clearing technology, and how despite a lot of work over the past few years, a big investment is still needed to bring OTC clearing to where it needs to be. And thankfully for those that sell clearing technology, regulations and continued fear of counterparty risk will ensure that investment will in fact happen. The subtitle to the aforementioned report explains the shift in mindset: "Bringing the Back Office to the Forefront".
But one problem is that while the industry knows clearing and transaction volumes will grow, it is unclear by much. Kevin McPartland, an analyst at Tabb Group, the US capital markets consultancy, estimates transaction volumes could increase twentyfold, and market data volumes up to 3-4 times above the current levels.
“As volatility alone can cause rapid intraday deterioration of major counterparty credit quality, a move towards near-time or real-time clearing is inevitable anyway,” said Mr McPartland in a recent report. “OTC derivatives transactions that once took days to clear and settle will be finalised in minutes, if not seconds.”
Certainty of clearing is turning into one of the hottest derivative reform debates. The crux of the issue is how can swaps traders be sure that when they execute on a SEF the trade will be accepted for clearing. In most other exchange-like markets the vertical integration makes this a moot point. If you trade equities at the NYSE or futures at CME, the exchange can easily check your single clearing account to ensure you have enough credit to cover the trade.
The swaps market presents a whole new set of challenges, top among them a world in which you can trade the same product on multiple SEFs and clear that same product at multiple clearinghouses – many-to-many. TABB Group research (and my experience) says this problem can be solved with technology, namely pre and post-trade risk checks, rather than a legal agreement. Most of the big banks disagree. I discuss this issue in detail in my recent study on US Swap Dealers.
Karen Brettell at Reuters does a good job of laying out the issue and diverging view points. My comments:
“The documentation issue is still the most polarized of the issues,” said Kevin McPartland, analyst at TABB Group in New York. “It’s very hot or cold depending on who you talk to.”
Having been on both sides as a regulator and now an industry participant, Walt’s perspectives are fascinating. Here we talk about NYPC’s success to date, how the potential NYSE/DB merger could impact his business and when he thinks the CFTC will get the rules finalized.
I’ve done a lot of thinking about this over the past few months – is it feasible for a clearinghouse to clearing CDS of its members (say, CDS on GS debt) or of sovereign debt, especially debt of the country where the CCP sits (e.g. ICE Clear clearing CDS on US debt). Too much wrong way risk exists to treat either case the same as other CDS – basically, the worse things got the worse they would get.
If a bank clearing member was nearing default, the other members would simultaneously be worrying about the impact on the clearinghouse as a whole while also needing to post additional margin because of the continuously widening CDS spread. A double whammy on the system. And as per my comments below, cleared sovereign CDS create an even more systemically risky situation.
Two important points to note: the market needs these instruments to hedge risk, so they can’t just go away. And second, their are ways for the CCP to deal with the additional risk – its just unclear (no pun intended) if those ways would make the products unattractive:
“The banks and sovereigns are where people are concerned about risk the most today,” said Kevin McPartland, director of fixed-income research in New York at Tabb Group, a research and advisory firm. “This is an exposure people need to manage, so we need to figure out a way to manage it.”
“Look at Greece possibly defaulting, it’s causing a global disaster,” he said. “Can you imagine if Germany defaulted? A clearinghouse wouldn’t do any good. There’d be a knock-on effect to every systemically important institution in the world.”
Read the full story at BusinessWeek.com.
TriOptima – now owned by ICAP – has been at the center of trade compression and portfolio reconciliation for nearly a decade. Derivatives reform rules certainly change things – trading will become more automated and clearing will bring a lot of compression into the clearinghouse. But as I’ve learned, TriOptima still is poised to sit in the middle of it all:
The FT did a great job covering TABB Group’s new research piece looking at the technology challenges facing clearinghouses and dealers as they prepare for central clearing mandates. Read the full story here.
And the press release:
TABB Says Dealers and Clearinghouses Need to Make Huge Investments and Upgrades to Current Clearing Technology
NEW YORK & LONDON, Sep 29, 2011 (BUSINESS WIRE) — Global regulators focusing on the clearing of OTC derivatives have started a technology revolution, says TABB Group in new research published today, “OTC Derivatives Clearing Technology: Bringing the Back Office to the Forefront.”
“OTC derivatives reforms are causing headaches all over Wall Street, the City and beyond,” say Kevin McPartland, a TABB principal, director of fixed income research and co-author with senior contributing analyst Finn Christensen. “Unfortunately, current clearing infrastructures are neither scalable nor flexible enough to handle the changes ahead, a fact driving a wholesale change from overnight (or longer) processing to near real-time clearing expected to occur during the next three to five years.”
Anticipating an increase in transaction volumes is a key component to the clearing technology roadmap, and using listed-derivatives markets as a guide, TABB estimates that as new trading and clearing mandates are implemented, transaction volumes could increase twentyfold with market data volumes rising three to four times above current levels. “Not only must clearing infrastructures be scaled up but upgraded in such a way that they can scale further if transactional growth exceeds current estimates,” McPartland says.
Despite the fully staffed IT teams and eight-figure budgets at big global dealers and some clearinghouses, the authors explain, building out this infrastructure will be difficult without third-party assistance. “Technology providers have already stepped in to revamp legacy systems and build new technology that solves many of the issues born from expected regulations. The biggest market participants will take a best-of-breed approach, utilizing the best off-the-shelf products they can buy and tightly integrating them with systems that are built by in-house staff.” They add that most buy-side firms expect swaps dealers and their service providers to provide the necessary connectivity and interfaces.
Real-time clearing of a broad range of OTC products will happen, McPartland says, as market participants and regulators demand it and innovative technologists guarantee it. “These improvements will come in phases, paralleling regulatory rollout and growth in clearing volumes. The first phases are underway and clearinghouses and dealers understand the winners will be those who can consume and disseminate data elements critical to trading, clearing and reporting in the least amount of time. But technology is the key catalyst behind the elimination of existing inefficiencies, reduction of expensive manual resources and lowering of operational risk.”
Based on conversations with clearinghouses, swap dealers, technology providers and buy-side clearing specialists, the 21-page TABB report with 8 exhibits examines the impact new OTC derivative regulations will have on clearing technology for both sell side firms and clearinghouses; the cost of implementing the technology needed to handle real-time clearing and intra-day margin calls; and a view of the new clearing workflow.
The report is available for download by TABB Group Research Alliance Derivatives clients and pre-qualified media at https://www.tabbgroup.com/Login.aspx . For an executive summary or to purchase the report, visit http://www.tabbgroup.com or write to email@example.com.