The absence of a central clearer has made such contracts risky because there is no guarantee that parties will pay out.
This systemic risk has fuelled the global credit crunch, prompting regulators to step up pressure on banks to show they are trying to make the system more dependable.
Credit derivatives allow investors to make bets on the creditworthiness of baskets of corporate debt. Global growth in the notional value of such contracts grew by 81 per cent last year to a value of $62,200bn.
Credit derivatives contracts are predominantly negotiated privately between traders who rely on their assessments of each other’s ability to pay under the terms of the contract. A clearer uses funds contributed by traders to guarantee against default.
“The credit crisis has definitely heightened interest in this kind of solution among the regulators,” said Kevin McClear, chief operating officer of The Clearing Corporation, the Chicago-based institution backed by the banks that will act as the new clearer. “We don’t think there’s a better approach to reducing systemic risk.”
The need to act fast to pre-empt stiffer regulation in the wake of the credit crisis has given impetus to a proposal that has been 18 months in the making. It has also been accelerated by attempts by other clearers, such as LCH.Clearnet, Europe’s largest independent clearer, and the CME Group, the Chicago-based derivatives exchange, to muscle in on the business potential of clearing such over-the-counter derivatives.
Thursday’s proposal is the result of an agreement between The Clearing Corporation (also known as CCorp) and the Depository Trust and Clearing Corporation (DTCC), the New York-based clearing group.
CCorp’s backers – including Goldman Sachs, Citigroup, JPMorgan, Bear Stearns and Morgan Stanley – will establish a guarantee fund to cover losses if any firm should fail.
While Thursday’s announcement is sure to be welcomed, questions remain about whether the proposal will raise industry standards or if it is largely cosmetic.
Clear chance to transform world of derivatives(FT) The headquarters of the Clearing Corporation in downtown Chicago are an unlikely setting for an institution that has set its sights on transforming the financial world in the next four months.
Unoccupied cubicles dominate the main working area, several of the adjoining offices are vacant and the overall atmosphere is soporific.
The organisation has not had a chief executive since the last one left in 2006 and it has cut its staff back to about 40.
Since it became independent in 2003 from the Chicago Board of Trade – where it had been the clearing house since 1925 – it has not been a significant clearer of derivatives contracts.
So there is bound to be scepticism about the Clearing Corp’s ambition to launch itself as the world’s first clearing house for the $62,200bn credit derivative industry.
Most obviously, there is the question of whether an institution that has been out of the spotlight can refocus itself as a clearer for the dynamic over-the-counter derivatives sector and achieve meaningful volumes before more thrusting competitors emerge to steal its thunder.
Kevin McClear, chief operating officer, takes umbrage at the notion that the Clearing Corp has been snoozing. “We’ve been off the radar but we’ve been active,” he says.
The firm currently clears trades for small exchanges such as the Chicago Climate Futures Exchange, but its total volumes are relatively small. Also it has been touted three times in the past decade as the institution that could be used by competitors to the Chicago Mercantile Exchange to break that exchange’s near-monopoly on futures clearing. None of those attempts succeeded.
Mr McClear points to the firm’s recapitalisation last December as a sign of its intent. Twelve big OTC dealing houses and three inter-dealer brokers pumped in about $60m with the idea of re-creating the organisation as an OTC derivatives clearer.
He further notes that in spite of not having a chief executive (it is searching for one), the Clearing Corp retained many of its experienced executives as it cut employee numbers back. It aims to double staffing at lower levels in the next two to three years.
The Clearing Corp also hopes it can begin in its new role using its existing technology. Initially it will clear only OTC credit default swap contracts that are based on North American high-yield and investment-grade indices.
“Those trade more like futures contracts,” Mr McClear says. “They’re highly liquid, we can clear them using our legacy systems, and we can manage the risk like we do with futures.”
In later phases the organisation hopes to move on to clear CDS products such as iTraxx indices, index tranches and single-name products, for which Mr McClear says it will need to introduce more up-to-date technology and risk systems.
Another doubt over the new venture is whether its sponsors are serious or are merely using it to get regulators off their back. The Financial Stability Forum has been calling for counterparty risk to be reduced as part of a wide-ranging set of reforms proposed in a report issued last month.
Regulators say they want a tangible response from the banking industry in the coming months.
“The regulators want to see some concrete action,” one senior banker says. “This is very tangible.”
The large investment banks are due to meet the New York Federal Reserve in the next few weeks to discuss reform. The New York Fed has informally indicated that it would welcome a more robust clearing mechanism and the issue is a central theme of a high-level report that Gerry Corrigan, former New York Fed president, is preparing with senior Wall Street figures.
Separately, the Corrigan group is discussing other possible measures to reform the credit-derivatives sector, such as introducing more standardised contracts. It plans to report in July.
Some sceptics even speculate that the investment banks behind the Clearing Corp’s agreement with the Depository Trust and Clearing Corporation have no real interest in the project. The advantage of OTC contracts is that they are customised. If such products become standardised and commoditised, the argument goes, banks’ margins would come down.
With a nod to the doubters, Mr McClear recognises that his organisation needs to prove it is up to the job by making its initial roll-out demonstrably effective in just a few months.
“Our goal is to get something up and running and show everyone its usefulness,” he says.
Mr McClear believes that – through multilateral netting of contracts, trade guarantees, collecting forward-looking margin to protect against adverse price moves, and daily marking-to-market of cleared positions – the initiative should be able to show quickly how it substantially lowers risk.
“It’ll be interesting if we can share the significance of the systemic risk that we’re reducing through the initial clearing efforts when we net down these huge positions,” he says.
Another concern is that the venture could reinforce the dominance of a small group of banks in credit derivatives. But Mr McClear says he is open to new clearing participants as long as they are well capitalised.
Whereas many start-up initiatives in clearing have failed, Mr McClear says the difference with the Clearing Corp is that it aims to tap into a huge book of transactions that are already housed at theDepository Trust and Clearing Corporation’s “warehouse” of OTC credit derivatives.
“There’s a huge trade out there of these products right now and it resides in DTCC in their warehouse,” he says. “We’ll be in a position to get between many of those bilateral transactions that are currently registered there and clear them. We’ll be a new counterparty in the warehouse. That’s where we can get the biggest bang in the shortest period of time.”