(Bloomberg) CME Group Inc. to guarantee credit- default swaps could put his entire $4 billion company at risk. pioneer says a plan by
CME Group's proposal to use its existing clearinghouse to clear swaps would require exchange members such as Peterffy's . to bail out a failed trader. Those companies have put up $101 billion to guarantee the now cleared by CME.
`It would be a great mistake,'' said Peterffy, 64, a Hungarian immigrant whose company executes 14 percent of the world's equity options. ``Mixing the two types of funds will jeopardize the entire financial system'' set up to guarantee futures trades, he said.
Peterffy, whose concern is shared by CME Group members including Penson GHCO Chief Executive Officer Chris Hehmeyer, is balking at a plan that CME developed amid pressure from the Federal Reserve to create a safety net for risky credit-default trades, now traded on an over-the-counter basis. Failed investment bank Lehman Brothers Holdings Inc. was among the top 10 dealers in the $55 trillion CDS market.
CME Group announced its CDS clearing plan Oct. 7, saying it would reduce counterparty risk and offer the market a ``key turning point.'' A rival proposal by Intercontinental Exchange Inc. would avoid the issue raised by Peterffy by creating a separate clearinghouse to segregate its futures and credit-swaps business.
A clearinghouse, capitalized by its members, all but eliminates the risk of trading-partner default by being the buyer for every seller and the seller for every buyer. It employs daily mark-to-market pricing and liquidates positions of traders who can't pay their margin.
In OTC markets, traders rely on their counterparty to make good on their agreements. A trader with a cleared OTC position could put other CME member firms at risk of making up a shortfall if the trader couldn't cover the losses. CME's clearinghouse hasn't ever suffered a default.
Kim Taylor, president of CME Group's clearinghouse, said she's taking steps to ensure solid pricing data for its CDS clearing. The plan to guarantee CDS indexes and contracts on individual companies is a partnership with hedge fund Citadel Investment Group LLC and includes a trading platform, which will create prices for the contracts, she said.
``The trading in the index products will migrate very quickly to the trading platform,'' Taylor said. Prices can also be created from market data, she said. ``This market already trades a significant amount,'' Taylor said. ``It's just that none of the information is public.''
Peterffy said he doubts that the exchange will be able to determine CDS pricing because they trade infrequently.
``There is no assurance once the buyer or seller goes bust you can liquidate those positions near the price'' that was settled upon the day before, Peterffy said. has as much as $1 billion pledged to equity and derivative exchanges, including CME Group, to fund trader shortfalls.
``I can see why people would be concerned by the CME's model,'' Penson GHCO's Hehmeyer said.
CDS pricing will still come from voice and electronically executed over-the-counter trades, said David Rutter, deputy CEO of ICAP Plc's electronic broking unit. Although most of these swaps trade daily, prices are not always available in all swaps, he said.
``The clearinghouse is potentially compromised if you don't have really good, independent and reliable mark-to-market information,'' Rutter said.
The amount of money traders must have on deposit, known as margin, is the main way clearinghouses insure against losses.
CME Group will require higher margin to trade CDS than futures, Taylor said.
To set futures margins, CME Group tallies a trader's total potential portfolio loss in one day and uses that amount to derive the margin rate. For CDS contracts, CME Group will add up the potential portfolio losses over two to five days, and use that amount to set the margin rate, Taylor said.
Margin calls on CDS contracts could be a greater risk than with futures, said Howard Simons, a strategist at Bianco Research LLC in Glenview, Illinois.
``You have highly correlated systemic risk,'' he said. ``We have whole industries where if one's in trouble, all of them are in trouble.''
When Lehman went bankrupt last month, the cost of on rose almost six-fold.
The CME Group risk committee, composed of the banks and hedge funds that capitalize its clearinghouse, will have to approve any new contracts cleared by the exchange. Taylor declined to comment on the risk committee.