Liffe, the futures exchange, and LCH.Clearnet, the London clearer, will on Monday become the first group to offer clearing of credit default swaps, financial instruments that are central to regulatory worries over the risks posed by defaults in the credit derivatives markets.
The development comes as efforts by regulators on both sides of the Atlantic to get such bilaterally negotiated, or over-the-counter (OTC), contracts shifted on to centrally cleared platforms are coming to a head.
Regulators want the CDS market to be centrally cleared because they fear that without such safeguards any future defaults could wreak the same kind of havoc on the financial system as September’s default by Lehman Brothers, which affected about $400bn (£267bn) in credit default swaps linked to the failed bank.
The European Commission last week received commitments from dealers and exchanges to shift CDSs, which are currently not cleared, into a cleared environment by early next year.
US authorities, led by the Federal Reserve Bank of New York, have for months been pushing for a centrally cleared mechanism for CDSs.
Four groups are working on such systems: CME Group, the Chicago derivatives exchange, with hedge fund Citadel; IntercontinentalExchange, another US futures exchange, with The Clearing Corporation and dealer banks; NYSE Euronext; and Eurex, the derivatives unit of Deutsche Börse.
Although some over-the-counter derivatives have been centrally cleared for some time – such as US Treasury bonds, European interest rate swaps and carbon emissions – regulators want CDSs cleared to reduce counterparty risk – that is, the risk that parties to a trade default.
A clearing house acts as the buyer for every seller and as seller for every buyer in a transaction, helping to virtually eliminate counterparty risk.
Liffe, owned by exchange group NYSE Euronext, will launch clearing for three CDS index contracts through Bclear, its trade registration service, prior to sending to LCH.Clearnet for clearing. They will be Markit iTraxx Europe, Market iTraxx Crossover and Markit iTraxx Hi-Vol.
Ade Cordell, head of wholesale services at Liffe, said the exchange expected a slow start so close to Christmas and that the timing was to allow participants to test the system before any meaningful volumes were achieved.
“We are expecting volumes really to come through in the second and third week of January once a critical mass of market participants has done that work,” he said.
Dealers in the CDS market have warned against there being too many clearing solutions, partly because of the cost of posting margin collateral at multiple clearing houses. Some are also uneasy about splitting the market into two pools of liquidity in dollars and euros.
However, last week the governing council of the European Central Bank reiterated its belief that there was a need for “at least one” European clearing solution, and that “given the potential systemic importance of securities clearing and settlement systems, this infrastructure should be located within the euro area”.
Eurex aims to start offering CDS clearing in March. It is in talks with unnamed entities about setting up a joint venture that would control a separate clearer for CDSs, distinct from Eurex Clearing, its existing clearing operation for exchange-traded derivatives.