Battlelines Are Drawn As CME/Citadel Win SEC Approval for CDS Clearinghouse Mar 17, 2009 URL: http://www.advancedtrading.com/showArticle.jhtml?articleID=215900688
With and hedge fund manager Citadel Investments receiving final regulatory approval from the Securities and Exchange Commission (SEC) last Friday to clear credit default swaps (CDS) through their joint venture CMDX platform, the business of central counterparty (CCP) clearinghouses is in full swing.
"It's about time and let's get started and see how this plays out," commented Kevin McPartland, senior analyst at TABB Group in New York.
Industry observers are expecting full-blown competition to break out as the various CCPs begin courting customers for order flow to send through their respective clearinghouses. "Now we've got three legitimate businesses in play," commented Alexander Harrison, managing director at IDX Capital LLC, an electronic interdealer brokers in credit default swaps based in New York.
In the U.S. market, ICE Trust, spearheaded by the IntercontinentalExchange, has gone live with bulge-bracket dealer support, while CME, the world's largest derivatives exchange, received the SEC's nod last week. In Europe, NYSE Euronext via Liffe's Bclear platform is live in Europe. In addition, Swiss-German futures exchange Eurex is also planning to launch a European-centric central clearinghouse for CDS in Europe. (Eurex is looking for dealers to invest in its initiative, in return for sending clearing flow into the system).
"The battle lines certainly have been drawn. Dealers have certainly aligned around the ICE," commented Harrison, who spelled out the differentiating features in an email. In New York, ICE Trust has materialized as the predominant dealer-supported play and has begun clearing index swaps already, said Harrison in the email. "ICE has set the participation barrier very high, and thus will prevent firms outside the bulge bracket from clearing trades," added Harrison.
"Conversely, the CME out of Chicago is pursuing broader participation via an FCM model where the participation hurdle is still in the millions, in terms of required balance sheet capital, but implies buy-side participation that would be disruptive to incumbent market structure," he added.
For weeks now, industry analysts have been saying that ICE Trust has the edge, given its wholesale dealer support. "The dealer-to-dealer market is still the majority of trading in CDS as well, so we can't ignore that fact," said Tabb Group's McPartland. But now with CME crossing the last regulatory barrier and opening its clearinghouse up to buy-side firms, including asset managers and hedge funds, analysts are acknowledging the strengths and experience of CME, the most dominant exchange in futures markets. "This is an organization that's been in business for 100 years and never had a customer default, and they're not about to today given the scrutiny on this asset class and the risk issues, particularly as they open for business to clear this new product with all the eyes of the financial world on them," said Harrison in the interview. What's more, CME has applied this FCM model, which has been successful in futures, to the clearing of swaps, noted Harrison.
Tabb Group's McPartland agrees that ICE Trust is going to have more of a dealer-to-dealer focus However, McPartland points out, "In some ways, the CME is going to be looked as more secure, because it's bigger. The ($7 billion) default fund is larger and they're going to be doing this for a long time." On the other hand, ICE Trust has the backing of the Federal Reserve which has had a "heavy hand in influencing financial policy over the last year or so," so that could be an advantage, contends McPartland.
But what might be difficult to beat is that dealers had earn-out provisions in the sale of their stake in The Clearing Corp. (TCC) to ICE. "It's a 50 percent earn-out provision. Every dollar of clearing revenue that the ICE makes, the dealers get a 50-50 revenue split."
CME and Citadel also invited equity participants to join the CMDX platform, so there could be an incentive to owners to send more clearing volume to CME, though it's unclear if other institutions have joined on, suggested Harrison.
Another issue is how the central counterparties connect with electronic trading venues that are likely to emerge for the liquid CDS indexes. "How each exchange views RFQ (request for quote) and (electronic) order book interfaces will be a key factor in strategy execution, and potentially ultimately the evolution into an exchange-traded CDS index security," said Harrison in the email.
Starting out, both CME and ICE Trust are offering to clear the CDX indexes, and then offer clearing in the single-name default swaps that are components of the indexes. "It's like clearing the S&P 500 index for starters, and then adding in the stocks," said McPartland. CME and ICE Trust are also seeking approvals to clear CDS in Europe.
While analysts and industry observers are not sure how the turf war will pan out, some suggest that four clearinghouses may be too many. Tabb's McPartland said, "It's positive competition that will ultimately be good for innovation and pricing. Now that the CDS clearinghouses are operating, "The expectation is that regulations will finally get sorted out and the market will get more streamlined," said McPartland. "You're going to see more buy side players come into this space because it will be easier to do electronic trading," he said. "The central counterparty adds some transparency. It's going to make asset managers and hedge funds come into this space more than they would before," he predicted.