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Capital Markets

Credit derivatives: CDS clearing hits a territorial bump

European Commission digs its heels in over central counterparty.

The long-expected establishment of a central counterparty (CCP) for credit default swap clearing is the latest initiative to become enmeshed in squabbling between industry and the regulators. Central clearing has been on the cards for CDS for some time (see Credit default swaps: On dangerous groundEuromoney August 2008) and several consortia have come up with proposals for clearing entities. But a dispute has erupted over whether or not there should be a global CCP or separate CCPs in Europe and the US, threatening to delay the entire process.

The European Commission has tried to persuade the industry that a separate European solution is preferable because it does not want the CCP to operate under a regulatory regime over which it has no control. The Commission apparently secured verbal agreement to the scheme late last year but dealers have subsequently been reluctant to sign up to it. In a terse comment issued in early January, a spokesman for Charlie McCreevy, internal markets commissioner for the EU, stated that "We haven’t got a commitment to move to central clearing... so now we feel that since there isn’t the engagement by the industry, the project as such has failed and, therefore, the Commission has to consider the appropriate next steps."

Regardless of whether or not a CCP is required, the proposal to somehow divide the process along geographical lines seems curious. "The advantage of a global solution is more efficient netting and thus the probability of an even smaller notional," says Michael Hampden-Turner, structured credit strategist at Citi. "Typically, US and European CDS investors take exposure to both markets and there is a high degree of correlation. It would be inefficient not to have a single CCP." He adds, however, that the scale of the challenge in getting parties to agree to a global CCP should not be underestimated. "The more people you have around the table, the harder it is to come to an agreement. But the efficiencies of having a single global solution should outweigh the practical issues, and hopefully in this environment we can be a bit more revolutionary."

Derivative Deutsche

Derivatives as a percentage of total assets at end 2007

Source: BNP Paribas

The International Swaps and Derivatives Association called a meeting in London on January 8 to try to move this process forward. Representatives of the European Central Bank, the Federal Reserve Bank of New York, the Financial Services Authority and the European Commission are understood to have attended the invitation-only event. "The workshop was an opportunity for potential users to obtain information on the range of capabilities of the various vendor platforms, as presented by the vendors themselves," Richard Metcalfe, global head of policy at Isda, tells Euromoney. "Isda hosted the session as a means of increasing the availability of information that will assist in facilitating member choice and in realizing the industry’s commitment to centralized clearing." A number of clearing houses are jostling for position as the CDS market’s CCP. They include ICE Trust (a chartered trust company created by Intercontinental Exchange to operate the joint clearing house operation) and The Clearing Corp (TCC), which is due to launch later this year. Another tie-up is between Chicago Mercantile Exchange and hedge fund Citadel, which plan to set up the Credit Market Derivatives Exchange. NYSE Euronext subsidiary Liffe launched its CCP initiative in December, the first in Europe. Eurex, the derivatives unit of Deutsche Börse, is planning to offer clearing after having reportedly previously backed the TCC solution.

Level field

The competitive field between the various exchanges was levelled in January with news that the Depository Trust and Clearing Corp will support all CCPs with data from its trade information warehouse (TIW). DTCC first published details from TIW in November in a move designed to dampen fevered speculation about the risks to the financial system that the CDS market poses. In early January, the firm announced an increase to the information that it makes publicly available, adding a new section covering weekly trade activity. TriOptima, the portfolio compression service, eliminated $30.2 trillion of CDS notional principal last year.

The rift between the CDS industry and the European Commission extends beyond the issue of geographic location. The differences in treatment of events such as a restructuring will have an effect on how trades are treated. In Europe, where restructuring is not necessarily deemed a credit event, there is a question as to whether long bond short CDS trades would be considered netted by accountants and crucially if it would give capital relief under Basle II.

"Every time I have been involved in negotiating these types of issues at the European Commission you don’t get a lot of market-oriented people around the table"

While most in the CDS market now accept that central clearing will happen, there is resistance to any proposal to move the market onto an exchange. Market makers claim that full exchange would reduce liquidity because margins would be too thin for them to support it. They also claim that there is a certain volume of OTC contracts that need to be accommodated that wouldn’t work on an exchange. A compromise could involve CDS indices being moved to exchanges while single-name CDS clear through a clearing house. Single-name CDS present a challenge for clearing because of their individual nature. It has been suggested that in order to clear, these contracts will have to have a fixed coupon – 100 basis points for tight spread credits and a 500bp coupon for wide spread credits. Broad body

"There are differences in the way that bonds work in different regions, and CDS contracts have to reflect this," says Hampden-Turner at Citi. "This means that they have to look like the underlying bond – something that is certainly doable." He suggests that the situation could require the involvement of an objective arbiter such as Isda or the Bank for International Settlements. "Perhaps a broad industry or regulatory body can help the market work through some of the practical issues."

It is difficult to judge the extent to which the European Commission is prepared to play hardball on this issue. Charlie McCreevy appeared to strike a conciliatory tone at a conference on January 27. "There is still time to have further talks", he said, adding: "Given the inadequate industry response so far I am keeping open the option of legislating." Some dealers have expressed frustration at the impasse. "Every time I have been involved in negotiating these types of issues at the European Commission you don’t get a lot of market-oriented people around the table," grumbles one. "There is not a lot of practical experience there. In the US it is the opposite – with a lot of bankers or ex-bankers around the table."

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