Wednesday, February 3, 2010

Opposition Mounts To CME Group's Credit Derivatives Clearing

Original posted on the Dow Jones Newswire:

CME Group Inc. faces growing opposition from futures brokers and Wall Street banks uncomfortable with the structure of its new credit default swap clearing service.

Brokers that post collateral for futures and options trades at CME said they remain wary of letting their customers' funds stand behind credit default swap transactions, a riskier and more opaque market.

Some swap dealer banks have become equally concerned, preferring a separate clearinghouse for credit derivatives positions, which are usually held longer and trade less frequently than listed futures contracts.

"The way it's set up, ultimately all the members back the CDS default process whether they're CDS clearing members or not, and likewise all the CDS members back the futures risk," said a senior futures brokerage official. "So you have people on both sides that aren't happy."

Such concerns have followed CME's oft-delayed effort to clear credit derivatives since the venture was announced in 2008, and the move to merge the two product groups under one clearinghouse saw a rival service from IntercontinentalExchange Inc. (ICE: 98.91, 0, 0%) gain a head start in the business.

ICE, which separates out CDS products from its futures clearinghouse, has handled more than $5 trillion in business since launching last March, thanks to support from dealer banks that dominate credit default swap trade.

CME officials note that their CDS venture, having handled $184 million since its mid-December launch, remains in its nascent stages. But executives are likely to highlight its progress when fourth-quarter earnings are reported next week, having identified over-the-counter derivatives clearing as a key growth opportunity amid a global slowdown in derivatives trade.

Over-The-Counter Opportunity

Both CME and ICE are targeting the credit derivatives market, estimated at $25.6 trillion, with clearing services that could bring in an estimated $320 million in total revenue per year, according to a December report from Morgan Stanley.

Regulators and lawmakers back the push, and are mulling a broad mandate for dealers and market participants to clear swap trades as a way to mitigate risk to the broader financial system.

CME has aimed its CDS service at buy-side firms like hedge funds and other institutions, many of which are already big traders in CME's futures markets.

Key to the offering is the ability for CME and clearing members to co-mingle customer funds set aside as collateral for both futures and credit derivative positions, ultimately making it more efficient for firms to do business at CME.

The derivatives exchange separates the two asset classes by a series of tranches, each providing a backstop in the case of a customer default.

On the CDS side, each clearing member's own collateral is tapped first, followed by a tranche of CME funds. If that's not enough to cover the entire loss, a tranche of collateral made up almost entirely of CDS-related capital is tapped. In the end, losses would be backstopped by the broader guarantee fund covering CME's futures and options markets.

The process follows a similar sequence of events in the event of a futures-only clearing member default.

"The structure has evolved over time to a place where there's a very good mix of protection in one asset class versus another asset class, because of these tranches," said Kim Taylor, president of CME Clearing.

Taylor said that the system of tranches was designed with feedback from participants, and approved by CME's risk committee, made up of exchange users.

Customer Reservations

But some clearing members maintain that credit default swaps and derivatives are distinct enough that the failure of a clearing firm on either side could cause major issues for the other.

"CDS are not integrally related to exchange-traded futures contracts and do not appear to provide any opportunity for cross-margining," wrote John Damgard, president of the Futures Industry Association, in a letter to futures regulators last fall. The FIA, which represents industry brokers, has opposed CME on a number of initiatives and competition matters in recent years.

A spokesperson for MF Global, among the largest futures brokers doing business at CME, said that commingling credit derivatives and futures collateral "raises significant issues that, if not properly addressed, could threaten the cornerstone of customer protection in our industry - the segregation of futures customer funds."

Futures participants worry that a default on the CDS side could take days to play out, given the potentially lengthy process involved in valuing credit default swaps, while the CDS-related collateral is drained in the meantime.

CME's Taylor said that the rules for credit derivatives clearing members, finalized in December, call for higher risk standards and capital requirement levels, meant to shield futures-only collateral from losses on the CDS side - and vice versa.

While officials at both dealer banks and FCMs said they would prefer a separate default fund dedicated to credit derivatives, Taylor said the exchange has no plans to separate the two product classes.

"We think there are significant customer benefits to having the pooled approach," she said.

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