Will Stormy Skies Give Way to Clearing?
With counterparty risk concerns taking the spotlight during the financial meltdown, government officials, regulators and market participants are searching for new protections.
When U.S. Treasury Secretary Timothy Geithner spoke to the House Financial Services Committee earlier this year, he began paving the way for a new trading, clearing and regulatory paradigm in the financial services sector.
“Over the past 18 months, we have faced the most severe global financial crisis in generations,” said Geithner in testimony to the House Financial Services Committee. “To address this will require comprehensive reform. Not modest repairs at the margin, but new rules of the game.”
Government officials and regulators have been fervently working to push away the dark storm clouds that are the financial crisis and restore confidence particularly in over-the-counter (OTC) derivatives markets. One major area of focus for the U.S. Department of the Treasury, in its broad framework review, has been on finding ways to improve counterparty risk management.
The answer in part is to expand clearing organizations to new markets.
“One of the problems has been that people couldn’t mark products to market,” says Gary DeWaal, group general counsel at Newedge, the world’s largest futures commission merchant. “But if you are clearing and trading on an exchange, you have transparency, better prices and double protection – the so-called ‘belt and suspenders’.”
Double Protection
Heightened awareness of counterparty risk plays to the strength of exchanges and their centralized clearing capabilities, particularly those with experience in handling complex derivatives.
Clearing houses have been given the green light to carve out a niche in the market, one that will benefit investors by helping them reduce risk. Central counterparty clearing (CCP) substantially mitigates credit risk because the clearing house acts as the buyer to every seller and the seller to every buyer, thereby guaranteeing the performance of every transaction. It also brings operational and financial efficiencies to the transaction. Kim Taylor, CME Group managing director and president of CME Clearing, says the exchange is doing just that across a number of OTC asset classes.
“Overall, our strategy is to answer the market’s call for clearing by providing a central counterparty guarantee in a market that traditionally hasn’t had that benefit,” Taylor says. “We are looking to provide central clearing in a flexible manner, so that clients can continue to maintain their choice of execution, but come to us for the added security of clearing. We think we can provide greater flexibility to them.”
CME Group acts as the central counterparty for derivatives ranging from interest rates to energy and agricultural products. It is in the process of launching an open clearing solution for the credit-default swap (CDS) market as part of its CME ClearPort services, which currently clears OTC derivatives in financials, energy, metals and agricultural commodities (see sidebar).
“CME Group is moving beyond the traditional exchange-traded space and I like their proposal best; it should attract the most participants,” DeWaal says. “There is an advantage to CME’s model in that it allows brokerage participation.”
The U.S. Treasury department’s proposed regulatory framework would mandate CCP for plain ‘vanilla’ or standardized derivatives, while more complex bilateral instruments will have to report to trade repositories and be subject to robust standards for documentation and confirmation; netting; collateral and margin practices; and close-out practices. Clearing houses and trade repositories will have to aggregate trade volume and position data.
Risk Adjusted Creativity
All of this ensures better risk management and transparency but critics say it might stifle creativity. This might not be such a bad thing, says Alan Grody, founder of strategic advisory firm Financial InterGroup.
“The boundaries today reward creativity at the expense of risk,” Grody says. “Bounded by the current view that ‘we are all in it together’ there must be boundaries on creativity when future outcomes are not restrained by risk appetite but rather by bonus pool incentives. Risk-adjusted creativity, to coin a new phrase, is what I see as the only inhibition, and a necessary restraint. Within this restraint there is much our creative society can accomplish.”
As exchanges stand to benefit from the new regulations, so does the marketplace. CCP offers a standardized way to view the products and quantities held, the exposures they represent and the counterparties that are exposed to risks under different scenarios of liquidity, credit and market conditions. This is one way in which to prevent the type of systemic risk that CDS posed to the global financial markets.
These attributes can go a long way to winning back investor confidence. CME Group is well placed to help with the process, Grody says.
“CME Group is a pioneer, an innovator, a consolidator, a best-of-breed organization that has proven itself in leading the industry forward, whether in new products, new risk management techniques, real-time platforms and/or in global partnerships,” Grody says. “Working with the global financial enterprises that make up their membership, CME can continue to lead and this time lead in close partnership within a willing global regulatory regime.”
Clear and Simple
With an expanded global emphasis on clearing, CME Group is well placed to assist market participants with increased security through its set of flexible clearing services for over-the-counter (OTC) markets, known as CME ClearPort.
CME ClearPort offers OTC market participants the same financial safeguards and sophisticated risk management found in CME Group’s exchange-traded products. Mark-to-market is done twice daily by CME Clearing and accounts are monitored by a professional risk management team on a 24-hour basis.
Using CME ClearPort, hedge funds, money managers, proprietary trading firms and banks all have access to CME Clearing’s performance guarantee for bilateral, OTC products that were traditionally only available for exchange-traded products.
“Clients on both the buy side and sell side are telling us that they need to use their capital more efficiently, mitigate counterparty risk and access stronger customer protections,” notes Kim Taylor, managing director and president of CME Clearing. “We think we can provide greater flexibility by preserving clients’ choice of execution at the same time we provide the added security of clearing.”
The benefits of clearing OTC markets are evident across a variety of markets. Bob Shults, a partner at brokerage firm Atlas Commodity Markets and Atlas Insite, said that CME ClearPort has helped bolster the ethanol market in several ways.
“The ability to instantaneously enter trades in CME ClearPort reduces errors and counterparty risk in OTC ethanol markets,” Shults says. “CME ClearPort credit mitigation has increased the number of eligible market participants and market liquidity.”
CME ClearPort is an open clearing service that users can access using most third-party execution platforms in a wide variety of markets. These include energy, metals, electricity, ethanol, and, most recently, agricultural commodities. CME ClearPort continues to grow rapidly with an average of 700,000 contracts handled by the service each day.
Taylor says even though CME ClearPort today is predominantly available for energy and metals trading, CME Group is adding clearing services for additional asset classes.
“For example, in early April we launched clearing services for the S&P GSCI Commodity Index Swaps as well as Grain Swaps and Calendar Swaps for corn, wheat and soybeans,” Taylor says. “We plan to launch clearing services for credit-default swaps soon as well, and we also plan to expand CME ClearPort to other asset classes in the future.”
CME Group plans to extend clearing services through CME ClearPort to other OTC markets and asset classes. With CME Group acting as the third-party central counterparty, counterparty risk is removed from the equation.
That is something regulators and market participants can agree on.
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