If opacity and counterparty risk were the two birds that flew in the credit crisis, central clearing may be the single stone that brings them down to earth.

Or so the regulators hope.

Leveraged positions in privately negotiated, over-the-counter derivatives were one of the most damaging faultlines in the credit crisis, and led to bailouts of institutions such as AIG and Citigroup. To avert a repeat, regulators have ordained that as much as possible of the market must in future be transacted in the light of public scrutiny.

In September 2009 the G20 group of countries called for “all standardised derivative contracts to be cleared through central counterparties by end 2012 at the latest”. Policy makers were quick to act and the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into US law in July. European Commission proposals published in September must come into force by the end of 2012.

In response, the dealer community committed to centrally clear 70% of new interest rate derivatives and 80% of eligible credit default swaps by late 2009. Those targets were exceeded – the Federal Reserve Bank of New York reported in March 2010 that 90% of eligible securities were being processed through clearers.

Nevertheless, the $700tr over-the-counter (OTC) derivatives market dwarfs its exchange-traded counterpart, accounting for 89% of notional outstanding of global risk transfer at the end of 2009, according to research firm Tabb Group.

Over the past 12 years the sector has grown at an average annual rate of nearly 19%, and turnover in 2010 is expected to hit $1.7 quadrillion.

For operators, the surge in demand for OTC clearing is a commercial bonanza. Morgan Stanley estimates a long term profit potential of nearly $1bn across all product segments.

“What we have here is a massive business in the midst of an amazing and unprecedented transformation,” says Paul Rowady, a senior analyst at Tabb Group in Chicago. “There are big opportunities for clearing houses and exchanges, and for those that get it right the rewards will be enormous.”

Gold rush

Like bees to the honey pot, a swarm of interested parties is rushing to take advantage. Up to 30 interdealer brokers and independent platforms are expected to register as swap execution facilities (SEFs) in the US. Exchanges are expanding their operations and developing new ones, and clearing houses devising new products and services.

Clearing operators, in short, are proliferating. The European Association of Clearing Houses has 21 members. Securities regulators in Canada are exploring a multi-asset central counterparty, and in January Hong Kong joined Japan in mandating clearing for OTC derivatives.

As the market expands, dealers and investors are faced with a dizzying array of propositions, and regulators are braced for inevitable squabbles over ownership and services.

The asset class with the most immediate potential for commercial rivalry is the $400tr interest rate derivatives market, which is transacted in some 79 currencies but dominated by euro and US dollar exposures.

The dominant clearing house in the OTC rates market is SwapClear, owned by London-based LCH.Clearnet Group, which had cleared some $228tr of swaps in 20 currencies up to August 2010, accounting, it says, for about 40% of all outstanding swaps. By June 2009 SwapClear reckoned it was handling 89% of new throughput in interdealer swaps.

In June SwapClear applied to the Commodities Futures Trading Commission to set up a subsidiary in the US, which vice-president Andrew McGuire said in July would be “the battleground for the next two years”.

While SwapClear has many US banks as members, a stateside operation would enable it to run the futures commission merchant (FCM) model, guaranteeing clients US bankruptcy protection.

That is a key requirement for buy side derivatives users such as mortgage finance agencies Fannie Mae and Freddie Mac, which last year announced their intention to start clearing interest rate derivatives.

Incumbents expand

The interest rate swaps market, though huge in its open interest – the total of all unexpired contracts – is exceeded in a different measure, notional turnover, by the interest rate futures and options market, dominated by the exchanges CME Group, Eurex and NYSE Liffe. Their combined notional trading volume of $1.35 quadrillion in 2009 amounts to around 90% of the market, according to Tabb.

Not surprisingly, these exchanges cast covetous glances at the interest rate swaps business, and want to exploit the trend for investors to embrace central clearing.

“We are very committed to offering clearing services in interest rate swaps,” says Kim Taylor, president of CME Clearing in Chicago.

CME, which controls some 95% of the market in US interest rate futures, launched an interest rate swap clearing service in October, relying on its strong relationships with investors including BlackRock and Pimco. It expects its ability to offer portfolio margining against futures to drive growth, Taylor says.

In December, CME also received approval from the UK Financial Services Authority to launch CME Clearing Europe in London. It plans to begin operating in the first quarter, initially focusing on OTC commodity products.

Eurex also wants to clear interest rate swaps, alongside new offerings for traded equity options and equity swaps, which it aims to roll out in the coming year.

“Our strategy is to leverage core strengths from our existing clearing business. We are able to offer the highest capital and operational efficiency as well as strong client protection,” says Thomas Book, a member of Eurex’s executive board in Frankfurt. “In the interest rate swap market outstanding notional is huge, but volumes in terms of transaction numbers are pretty low compared to listed derivatives. Still, there is further potential from standardisation.”

Eurex plans to expand its range of derivative products across asset classes, from interest rates, equities and indices to dividends, volatility and commodities.

“A core objective is onboarding the buy side,” says Book. “Key benefits we want to offer are sound client protection solutions and superior capital efficiency across products.”

The one pot option

NYSE Liffe US, the subsidiary of NYSE Euronext launched in 2008, is taking aim at CME’s interest rate futures business, with a new set of products to be cleared though New York Portfolio Clearing. This new clearing house, a joint venture between NYSE Euronext and the Depository Trust & Clearing Corporation, is set for launch in the first quarter.

NYPC’s unique selling point is its relationship with the DTCC’s Fixed Income Clearing Corporation, which clears the US Treasury bond market. That will enable clients to cross-margin their positions across futures and cash bonds – so-called ‘one pot clearing’.

In contrast with the vertical clearing model at the CME, NYPC is designed to operate ‘horizontally’, allowing open access to clear trades from other exchanges. However, NYSE Liffe US will be the exclusive exchange partner for an initial period, something that has angered other futures exchanges such as ELX Futures, which claims that will give NYSE an unfair advantage.

“Every competitor needs a catalyst and where the battles will be fought in the future is capital efficiency, which will drive business in our direction,” says Walter Lukken, chief executive of NYPC in New York. “We are working on reducing costs and while we are first focusing on interest rate futures there is no reason why we would not look at swaps in the longer term. Certainly we feel there is room for a number of players.”

Going in house

In Europe, NYSE plans to build two new clearing houses, in London, for derivatives, and Paris, for equities. The aim is to bring in house clearing revenues that at the moment its customers pay to LCH.Clearnet.

In a parallel move, the London Stock Exchange said in May it was reviewing its clearing relationship with LCH.Clearnet. The project to build a clearing house was kept secret, but in October LSE hired a former LCH.Clearnet CEO, Patrick Birley, to lead it. Two months later he left, although a spokesman said he was still employed on a consultancy basis.

Further along is Nasdaq OMX, which in 2009 launched International Derivatives Clearing Group, which clears swaps and swaps as futures under the FCM model.

“We initially chose to clear swaps as futures to give our clients confidence in the protection they can get under the established FCM regime, which is a strong tradition in US futures houses,” says Garry O’Connor, chief executive of IDCG in New York. “We have now expanded to include cleared-only swaps as the protection has been extended.”

ICE takes the credit

After interest rate swaps, the second pivotal area for growing use of central clearing is credit default swaps. This market is at present transacted entirely over the counter, and its size has stabilised at around $40tr of notional outstandings, after a 40% decline from its 2007 peak.

Some market participants say single name CDS are complex products to clear, as, apart from the most liquid names, they trade relatively infrequently. Margin requirements depend on model-derived default probabilities. Others suspect that these objections are mere foot-dragging by banks that do not want their profitable OTC market to become more commoditised and transparent.

The latter view is supported to a degree by the success that Intercontinental Exchange Group, which runs ICE Trust US and ICE Clear Europe, has had in clearing CDS since the beginning of 2009.

The group reported a 2010 monthly growth rate in clearing single name CDS of some 62% in the US and 27% in Europe.

ICE, which is supported by most of the big investment banks, has cleared about $14tr of CDS contracts since launching its service in March 2009. LCH.Clearnet, meanwhile, has cleared $27bn while CME Group clocked $236m. Eurex has a CDS clearing facility but has achieved scant volumes to date.

“After Enron there was a big move to push energy swaps into central clearing and we built on our experience in that market to build our default swap business,” says Paul Swann, president and COO of ICE Clear Europe in London. “There are specific features in CDS such as jump to default risk which need to be accounted for in our risk models, and we have worked closely with the industry to develop a tailored approach.”

Parallel reforms

The Bank for International Settlements’ Committee on Payment and Settlement Systems and the technical committee of the International Organisation of Securities Commissions, the leading policy forum for securities regulators, are reviewing risk management standards for central clearing, and are expected to finalise methodologies that will apply to CDS in the coming months.

A complete set of rules for US central clearing arising out of the Dodd-Frank Act must be in place by the middle of this year. European regulators published their proposals in September, and the text has been passed to the European Parliament for approval.

While the thrust of the US and European rules is likely to be similar, there may be differences in the detail, such as which derivative contracts will be subject to mandatory clearing.

“Dodd-Frank is more progressed, while in Europe a number of legislative initiatives are still in discussion,” says Book at Eurex. “We are very concerned that the approaches remain consistent in Europe and the US. Some paths are diverging, for example on standardisation of OTC derivatives, actively driven in the US by swap execution facilities but not addressed in Europe.”

In Book’s view, the worst case in a global market is that the rules end up creating opportunities for regulatory arbitrage. “There is a medium, not small, risk that will happen,” he warns. “The competitive dynamics need to be on regulator’s minds.”

One area where there is already considerable divergence is on the cost of clearing, which is up to 10 times higher in Europe than in the US. As competition for clearing business intensifies, the issues of margin and clearing fees are likely to become a battleground.

Costing risk

At present, some 70% of OTC derivative trades by volume are collateralised, according to Tabb Group, but there is still a significant degree of under-collateralisation by value, caused by offsetting and competition for business.

Total liabilities to counterparties amounted to more than $3.5tr in 2009, Tabb says. Based on the annual margin survey by International Swaps and Derivatives Association (Isda), some $1.6tr of collateral is committed in OTC markets, leaving a shortfall of nearly $2tr.

One interpretation says that can be read as the nominal cost of switching all those trades from bilateral to central clearing. Conversely, doing so would presumably remove $2tr of uncollateralised risks from banks’ and other firms’ balance sheets.

Higher costs of collateralisation in central clearing might also be offset by lower transaction costs, as the OTC bid/offer framework is replaced.

Closely related to the issue of cost is the ability of clearing houses to offer capital efficiencies across asset classes.

“Where the battles will be fought in future is the ability to offer capital efficiency,” says Lukken at NYPC. “When you look at costs across existing clearing houses it is difficult to compare apples with apples, but we are working hard on costs.”

So far, market participants can benefit from a degree of cross-margining between different asset classes at a single exchange. But there is little sign of exchanges and clearing houses agreeing to cross-margin each other’s products – with the notable exception of the US options market, where nine exchanges all use the Options Clearing Corporation, which centralises all open interest.

One clearer or many?

As the clearing world becomes more complex, with even more clearing houses handling multiple asset classes, clients may be torn between putting all their business through fewer houses, to take advantage of offsetting, or shopping around for the best deal, and losing the advantages of one-pot clearing.

“Ideally the business would work better if you had one clearer for each product,” says Hartmut Klein, a consultant with Goodacre UK and former head of Eurex’s London office. “In Europe there is a push for interoperability, but the complexities of margining across numerous clearing organisations means we are unlikely to see any real progress in practice.”

Interoperability is a complicated word for a complicated thing – the right for trading parties to choose where their contracts are cleared, without being tied to one clearing option by their choice of trading venue.

At the forefront of the interoperability campaign in Europe is EuroCCP, the clearing house owned by DTCC that focuses on equity markets.

“Interoperability would give trading firms the choice of where to direct flow, which is going to be a huge benefit in terms of margining, and which will directly drive reduction in costs,” says Michael Bodson, chief operating officer of DTCC in New York. “Those with the best price and best service will win market share.”

The power of the banks

As competition to clear derivatives heats up, US regulators are keen to prevent individual providers taking ownership of any particular market segment.

The Department of Justice said in December it was concerned on two fronts: first, that an individual firm might be motivated to ensure certain OTC derivatives were not centrally cleared, and second, that it might prevent rivals gaining access to clearing houses.

Legislation proposed in October would prohibit any swap dealer, such as Morgan Stanley or Goldman Sachs, from owning more than 5% of the voting power in a clearing house. More powerfully, all votes held by all dealers put together must not exceed 20%.

The rule would also limit dealers’ membership on clearing houses’ boards and establish rules to limit conflicts of interest.

“An inherent conflict exists between broker-dealers and clearing houses and exchanges,” Democratic congressman Stephen Lynch was reported by Bloomberg as saying. “Brokers and dealers should not be able to capture trading and clearing intermediaries.”

With many of Wall Street’s biggest names now owning stakes in clearing platforms, the proposals have sparked a furious debate. Some argue excluding dealers will increase risks and raise costs.

Five big dealers hold 95% of US banks’ OTC derivatives, according to the Office of the Comptroller of the Currency, or 37% of global OTC derivative outstandings, according to Isda.

Needless to say, they have written to regulators opposing the proposals. Isda, champion of the OTC dealers, says the supervision required by Dodd-Frank obviates the need for ownership and voting limitations.

“There is still a lot of dust in the air but there is a real concern over conflicts of interest if the banks can have too much ownership, for example of fees and risk modelling,” says Rowady at Tabb Group. “Our sense is that they will not be able to totally eliminate bank ownership – so the question is, where will they set the bar?”