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Swaps-Clearing Mania

After languishing on exchanges' back burners for years, swaps clearing facilities are suddenly all the rage.

By Robert Hunter

Call it a kick in the pants. When the London Clearing House announced in August 1997 its intention to introduce a facility to clear swaps between member firms, U.S. exchanges scratched their collective heads in bemusement. After all, the idea had first made the rounds way back in 1992, when the Chicago Mercantile Exchange announced the ill-fated CME Depository Trust Co., a swaps-clearing proposal that eventually fell on its face. The derivatives climate in August 1997 didn't seem to have changed enough since 1992 to suggest that the market was in need of a swaps clearinghouse. Over-the-counter business was booming, and counterparty credit risk was hardly a burning issue in the dealer community.

But a year later, when the LCH formally applied to the Commodity Futures Trading Commission for regulatory exemption, things had changed dramatically. The Asian and Russian crises, along with the sorry plight of the Japanese banking system, some high-profile hedge fund implosions and an unprecedented energy price spike, combined to destabilize the world financial system to an alarming degree, and counterparty credit risk began to weigh heavily on the minds of swappers.

Suddenly, the LCH's SwapClear facility, set to launch in August 1999, seemed appealing to increasingly risk-wary dealers. Now, after years of rumination, the New York Mercantile Exchange and the Chicago Board Brokerage—the cash Treasury offshoot of the Chicago Board of Trade—have lined up in vocal opposition to the LCH's proposal for regulatory exemption, and have announced plans of their own to clear swaps sometime down the road.

The Nymex is the primary player in the new swaps-stakes. It is busy developing a system to clear swaps in its franchise markets—energy and metals. “We've looked at this for the better part of the last five years,” says Pat Thompson, president of Nymex. But clearly the LCH's SwapClear proposal and the massive energy price spike in June, which bankrupted several energy companies, served as wake-up calls. “Credit risk has become a much more visible issue over the last year or so,” he says. “I think dealers in the energy swaps market have come to realize that expanding their ability to offer swaps to a broader marketplace, and having a credit facility in place to reduce their exposures, can improve their competitiveness.”

The Nymex opposed the LCH's CFTC exemption request on the grounds that exemptions should not be granted on a case-by-case basis. “The CFTC should design a regulatory scheme that all [prospective swaps-clearing entities] should adhere to. It should issue a set of regulations that apply to everybody,” it said in its September 23 comment letter to the CFTC. But CFTC chairperson Brooksley Born indicated in early November that the CFTC might reject Nymex's argument and grant the LCH approval by the end of the year. What does this mean for Nymex? “If the CFTC doesn't agree with our position,” says Thompson, “then our intention is to file relatively quickly for a swaps-clearing exemption based on what we believe are the appropriate ways to design this type of facility. We will be in position to make an application in very short order—I hope by early next quarter.”

The mechanics: When two banks agree to terms and confirm a trade with each other, the contract will be sent to SwapClear, which will run a series of checks on the deal and become a counterparty to the trade. From that point on, the banks won't have any exposure to each other, but rather to the LCH, which will keep positions, net trades and reset margin accounts and calculations.

The benefits: It will virtually eliminate counterparty risk, thus freeing up risk capital, and will dramatically reduce back-office costs, since members will have to deal with only one counterparty for all transactions going through SwapClear.

The products: Initially, SwapClear will cover interest rate swaps and forward rate agreements up to 10 years, but more exotic products are in the pipeline.

The Chicago Board Brokerage, which launched in September, is taking a more deliberate approach. It will likely examine the performance of SwapClear before developing a system of its own, although it maintains that it has definite plans to do so down the line. “It is part of our long-term plan,” says Deborah Kostroun, a CBB spokeswoman. “We have always intended to offer swaps clearing, but right now we're focusing on our core products—cash Treasuries and repurchase agreements across the entire yield curve.”

“We will be in position to make an application to the CFTC for a swaps-clearing exemption in very short order—I hope by early next quarter.”
Pat Thompson

One thing is clear: languishing business initiatives, like ex-lovers, are often at their most appealing when embraced by others.

The Merc Tackles Credit Derivatives

No longer are credit derivatives the exclusive domain of money center banks. The Chicago Mercantile Exchange last month launched the first exchange-traded credit derivative products—futures and options based on the CME's Quarterly Bankruptcy Index (QBI).

The QBI tallies the number of bankruptcies filed each quarter—a number that, according to the Merc, correlates well with credit card charge-off rates. In the first quarter of 1998, for instance, there were 354,118 filings, up from 347,685 filings in the fourth quarter of 1997. The notional value of the futures contract is, essentially, $1 times the QBI, and the contracts are cash-settled at expiry. The option contract is American style, meaning that it may be exercised at any time before expiration, and is dollar-valued at $1,000 times the premium of the option (a quote of .100, for instance, represents a premium of $100, or 100 filings).

The Merc thinks the products will serve as nice hedges for the MBNAs and First Unions of the world. “The QBI products ought to be an effective hedge against charge-offs,” says Peter Barker, director of interest rate product marketing at the Merc. “They can also serve as a surrogate for the business cycle, since bankruptcies usually rise and fall with the business cycle.”

The products are novel, and likemost novel products, they got off to a rocky start—no contracts were traded on the first day. Barker cites the lack of proven pricing mechanisms as the culprit, although he notes that the Merc's web site offers a great deal of historical information on the QBI to make pricing easier. “There's nothing like it out there at the moment,” he says. “So I can't, say, call the bankruptcy trading desk at Merrill Lynch and ask for a price against swaps, because there isn't such a desk. We've got to get a whole army of new people to trade them.”

As for the products' prospects for success in the near term, Barker is cautiously optimistic. “I don't think people's expectations of bankruptcy volumes will change second by second, so you probably won't see them ticking up and down minute by minute, although that would be nice. You'll probably see a lot of negotiations going on and contracts trading on a one-off basis at first.”

For historical data on the QBI, see www.cme.com/qbi.