By Suchita Nayar
Despite the global financial collapse and a shift in political power in Washington, there's still little certainty about what financial reform will look like. But of all the proposals floating around, the move to central clearing for the credit default swaps market seems most likely to happen. Hedge funds, which make up a big chunk of the market, are getting ready for the inevitable.
Over the past six months, the industry has taken initial steps toward standardizing some contracts to prepare for central clearing. Legal counsels have pored over minutiae of agreements. Managers, meanwhile, have analyzed the portfolio and trading risks of clearinghouses' higher collateral requirements, all of which will make the new system more costly to hedge funds.
Once managers have figured out the financial details, they'll have to devise a way to make their order- and risk-management systems reflect the change from bilateral to central clearing, says Kevin McPartland, a senior analyst of over-the-counter derivatives and financial technology at TABB Group. They'll have to establish connectivity linkages with both their clearing dealer and the central clearinghouse, and that will vastly speed up the entire negotiation-to-post trading process, which now takes up to a week of hammering out contract details and going through a lengthy series of trading, clearing and settlement steps for each trade.
"We'll enter trades into our system throughout the day as they occur, and multiple trade files will be sent to the prime broker and central clearinghouse each day," explains Brian Schuster, risk manager at Pine River Capital Management, a relative-value hedge fund in Minneapolis. Pine River is already getting its infrastructure in place for central clearing. "This would result in all trades being cleared and settled daily with the central clearinghouse via our primary broker-dealer."
Two clearinghouses are already in the works: ICE Trust, which is run by 13 big bank dealers, and the Chicago Mercantile Exchange's CME Clear. On December 15, CME Clear went live for OTC CDS contracts but cleared only $189 million in contracts. Meanwhile, ICE, also started testing customer contracts that day, but it has handled $5.5 trillion in trades between banks over the past year, and its European counterpart has likewise cleared trillions of dollars worth.
"Everyone expects an uptick in central clearing through 2010, especially for standardized products," says George Harrington, head of fixed-income trading at Bloomberg, whose terminals will work with both of the clearinghouses. "We're starting to see interest from customers who left before the credit crisis hit and also from new players who want to get in for the first time."
Both ICE and CME have a member-sponsored guarantee fund to ensure against the type of counterparty default that disrupted the market when Lehman Brothers collapsed in September 2008.The two entities are making dealers pony up enough margin and corresponding collateral to cover potential losses, and they charge a processing fee, at least some of which is expected to be passed along to clients. Goldman Sachs and JPMorgan have begun offering all-in packages to hedge funds.
But it's up to the legislation to determine the precise capital and collateral requirements, which in turn will shape the risk modeling done by hedge funds, with the collateral moving back and forth daily. But firms can't get a handle on exactly what this will mean, given the uncertainty. "Lack of clarity about the future regulatory regime is slowing progress toward clearing, but the industry remains committed to creating access for buy-side firms to efficient, effective clearing," says Darcy Bradbury, director of external affairs at D.E. Shaw and one of the one of the industry officials working on the operational and legal hurdles to customer access to clearing, at the request of the New York Federal Reserve. D.E. Shaw and other hedge funds, including King Street Capital Management, BlueMountain Capital Management and Brevan Howard Asset Management, are focusing on broadening products that can be cleared by customers and working on both the risk models for determining collateral and more automation of the process.
Even if progress is slow, no one thinks this issue is going away. "I can't see regulators backing down on central clearing," says Jeff Gooch, an executive director at London-based Markit Group, which runs credit auctions and CDS indices, among other things. "But given that the legislation may not become effective until 2012, some people are of the mind-set 'Why change right now?'?"
To prepare, Markit has retooled its platform for central clearing and electronic trade confirmation. Its information technology plumbing will link brokers and multibillion-dollar hedge funds directly to central clearinghouses. Smaller funds use its MarkitSERV joint venture with DTCC to connect with a dealer acting as their gateway to the central clearinghouse and to other brokers.
However, indirect access for smaller funds is an imperfect mitigation of counterparty risk, says John Jay, a senior analyst of OTC derivatives at Aite Group, a Boston research and advisory firm. The Federal Reserve's recent communication with the industry clearly states that the buy side should participate directly in both the clearing and settlement processes. "Having a direct pipe into the central clearinghouse could potentially simplify things in the case of a bankruptcy proceeding of the counterparty," he explains. Moreover, the type of counterparty risks that drove managers to have multiple prime brokerage relationships following the Lehman collapse are likely to lead them to employ multiple clearing firms. How such inter-clearinghouse connectivity will work is unclear. "If there are differences in prices of contracts at ICE and CME, you may see dealers and hedge funds trying to find arbitrage opportunities between them," a market participant says.
Central clearing will fundamentally change operations. Since a central clearinghouse will process trades much faster, a back office that historically has taken up to a week to match trades will have to react faster to determine net asset values. "There's no reason credit can't be as efficient as some of the other OTC markets," says Markit's Gooch.
"Trade reconciliation will get simplified as market mechanisms will determine the ultimate price of the contract, rather than some bank model," says Laurent Chevallier, portfolio management head at Swiss manager Eurofin Capital. Without the risk of manual input of price, the back office function will become easier and more transparent. "The risk of model misappropriation and other pricing issues with counterparties also gets taken away. This reduces the chance of somebody making a big mistake."
While central clearing will improve pricing clarity for standardized issues, it won't solve the issue for nonstandard contracts in which key information remains confidential. For that, a manager would need an investment management system that is capable of handling complex instruments and can give detailed counterparty information. "The current systems lack the ability to provide granular and critical information on these instruments. With regulatory pressures rising, managers must take responsibility of maintaining this sort of information on their books," says David Kubersky, managing director of SimCorp, a maker of investment management systems.
Nonetheless, expect some initial bumps. Says McPartland of TABB, "Longer-term, it'd be a net positive in that there would be more transparency and streamlining of processes." In the end, managers may require less technology infrastructure because the central clearinghouse will determine collateral and margin call process, he says. "But there will certainly be growing pains."