As the end of November draws near and the competition intensifies between the candidates in the credit default swap (CDS) clearing counterparty (CCP) race, it seems that everyone in the market has an opinion on the matter. This week it is the turn of two CEOs from the interdealer-broker camp and the Wholesale Market Brokers’ Association (WMBA) to share their two pennies worth.
CEO of Tullett Prebon Terry Smith and GFI head Mickey Gooch have both indicated their support for the introduction of CCPs in the CDS space but with the proviso that regulators step in to ensure competition remains in the market. Both are seemingly concerned that there will be a monopoly, or even a duopoly, in the OTC market with regards to clearing. This would likely be in the form of IntercontinentalExchange (ICE) or the Chicago Mercantile Exchange (CME), both of which are due to launch their platforms by the end of the month, according to Smith.
With such a set up, the market could be forced to pay higher prices and be saddled with a “less open” market, contends Smith. Gooch adds that there is some concern within the industry about the capital that will be required for the clearing mechanism, calling the CCP race a “complex” issue.
Gooch and Smith are not alone in their concerns, evidently, as the WMBA, which represents the world’s largest interdealer brokers, also has stepped in to clarify what it believes are implicitly negative assumptions about the OTC markets. Like the two CEOs, WMBA says it supports the introduction of a CCP (so far, so good), but (and this is an important but) it stresses that a CCP is not desirable for every OTC market. For example, OTC products such as US Treasuries, European interest rate swaps, OTC equities, spot foreign exchange and carbon emissions have been executed OTC and cleared centrally for some time, says the association.
WMBA’s chief executive, Stewart Lloyd-Jones, elaborates: “Currently, on the run US Treasuries trade OTC fully electronically, but clear centrally through the DTCC. US energy derivatives trade OTC via voice brokers and electronically, but are also centrally cleared through ICE or NYMEX/CME. Similarly, this applies to the operation of CLS in foreign exchange markets. These have proven to be effective mechanisms and such structures can be duplicated elsewhere in the OTC world.”
He illustrates this by highlighting that approximately 60% of OTC European credit derivatives traded via interdealer brokers are executed electronically. “Furthermore, nearly all European credit derivatives transacted via interdealer brokers, including those that are executed by voice, are fed into identical straight through processing formats. As a result, this OTC market is now ready to support a CCP,” he adds.
According to WMBA, for the purposes of counterparty risk, it is essential to note that in OTC markets the means of execution is not relevant as long as transactions are matched and confirmed electronically. By this logic, voice assisted or fully automated OTC trading is entirely consistent with, and supportive of, the existence of a CCP. However, while executing trades on an exchange generally involves a CCP, and while exchanges themselves often own the CCPs that clears trades executed OTC, trading on an exchange is not the sole means by which transactions can be centrally cleared, the association contends.
Lloyd-Jones believes strongly that the OTC markets have traded, and need to continue to trade, separately from exchange markets for many reasons. “OTC markets are both larger in scale than exchange markets and may be customised to render them a flexible risk management tool,” he explains.
“Also, an inaccurate distinction is often made between ‘regulated’ and ‘unregulated’ markets, with exchange markets often being presented as ‘regulated’ due to exchanges being mandated to regulate the content, behaviour and participation in specified products. The perception that all OTC markets are unregulated is incorrect,” he continues. All major OTC financial market participants are individually regulated and supervised, says Lloyd-Jones.
For example, interdealer brokers’ activities are overseen by national regulators, including the Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Financial Industry Regulatory Authority (Finra) and the Financial Services Authority (FSA), he says. “In contrast to exchanges, the primary regulatory focus in OTC markets is on the participants themselves. In conclusion, given that many of these products have already embraced the benefits of CCP clearing, there is no need to move to an exchange in order to clear OTC products,” he reasons.
The spectre of a regulator imposed CCP in every OTC derivatives market truly seems to have set the cat amongst the pigeons in the interdealer-broker community. This is no surprise given that they are being forced to accept the inevitability of margining and increased oversight by the SEC in the CDS space. However, given that the decision over which regulatory body will eventually oversee the new CCPs has not been made yet, it will some time before the smoke clears enough to see the final outcome of the race.