A major difference in opinion has emerged between exchanges bidding to launch central counterparty clearing services for credit default swaps (CDSs) over the viability of clearing single-name trades.
All four exchanges - the Chicago Mercantile Exchange (CME), Eurex, IntercontinentalExchange and Liffe - say they intend to clear single-name contracts this year. Yet senior figures involved in the process suggest the high margin payments and size of the default funds required to protect against losses on single-name CDSs could make it uneconomical.
Liffe, the London-based derivatives arm of NYSE Euronext, launched its platform on December 22 in partnership with London-based clearing house LCH.Clearnet. The facility was rolled out to clear trades linked to series 8, 9 and 10 of the Markit iTraxx Europe, Hi-Vol and Crossover indexes (see pages 76-77).
Liffe wants to extend the service to single-name trades later this year. However, Simon Grensted, managing director of business development at LCH.Clearnet, says the volatility and counterparty risk associated with single-name CDSs could necessitate substantial revisions to margin, collateral and default fund contributions by clearing members.
"Clearing has to be financially viable for the user. The amount of collateral a user will be required to put up may be uneconomic compared with the needs of a clearing house to call sufficiently high margins to protect itself," says Grensted.
Uwe Schweickert, senior vice-president at Frankfurt-based Eurex, which plans to clear trades linked to series 7, 8, 9, 10 and 11 of iTraxx Europe, Hi-Vol and Crossover indexes this quarter, agrees the clearing of single-name CDS trades will be more difficult than indexes. Nonetheless, he says the exchange hopes to clear single-name contracts in the second half of this year.
"Single names are harder to process than index CDSs and, as central clearing is effectively insurance against counterparty default, I expect the insurance premium to be higher for single names," he asserts.
Heightened fears over counterparty risk, particularly since the collapse of Lehman Brothers on September 15, are likely to influence margin payments. CDS spreads on many major dealers soared in the wake of the Lehman bankruptcy. At the same time, recovery rates on the obligations of some defaulted firms have been lower than expected. The collapse of another major dealer, at the same time as a succession of defaults with low recoveries, could mean the clearing house is left having to make hefty payments to make good on the trades in which the defaulted dealer sold protection.
LCH.Clearnet requires clearing members to make an initial margin payment, along with daily variation margin payments, which are used to close out positions and pay off losses in the instance of a member default. If margin payments prove insufficient to cover losses, the clearing house has recourse to a £594 million default fund, also contributed to by clearing members.
Grensted speculates hundreds of millions of pounds may need to be added to the default fund by clearing members if the service extends to single names. Currently, Grensted says LCH.Clearnet has not yet found a model it is comfortable with for assessing the risk associated with single names, but expects that whatever model is used will be geared around stress tests and analysis of the implications of simultaneous defaults.
He rules out the Standard Portfolio Analysis of Risk (Span) margining tool developed by the CME in 1988 for clearing equity derivatives, which he argues is not robust enough for single-name trades. Eurex will also not use Span. Its charges will include a credit event margin for protection sellers, a mark-to-market margin, a next-day margin (taking into account value-at-risk) and a liquidity margin to factor in the possibility of a clearing member being liquidated.
CME, meanwhile, has developed a scenario-based model designed to take into account systemic and idiosyncratic risk factors. Nevertheless, the exchange is less concerned about the economic viability of clearing single-name trades. It plans to clear 509 reference entities included in the iTraxx and CDX indexes as soon as its clearing platform is given regulatory approval.
"Our margin methodology will address the question of calculating what the largest net debtor's amount owed to clearing will be for a credit portfolio," says Tim Doar, managing director of CME Clearing. He says extensive testing has been conducted on the CME's new model, which indicates that for a portfolio consisting primarily of index products the margin coverage would be in the range of 1-2% of notional. In comparison, the margin on single-name CDSs could rise to as high as 10% - although a trader with a large, diverse portfolio may see significant reductions in margin payments.
Some clearing members might question whether a 10% margin makes economic sense. But if regulators make good on their goal to centrally clear the majority of CDSs, protection sellers will be forced to either pay the high margin or pull back from the business.
"It may make less sense for a protection seller that has not accurately priced risk into its products, and finds central clearing comes at a premium. But from a regulatory and market integrity perspective, central clearing makes sense. It is good for protection buyers, because currently when they buy CDSs and the protection seller goes out of business, the product is worthless," notes Schweickert.
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