Exchanges would appear to be one of the winners from regulatory change designed to tighten up the over-the-counter derivatives market. The Group of 20 nations has called on banks to trade all standardised OTC derivatives contracts on exchanges or electronic trading platforms, where appropriate, and clear through central counterparties by the end of 2012. The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law in the US in July, has similar provisions – swap contracts eligible for clearing must be traded on an exchange or through a swap execution facility (Sef).
Craig Donohue, chief executive of Chicago Mercantile Exchange (CME) Group, reckons 60–70% of the OTC derivatives market could eventually be eligible for central clearing. He is not convinced the same percentage will move on to exchanges, however.
“Things are far less clear on the exchange-traded side. I would guess most swaps will continue to be traded bilaterally or on a Sef. We believe in transparency, but if you have very illiquid, highly structured products, it is not clear an exchange market is going to develop just because the regulators require it to,” he says.
CME Group’s own exchange business had a strong year, with average daily trading volumes reaching 11.6 million contracts in the third quarter of 2010, a 14% increase over the same period in 2009. The first and second quarters also saw strong increases of 12% and 31%, respectively. In addition, the exchange reported its highest ever monthly average daily volume in May of 16.8 million trades.
For Donohue, one of the highlights of 2010 was the launch of a new joint venture company with Dow Jones called CME Index Services. CME Group will have a 90% stake in the company, which incorporates the Dow Jones indexes business, including the Dow Jones Industrial Average. As part of the deal, CME paid $607.5 million to Dow Jones. “This will allow us to work with our partners around the world to develop new indexes and new trading products based on indexes, and to provide calculation services for our various exchange partners,” says Donohue.
However, much of the focus last year was on regulatory change – and CME Group has been at the forefront of the debate, with Donohue and executive chairman Terry Duffy called upon to testify before Congress on several occasions during the legislative process. But while the exchange sector appears to be a beneficiary of the regulatory transformation, Donohue questions whether there was a need for formal legislation.
“We didn’t feel it was the right solution. We definitely believe in central clearing, but we felt the industry was moving in that direction without the necessity of legislation. In our testimony and discussions with regulators, we advocated a system of incentives where capital requirements for swap dealers and financial institutions would be more favourable if they used central clearing, but the political dynamic was such that Congress went much further than that,” he says.
Nonetheless, CME Group is moving fast to position itself for the forthcoming changes. On October 18, the firm announced it had launched a clearing service for OTC interest rate swaps in the US with the support of several major dealers and buy-side firms, including BlackRock, Fannie Mae, Freddie Mac and Pimco. It followed up on December 16 with news that CME Clearing Europe, a wholly owned subsidiary, had been approved as a recognised clearing house by the UK Financial Services Authority. The focus will initially be on commodity products, with clearing solutions for OTC financial instruments coming soon after launch.
But CME isn’t just focused on the clearing part of the pie. On December 9, the group revealed it had acquired London-based Elysian Systems, a provider of electronic trading and market technology – suggesting the firm is keen to qualify as a Sef. The Elysian technology – which enables online trading across a range of products including commodities, credit default swaps and interest rate swaps – allows traders to submit and execute orders in an electronic market-place. The exchange will initially focus on the energy markets, combining the Elysian technology with its CME ClearPort clearing service to provide straight-through processing and central clearing.
“The main reason for acquiring Elysian Systems was to help our customers in the energy market aggregate OTC prices across our ClearPort products. We haven’t made any public announcement on plans to expand the system across asset classes, but it is a very flexible package,” says Joe Raia, managing director, energy and metals products, at CME Group. “We don’t see the system as a one-size-fits all-approach. We may potentially operate a Sef in one asset class and not in another, depending on the final definition of what a Sef actually is.”