Ice to clear single-name bank CDSs from April 10

US participants will be able to start clearing credit default swaps referencing Ice clearing members

Green light: the service will finally allow US clearing of single-name CDSs on financials

Intercontinental Exchange (Ice) intends to launch US clearing of single-name credit default swaps (CDSs) referencing clearing member banks on April 10, can confirm.

The Atlanta-based exchange’s Ice Clear Credit service will offer central clearing for CDS contracts written on financial institutions that are direct clearing members of the central counterparty (CCP) after originally postponing an expected roll-out in mid-March.

Fourteen additional single names – six North American and eight European financial reference entities – are to be made eligible for clearing. The additions will bring the total number of single names allowed to clear at Ice Clear Credit across corporates and sovereigns to 484.

“The CDS folks at Ice… were originally trying to get financials single-name clearing going by March 17 in order to be ready in time for the CDS indices roll on March 20. I don’t know what the hold-up was, but from what I’m hearing they are on course for an April 10 launch,” says one CDS market-maker.

The prospective April 10 date is confirmed by three other sources, although they caution that a further last-minute delay is possible.

The sources also confirm that the initial launch date was postponed until after the March 20 roll “to give participants more breathing room to ease into [the] clearing of financials”. The period since then has been spent focusing on giving CDS counterparty back offices more time to adjust internal systems to accommodate the 14 new clearing-eligible names.  

“Bringing out this offering on March 17 would have led market participants to question why Ice would introduce clearing of a series of new names just three days before the roll of the CDS indices. That would be a back-office nightmare,” says a New York-based CDS trader. “It probably just made more sense to delay it. The back office works hard to ensure that we are able to roll on the roll dates – they don’t need to be figuring out a new population of trades that can clear.”

Clearing of single-name CDSs referencing clearing members has been available to European members of LCH’s Paris-based CDSClear since June 2015, but the launch of the Ice Clear Credit service represents the first time these reference entities will be available to US futures commission merchants (FCMs) and their clients for clearing.

Contagion effects

Financial names have presented two particular challenges for clearing houses due to the potential for wrong-way risk in the event of default by a clearing member. The first is the contagion effect on non-defaulting clearing members arising from the collapse of one of their peers. This contagion would probably cause spreads on CDSs referencing healthy banks to blow out as sellers of credit protection evaporated in roiling markets.

CDSClear and Ice Clear Credit seek to combat this risk by building factors into their margin models that look at correlations between a clearing member and the underlying name in order to calculate the appropriate level of margin to be posted.

One CDS clearing expert uses the example of three large French banks to illustrate the point that correlation between protection issuers and reference entities is more important when setting margin than whether a reference entity is a member of a clearing house.

Both BNP Paribas and Societe Generale are members of CDSClear. A default at BNP Paribas would be likely to widen spread levels and the jump-to-default risk on CDSs referencing Societe Generale, but this is because the two banks are similar types of institution, not because they are both clearing members of the same credit derivatives CCP.

“Credit Agricole has a very similar business to both BNP Paribas and Societe Generale, but it is not a member of CDSClear. In the event of a BNP Paribas default, the contagion to the positions referencing Credit Agricole would be quite similar – if not exactly the same – as it would be [to those] on Societe Generale. The clearing house had to develop a margin and risk framework that captures that risk appropriately,” explains the CDS clearing expert.

Self-referencing risks

The second major obstacle has been self-referencing trades – the risk that clearing members participating in the auction of a defaulted members’ portfolio of client positions could inadvertently wind up as counterparty on cleared trades in which the bank itself is the reference entity.

CDSClear resolves this issue by splitting a defaulting members’ client portfolio into distinct packages. During the auction process, a clearing member is unable to bid on any package of trades that contains CDSs referencing itself.

Ice Clear Credit’s approach has been to eliminate the concept of forced allocations, in which clearing members are obligated to accept ported client positions from a defaulting members’ portfolio in order to return the CCP to a balanced book. Such allocations left FCMs exposed to the risk that they may have self-referencing trades foisted upon them by the CCP.

On January 6, the Securities and Exchange Commission approved a decision by Ice to revise its recovery and default management rules to eliminate the concept of forced allocations – a critical step in allowing the exchange to move forward with the launch of CDSs on financial names.

Just how significant the new clearing service will be for CDS market participants is unclear. Although the SEC granted CDSClear approval to offer single-name CDS clearing to US clients in December last year, none of the country’s FCMs had been onboarded to the service as of early April. This is probably due to unwillingness among US participants to split their CDS books across CCPs, thereby separating them into two separate netting sets and consequently doubling their margin requirements.

With Ice Clear Credit already acting as CCP to virtually the entire US cleared CDS market, some buy-side entities are excited to begin clearing the outstanding financial names, which are estimated to comprise roughly 6–7% of total outstanding single-name CDS notional. 

Clients like us have been asking for financials clearing for going on two years now… this was the last piece that was glaringly missing
Credit trader at a Connecticut-based hedge fund

“Clients like us have been asking for financials clearing for going on two years now,” says a credit trader at a Connecticut-based hedge fund. “We focus mainly on the CDS index constituents – the only other single names we look at are financials. Almost all of the investment-grade index names and about 60–75% of the high-yield index names are eligible to clear across the US and Europe. Ice also launched clearing of all the emerging market index constituents recently, so this was the last piece that was glaringly missing.”

Others, however, are playing down the likely impact of the launch on the CDS market in the US.

Joel Kent, head of Americas flow credit derivatives at Credit Suisse in New York, says he expects the new service to have a beneficial impact, but he cautions against expectations that the single-name market will be transformed by the development. “It is going to help advance the process of moving the market toward the clearing of single names – a goal that we’ve long been supportive of. The banks’ single-name segment is less topical given where we are in the economic cycle, but it is still an active, very liquid part of the market. If you could move an incremental amount of your outstanding risk to clearing, that’s a positive. But I don’t think it’s going to change the way people do business,” he says.  

End-user single-name CDS clearing is currently undergoing a boom at Ice Clear Credit. The cumulative buy-side gross notional of cleared single-name CDSs has jumped from less than $50 billion in the first quarter of 2015 to $350 billion in the first quarter of 2017. Over the same period, buy-side gross notional cleared per quarter has leapt from roughly $5 billion to $100 billion. 

A total of 103 new buy-side clients began clearing single names at Ice during 2015 and 2016, buoyed by the voluntary commitment of 25 of the market’s largest asset managers to clear single names and the implementation of non-cleared margin rules that are set to make bilateral CDS trading increasingly expensive for buy-side firms in the coming years. The trend has continued this year, with Ice onboarding a further 19 buy-side clients in the first three months of 2017.

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