European CDS dealers ready for start of central clearing

Credit derivatives dealers, clearing houses and large buy-side firms were making final preparations for the transition to central clearing of European credit default swaps (CDSs) as Risk went to press, ahead of the European Commission's July 31 deadline for the first trades to be cleared.

As part of the push to standardise the CDS market to facilitate central clearing, the International Swaps and Derivatives Association launched its 'small bang' protocol on July 14, which integrates restructuring as a credit event into the auction settlement process (Risk July 2009, page 111). The protocol closed for adherence on July 24 with 2,125 signatories, and became effective on July 27.

Meanwhile, trading of single-name CDSs with fixed coupons began on June 22, despite ongoing disagreement over the optimum number of coupons. While the North American market moved to two fixed coupons of 100 basis points and 500bp on April 8, major dealers agreed European CDSs should include two further coupons: 25bp and 1,000bp.

But since the transition, some dealers have confirmed they have also been making markets at 300bp and 750bp - coupons originally intended only for the purposes of re-couponing legacy trades.

"One thing we agreed on was that dealers should be free to trade whatever they want. Some people would be happier if no-one was doing anything apart from 100bp or 500bp because it would make life operationally neater, but we certainly think CDS is too powerful a product to be dumbed down. We have no interest in narrowing the range of coupons we can trade on," says one senior credit derivatives dealer at a US bank.

But the use of multiple coupons continues to be unpopular with some parts of the market, particularly on the buy side. "Fewer coupons, with complete transparency around pricing, will create a more liquid market, with non-core credit participants more likely attracted to using credit derivatives as part of their overall trading strategies. More coupons would likely lead to more coupon rolls and a more opaque market, which in turn could create arbitrage opportunities for market makers and scare off non-core participants," remarks Jeffrey Kushner, European chief executive at London-based asset management firm BlueMountain Capital Partners.

Some observers have played down the issue, suggesting dealers are still getting used to the new regime. "As many market participants suspected, trading and liquidity has migrated mainly to 100bp and 500bp, although there are a few quotes at 300bp for names that fall between the 100bp investment-grade and 500bp high yield. The market is still finding its feet, and whether 300bp will be a permanent fixture remains to be seen - it depends how much take-up there is from end-users and interdealer brokers," says Charles Longden, managing director in fixed income and credit at London-based data provider Markit.

The use of multiple coupons depends largely on the ability of the new central counterparties (CCPs) to clear them. An official at Frankfurt-based derivatives exchange Eurex insists its platform, Eurex Credit Clear, does not depend on a limited number of coupons. "Our clearing model is not based directly on the coupons because in the consultation process with the market, we learned participants would prefer for a clearing house to be able to clear any coupons," he explains.

Eurex announced on July 24 that Eurex Credit Clear had gained regulatory approval and was set to begin clearing on July 30, having originally planned to launch in the first quarter of 2009. The platform will initially clear the European iTraxx indexes and 17 single-name iTraxx index constituents from the utility sector, with plans to expand in due course.

Meanwhile, Ice Trust Europe, the facility set up by the Atlanta-based IntercontinentalExchange (Ice), gained approval from the UK Financial Services Authority (FSA) on July 29. The CCP will start by clearing index trades and single-name constituents of those indexes, following the path set by Ice's US CDS platform, Ice Trust, which launched in March.

The initial clearing members of Ice Trust Europe include: Bank of America, Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley and UBS.

An unnamed venture set up by CME Group and Chicago-based hedge fund Citadel Investment Group was still in discussions with the FSA as Risk went to press.

A spokesperson for CME Group refused to say when it expects FSA approval, stating: "The application to become a UK-registered clearing house is with the FSA and we are working with them to gain clearance in good time."

A rival initiative launched in December by NYSE Liffe in partnership with London-based clearing house LCH.Clearnet is currently under review, having yet to clear any trades. An official at the company told Risk: "We had hoped by starting first we would see business early on, but we haven't so far and are reviewing where we go from here."

Joel Clark