Central clearing house becomes a reality

After months of discussions between dealers, brokers and other market participants – not to mention talks over the past 20 years - the OTC derivatives market will finally get a central clearing house.

The demise of Bear Stearns earlier this year raised concerns that major dealers were not aware of the full extent of their counterparty risk exposures. Consequently, the new initiative – which will see firms deal with a single counterparty – is intended to remove complexity, risk and uncertainty from the OTC credit derivatives business.

In a statement, Clearing Corp and DTCC said the clearing house is scheduled to launch in the third quarter. Initially, dealers will use the facility to clear CDX North American High Yield and Investment Grade index trades. Over the remainder of 2008 and 2009, the service will be rolled out to include iTraxx indexes, index tranches and single-name credit default swaps.

Clearing Corp will handle netting and risk management processing, while servicing will be done via DTCC’s trade information warehouse. According to DTCC, the warehouse conducts post-trade processing for three million contracts, with 10,000 new contracts processed daily.

Eligible dealers whose trades are stored in the warehouse can opt to replace bilateral agreements with a new contract guaranteed by Clearing Corp. Effectively, the clearing house will act as the central party guarantor; providing multilateral netting and collecting forward-looking margins on each trade to protect against adverse price moves. Clearing Corp will also perform daily marking-to-market of cleared positions. The warehouse will be responsible for credit default management and centralised net settlement of quarterly payment obligations between counterparties.

“Through the use of multilateral netting, margin collateral and daily marking-to-market of positions, Clearing Corp’s clearing facility will improve capital efficiency, increase regulatory transparency, lessen direct counterparty risk and reduce systemic risk relating to the multi-trillion dollar market in credit default swaps,” said Michael Dawley, chairman of Clearing Corp.

It is not clear how many dealers will be eligible to use the central clearing house. In a statement, Clearing Corp said “it will be open to all qualified clearing participants that satisfy Clearing Corp’s requirements relating to credit worthiness and experience in the CDS market,” but did not stipulate what these requirements are.

Initially, it seems probable the service will be used by be the 11 major dealers who feature among Clearing Corp’s shareholders: Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley and UBS.

Athanassios Diplas, chief risk officer and deputy chief operating officer, global credit trading at Deutsche Bank, has been involved in the discussions as to how the central clearing house will work. Speaking at the International Swaps and Derivative Association’s annual general meeting held in Vienna in April, he admitted there would be strict entry criteria.

“The criteria will take into account how well capitalised the firm is, how the risk is dealt with, how the variation margins are going to be posted and what the expected gap risk is going to be,” he said.

See also: Dealers work towards clearing house for credit default swaps