LONDON -- The drive to create a credit derivatives clearing house is gaining pace, with launch targeted for the third quarter, as it addresses two issues central to the credit crisis: bank capital constraints and counterparty risk.
The agreed sale of Bear Stearns to JP Morgan in March on fears it could fail, emphasised the need for a project that a group of major broker dealers had begun months before. Investors had been refusing to approve derivatives transactions that would pass risk to Bear.
However, the biggest advantage for banks is likely to be the lower amount of capital they would put in a central guarantee fund at the clearing house than they now set aside individually to cover losses from counterparty defaults in the $62 trillion market.
That is because the clearing house would net out the positions of multiple brokers, leaving it with a relatively small amount of overall exposure to underlying default risks.
Reduced capital requirements could mean some benefits for investors as well, said Richard Metcalfe, global head of policy for the International Swaps and Derivatives Association.
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"If you free up capital, that capital is available to take on other positions. At the margins, it could add to the market's capacity to take on business and take different sorts of risks."
Bankers say clearing house rules will limit membership to strong institutions with plenty of capital. That would probably exclude hedge funds and most other buy-side clients.
"When you design something that will almost never be used, it does net out a lot of theoretical exposure in the market," said Jeff Gooch, executive vice president of Markit.
LOW PROBABILITY/HIGH IMPACT
U.S. bank balance sheets have grown by 60 percent in the past five years, or an annual 7 to 11 percent, while the credit derivatives market has had an annual growth rate of 95 percent since 2002, analysts at Dresdner Kleinwort wrote in a recent report.
"It is tough to know the appropriate amount of capital to put against counterparty risk as it is a low probability/high impact event," the analysts wrote.
The clearing house could also enable banks to reduce back-office costs by cutting the number of counterparties they must deal with and by helping streamline post-trade processes.
But the savings are likely to be offset or outweighed by the fees and margins that banks will have to pay.
"Although it would be more expensive to clear trades, other participants would be insulated from the failure of one dealer," Dresdner analysts wrote.
"This would not be perfect, and in effect it would spread the cost of such a failure across all houses using the clearing facility."
The clearing house will have several tools to reduce market disruption in the event of a counterparty failure.
It would centrally manage an orderly process worked out in advance to cope with a failed member's portfolio — replacing a potentially chaotic event with each dealer scrambling to hedge its own position.
Besides the guarantee fund, it would also collect an initial margin from each member to help cover losses from closing out a portfolio.
The Clearing Corp., based in Chicago, would operate the clearing house. (For a factbox, click on [ID:nL02200441].)
The service would be limited to simple instruments that trade in volume and have clear market prices. The plan is to start with the Markit CDX and iTraxx market indexes and then add liquid single-name CDS in subsequent months.
These liquid instruments account for the large majority of trades, Gooch said, but he could not cite a percentage figure. "If the clearing house is limited to major banks trading liquid products between each other, it would not limit innovation."
Investors stand to benefit indirectly. A clearing house provides "reassurance that the broker has reduced operational and counterparty risk when they go to do a trade on your behalf", said Kevin O'Reilly, who leads global banking consulting for Deloitte in London.
Currently, "you don't always question who is processing the other side of that trade. This takes some of that variability out", he added.
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