Eris Exchange Chief Executive Neal Brady Talks About Building A Swaps Futures Exchange From The Ground Up

Neal Brady has spent the last five months or so working to get the Eris Exchange up and running as the first swaps futures exchange created after Congress passed the Dodd-Frank financial reform bill ordering swap trades onto public exchanges. As the deadline looms on finalizing Dodd-Frank, Eris aims to be the venue of choice for clearing services to reduce systemic risk in the over-the-counter market. Thus far, the new exchange for interest rate swap futures has handled over $19 billion in notional value since trading started in August.


Q: How did you get involved with the Eris Exchange?

Brady: I was previously managing director and head of business development globally for the CME. While I was at CME I was very involved in a variety of initiatives related to OTC clearing and trading. After leaving CME to run a venture fund where I was involved with many of the Eris founding partner firms, we began discussing with CME the possibility of clearing an interest rate swap futures product as a way to broaden access to the OTC interest rate swap market and respond to the new regulatory environment. I've been in the exchange and derivatives business for a long time and founded a venture several years back called Liquidity Direct which was eventually acquired by the CME. A number of proprietary trading firms were involved in that earlier venture as well as founders and partners, and that's how I ended up being involved with Eris. 

At Eris Exchange, we’re up and running with a product and clearing solution that is very much within the spirit and guidelines of the Dodd-Frank legislation. There is a lot of talk in the marketplace about what new cleared OTC products and platforms will look like a year or two from now. What distinguishes Eris is that we are operational today with a product that meets the Dodd-Frank guidelines for OTC clearing and trading while using the tried and true infrastructure of the futures markets and not forcing firms to cut over to new and untested ways of doing business and processing derivatives trades. Eris also opens up access to a market that hasn't traditionally been open to all. To trade in this market, it has traditionally required bilateral arrangements, ISDAs, lengthy OTC documentation procedures, and a willingness for each dealer to admit each customer, one by one, as an acceptable counterparty. At Eris, we have created a product that directly replicates - dollar for dollar - an OTC interest rate swap product, but  it is cleared and so available to a much wider community – anyone with a clearing relationship with an FCM who also qualifies as an Eligible Contract Participant as defined by the CFTC.

The Eris swap futures contract is very flexible – you can trade at any coupon rate you'd like and at any maturity day out to 30 years. If you have a valid customer account with a futures commission merchant at the CME that has more than $50 million in capital, you're eligible to participate. So it's an open access model that replicates the OTC market. We are also applying to the CFTC to become a designated contract market (DCM), at which point the Eris contracts will sit in 4d accounts at the FCM. A 4d is the account class that traditional futures accounts sit in - so Eurodollar futures, Treasury Futures, etc. all sit in 4d accounts. Once we become a DCM, our contracts will sit in that same pool and then will be eligible for cross-margining at CME against Eurodollar and Treasury futures. That will be a big capital savings for users of our product and we’re very excited about it.  Once that’s available, there will be an even more significant cost advantage and capital efficiency advantage to using our product. We expect to become approved as a DCM this year.

Last but not least, we are also promoters of increased transparency in the market, so we announced a technology partnership with State Street Bank who is providing a matching and trading platform for us. When we launch on the State Street platform early this year, you will see liquid quotes for 2-, 3-, 5-,7- and 10-year benchmark maturities in interest rate swaps-- two-sided, transactable streamed quotes from dedicated liquidity providers-- the founding partner firms plus others that have signed up to stream quotes as well. This liquidity will be available to any customer or front end provider that is connected to State Street’s global trading platform. We’re very excited about offering that to buy side users and others interested in accessing the market.


Q: So this is strictly swaps? You have no interest in trying to compete with, say, the CME Group on Treasury products?

A: No, we have no interest in that. We are here to tackle the OTC-cleared market with a unique futures product. We think the CME's core business is their core business and they are very good at what they do.  CME is purely a clearing services partner for Eris and they have an open clearing facility. They are not an equity owner in the exchange. We are an independent exchange, but cleared through the CME, and we’re very happy to have them as our clearing partner.


Q: Who do you see as your main customers at the Eris Exchange?

A: The main customers are anybody who today is an interest rate swap user - asset managers, corporates, hedge funds, insurance companies, GSEs like Freddie Mac and Fannie Mae – anybody who is a participant in this market that wants to lay off or put on a position at the Eris Exchange. There is also a lot of interest from emerging dealer banks that don’t have the same ISDAs and bi-lateral arrangements that the top tier dealers have. We are targeting anybody who trades interest rate swaps today. Many of these participants will be required to do all their business - cleared - on the date that Dodd-Frank becomes effective. If Dodd-Frank becomes effective a year from last July, at that date many firms will no longer be able to trade bilateral standardized swaps; they will need to do them cleared,  either on a DCM or on a SEF. There are a number of emerging SEFs, but we aim to be the benchmark interest rate futures venue that also fulfills the Dodd-Frank mandate. Lastly, we also think there are non-traditional users, who currently do not have access to these markets, who will come into the market once it is a cleared marketplace. These are the users who don't have the time, resources or back office expertise to set up ISDAs and bilateral arrangements with the dealer banks.


Q: Could you tell me a little bit more about these new users?

A: We think there are banks and a variety of other users that would like to participate in the interest rate swap market but don’t because it's too much of an operational burden to set up proper bi-lateral arrangements. In terms of market-making, there is a large community that would more actively make prices upon request or stream transactable prices if they had access to this market. These firms are not making markets today because they don't have access. Once you provide clearing, the issue simply becomes who can reliably provide the most competitive prices and significant size.


Q: It seems there is an awful lot happening right now in terms of OTC and swaps. Who would you see as your main competition? Do you have a first-in advantage?

A: We think it will be a very interesting couple of years as the industry migrates to cleared interest rate swap trading. There are a number of swap execution facilities (SEFs) that are in the early stages of being formed, and that are only waiting for the specific rules from the regulators on what it means to be a SEF and details on required trading platform protocols. Right now the CFTC has put out proposed rules for public comment and the market is waiting for the official rules to be published and the time line for implementation. The CFTC has recently proposed rules to describe how to register as a SEF and there are a number of initiatives and corsortia discussing the possibility of forming SEFs.  So certainly we think there will be a number of SEFs out there. I think anybody who has seen markets develop would probably assume that there will be some sort of consolidation and aggregation. There will be a number of SEFs and liquidity pools that consolidate down to a handful of primary venues. What we aim to be is the primary benchmark futures market equivalent that exists alongside the major SEF platforms.

It's a very large market, and if we can get a meaningful percentage of that overall market we will definitely be considered a success. We think our futures product in all likelihood will be carried on a number of third-party front ends and put in front of major buy side firms -- along with prices from various other SEFs. The legislation mandates that swaps need to trade either on a SEF or a DCM and we believe the clients should be free to decide which execution and clearing venue most suits their needs. 

We also think our unique contract design distinguishes us from the rest of the market as it fully “futurizes” the economic exposures of a standard, cleared OTC interest rate swap. We do that by embedding all of the economics of the swap into a single futures price that gets independently marked-to-market and settled every day. Periodic cash flows are accrued and paid on a daily basis and get reflected in the futures price. We only move cash via the daily variation margin process that is well-known to the futures industry. Our product design is novel enough that we have even filed for a patent on some aspects of our final settlement calculation that allows us to truly match the economics of a standard OTC swap dollar-for-dollar.

We passed $18 billion in notional trading the other day - which relative to the overall OTC rates market is small, but we've shown that trades can occur and get seamlessly processed by futures back office infrastructure. Customers can use their existing futures systems and are not required to implement any new modules.  

Q: Could you give any examples of the early interest in the Eris Exchange and its products? Examples of how enthusiastic the financial industry is about your services?

A: In every major client segment, we have interested participants that are actively pursuing or testing this out and working with us. We have a number of major FCMs that have processed trades, and many more in the pipeline getting ready. On the end user side, we’ve had interest from all the major participant types including asset managers, insurance companies, corporate, GSEs, hedge funds and major proprietary trading shops. 

We are up and running and are available to almost the entire CME FCM population, so we are unique, and that draws a lot of interest. Every one of the major client groups is actively looking at how they are going to respond to and meet the coming regulatory requirements.


Q: How do you see the exchange evolving?

A: Our product road map involves moving from spot-starting, dollar-denominated interest rate swaps to forwards, which is a big part of the market, and then onto swaptions (options on forwards). That will require a lot of organizational focus from the exchange and support from our clearing and technology platform providers, and we’re very busy at the moment executing on that roll-out plan. Beyond that, we could eventually move into different asset classes and other non-dollar-denominated products.



Q: What would be a rough time line for these other products?

A: We are actively working on a number of product fronts with our various partners and will come to market as we have agreed upon time lines for launch. Dollar-denominated forwards is the next product in the queue for us to launch. 


Q: Does the public, or at least the investing public, have a better handle on the OTC market and how the market works, or will the OTC market always be on the fringe to the educated retail user?

A: We are certainly targeting an institutional user base and not the retail market. Even if it is centrally cleared, an over-the-counter interest rate swap is a product tailored to the institutional user. However, after the recent financial crisis, the educated retail market and even the general public has become much more aware of the systemic risk and the pitfalls of bilateral, over-the-counter trading. The general investor and the general U.S. taxpayer is now aware of the risks inherent in OTC derivatives trading and the importance of assessing risk exposures daily and not letting losses accumulate. One of the major lessons we can all take away from AIG and the financial crisis is that futures-style margining works very well, and the system works because there is an independent risk assessment made and money moves daily based on the settlement prices determined by the independent clearing house. So even if the retail investor will not participate in institutional products on Eris Exchange, I think in the post-crisis environment an educated investor or even general taxpayer can appreciate the role this product fills in the marketplace.

Now, do I think OTC products will come into the mainstream? Potentially, for other asset classes, but I don't think interest rate swaps will be a major area of growth in the near term for the retail market. Retail investors are much more involved in equities, metals, agricultural commodities and ETFs. Interest rate swap futures are a little more capital intensive and more of a customized product for institutional clients.


Q: Were you hoping to do something like you are doing now when you were in school?

A: I studied government and international economics in school, I got an MBA and a master’s in international affairs and I started my career at the IFC-World Bank (International Finance Corporation), so I worked heavily in emerging market finance.

I was based in the U.S., but traveled to Asia, Africa, Latin America. I did a lot of work around the world. Then I came back to Chicago, where I grew up, and worked at the CME in emerging market product development. I was involved in international market development and then worked at the CBOT in a similar area. At CBOT we provided international consulting to emerging market exchanges who wanted to set up their own derivatives exchanges.

I've been involved in markets and new market development from early on in my career, and then started Liquidity Direct, which was an options spread trading platform focused on the interest rate options market and supported by a number of major trading firms in the industry. After we were acquired by CME, I ended up  running CME’s business development, working on things like CME’s investment in BMF in Brazil and a variety of OTC clearing initiatives.

So could I have predicted that I would be running an OTC interest rate swap futures exchange? No, that's based on the particular moment in time and the specific macroeconomic context today. But I've been involved in starting new product ventures, new exchange-type ventures my whole career. That's the logical progression. I moved from emerging markets to something more close to home, but it still involves opening up new markets and providing access to new products.


Q: Is there anything else that we haven't talked about that people should know about the Eris Exchange or its products?

A: I think the message that we haven't touched on is this is a very exciting time for the futures industry. The futures market performed extremely well during the recent financial crisis. It handled the Lehman default and bankruptcy without a hitch.

Whereas major players were having issues in the OTC market, the futures market was a stable source of liquidity throughout that crisis. I believe if the industry transition to cleared OTC trading occurs the way we envision, it will be a boon to the futures industry in general. This is a major shift in the futures markets and the capital markets in general, and it's a whole new world of opportunity.

It will ultimately result in a much better, more stable product for the current OTC end users. They get
transparency, they get independent marks, they get a more robust credit facility on the back end and they don't have to worry about balance sheet exposure. They get all the benefits they currently have and they remove a significant part of the risk.

Overall, it's a big win-win for everybody. And it will be a very interesting couple of years as this all plays out.

Statement by SIFMA President and CEO Tim Ryan in Connection with National Economists Club Speech

Press Release

Release Date: October 26, 2010
Contact: Andrew DeSouza, (202) 962-7390, adesouza@sifma.org


Statement by SIFMA President and CEO Tim Ryan in Connection with National Economists Club Speech

Washington, DC, October 26, 2010—The Securities Industry and Financial Markets Association today released the following statement from President and CEO Tim Ryan in connection with his speech to the National Economists Club:

—The Securities Industry and Financial Markets Association today released the following statement from President and CEO Tim Ryan in connection with his to the National Economists Club:

235 rulemakings, 41 reports, 71 studies authored by eleven different federal agencies, bureaus and the Government Accountability Office.

That’s what, as legislated by the Dodd-Frank Act, needs to be studied and written over the next two-to-five years. And that’s just in the United States.

Parallel rulemaking is taking shape across the globe, initiated by the same financial crisis, and necessitated by the fact that we do business today in a global economy. It will be vital for global rules to be coordinated and to apply equally to the entire industry to avoid market distortions, regulatory arbitrage and competitive advantages among different jurisdictions.

Our focus—everyone’s focus—must be on how we safeguard our financial system without constraining capital formation, credit availability and our industry’s ability to contribute to economic growth and job creation.

With the breadth and depth of SIFMA’s membership—which includes global, national and regional securities firms, banks and asset managers active in financial markets around the world— we can and will be a trusted, credible resource for everyone participating in the regulatory rulemaking process.

This isn’t about simply meeting the rulemaking deadlines, it’s about getting it done right. The stakes are too high for anything less. Poorly crafted regulations that create market distortions or other unintended consequences could constrain capital formation or even increase systemic risk—the exact opposite of the intent of Dodd-Frank.

To be most effective, SIFMA is focusing primarily on seven areas:

· systemic risk, specifically the new Financial Stability Oversight Counsel and its research arm the Office of Financial Research;

· resolution authority and living wills;

· oversight of the over-the-counter derivatives market;

· securitization and the credit rating agencies;

· capital and liquidity standards via Basel and Dodd-Frank;

· the future of proprietary trading and private equity under what’s come to be known as the Volcker Rule; and

· the creation of a federal fiduciary standard for investment advisors and broker/dealers who provide personalized investment advice to retail investors.


With many firms operating in a global financial system, what happens in one jurisdiction does affect firms operating globally. In addition to the work we’ll be doing on Dodd-Frank rulemaking, we’re paying close attention to what is happening globally, focusing primarily on the west by looking at the regulatory efforts of the United Kingdom, the European Union and the Financial Stability Board.

Systemic Risk



To deal with systemic risk in the U.S., Dodd-Frank has created two new entities, the Financial Stability Oversight Council (FSOC), and its research arm, the Office of Financial Research, which will provide analytical support. FSOC will oversee bank holding companies with total consolidated assets of more than $50 billion. The FSOC can also designate non-bank financial institutions as systemically significant by a 2/3 vote of the FSOC’s 10 voting members.

In Europe, the European Commission is looking into what attributes beyond size alone make an institution financially risky, and, much like the FSOC, has established the European Systemic Risk Board, monitoring risk to the 27 EU countries and coordinating the actions of national supervisors. It is comprised of Europe’s Central Bankers, and to coordinate with among others the European Supervisory Authorities.

Resolution Authority

To address the failure of a large, interconnected financial institution the U.S. and UK has already created a new resolution authority, with Europe following. Dodd–Frank has granted the FDIC the explicit authority to unwind failing firms or covered financial companies, and large complex companies are now required to periodically submit living wills to the FDIC and the Federal Reserve.

In addition to the existing resolution authority, the UK is proposing a separate administrator for investment firms. The UK’s recently passed Financial Services Bill also requires firms to submit living wills. In addition, they are investigating the utility of contingent capital or “CoCos” and bail-ins. Questions remain as to what other countries within the EU might consider and how each of these processes will interact.

In the end, the goal is to provide for a process that will wind down failing institutions, end ‘too-big-to-fail,’ and ensure functioning financial markets.

Derivatives

For the first time, the trading of derivatives will move from a primarily over-the-counter market to one utilizing central clearing houses and exchange trading. Both the EU and the U.S. will soon have mandated central clearing of most swaps. In the U.S., beyond those swaps that are fundamentally not suitable for clearing, the only exception to the mandated clearing requirement is for trades where one party is a non-financial, hedging end-user. Otherwise, all swaps that are clearable will be cleared, and in addition required to be executed on an exchange or swap execution facility (SEF). Dodd-Frank also now makes the regulation of over-the-counter derivatives the responsibility of the Commodity Futures Trading Commission and the Securities and Exchange Commission.

In Europe, central clearing of standardized contracts also will take place through CCPs, with additional capital charges made for non-centrally cleared contracts.

SIFMA is working with ISDA and the FIA to ensure that these reforms, among others, will aid in more effectively managing the interconnectivity these products create, without making the cost of risk management prohibitive.

Securitization

When it comes to securitization, we again see very similar mandates on both sides of the Atlantic— mandatory risk retention of 5 percent. However, here in the U.S., Congress provided regulators discretion in imposing such retention and exempted any retention for securitizations of “qualified” residential mortgages, a new classification to be defined, but presumably your plain vanilla, well underwritten, 30-year home loan and allows regulators to implement retention regimes—and amounts—calibrated to different asset classes.

Dodd-Frank also states that regulators should reduce financial institutions’ reliance on credit rating agencies in regulation and supervisory practices. Bank regulators have put out for comment an initial proposal regarding this provision.

The EU has already addressed this by requiring EU market participants use only EU-registered CRA issued ratings for their regulatory purposes.

Getting these efforts right will help create more aligned interests of dealers and investors, without choking off consumer credit for businesses and families.

Capital and Liquidity Requirements

When it comes to capital and liquidity requirements for systematically important companies, Dodd-Frank and Basel III are both fairly specific.

Dodd-Frank requires these companies to maintain a debt-to-equity ratio of 15-to-1, with trust preferred and hybrid capital counting as Tier 2, not Tier 1, capital. Banks are required to hold a 30-day liquidity buffer. What we still need to formulate is a counter-cyclical means of permitting banks to build in capital buffers.

Basel III’s capital and liquidity rule sets out total capital requirements of 10.5 percent, broken out as 8.5 percent Tier 1 capital and 7 percent common equity. Liquidity requirements include a liquidity coverage ratio for 30-day systemic and idiosyncratic risk and a net stable funding ratio for 1-year idiosyncratic risk.

The leverage ratio will supplement, rather than replace, the current risk-based minimum capital ratio.

Still being explored by the committee is the utility of dynamic provisioning as a useful countercyclical measure.


Volcker Rule

Financial institutions in the United States will also have to work with the ban on proprietary trading and private equity within Dodd-Frank has come to be known as the Volcker Rule. All proprietary trading by bank holding companies is prohibited. The important aspect will be how regulators define what activities are deemed “proprietary”’ and thus prohibited, while ensuring that markets remain liquid and deep.

Also, bank holding companies are generally prohibited from investing in, advising on or owning hedge funds or private equity funds. Total investments are limited to 3 percent of tier 1 capital. Investments in a fund within the first year of its establishment are capped at 3 percent of that fund.

The UK’s Independent Banking Commission is calling for evidence on whether limits on proprietary trading and investment are warranted. But how will a U.S.-only rule such as this affect our nation’s competitiveness with Europe, who is generally not considering such a rule?

Fiduciary Duty

A strictly domestic, and far less cut and dry, piece of rulemaking is the creation of a federal fiduciary standard that would apply—uniformly—to all investment advisers and brokers providing personalized investment advice to retail investors about securities, regardless of their business model.

Making sure the standard is written in a way that preserves investor choice of the products and services that best fit individual investment needs is a little tougher. It’s writing rules about the intersection of conduct and offerings.

So, as you’ve seen, six out of the seven areas in Dodd-Frank we’re focusing on have a global, or at the least EU, equivalent.

But we’ll be involved in other areas of the Dodd-Frank rulemaking process, such as compensation, the regulation of hedge funds and short sales. And we’ll also be offering commentary on the convergence of FASB and IFRS and the resulting accounting standards that will emerge.

Reforming Housing Finance

And there are some issues that are vital to the U.S. economy and financial markets that are not in the Dodd-Frank Act. Two immediate concerns are reforming our housing finance system and the taxing capital gains and dividends.

The GSEs, government sponsored entities, primarily through Fannie Mae and Freddie Mac in mortgage finance, have made possible cost-effective lending to consumers for the past 30 years. Our members active in these markets believe some form of government support will be necessary to attract and maintain capital investment in the U.S. mortgage market anywhere near the historical level over the past several decades, but recognize there is no single, easy answer for the task of reforming them.

Additionally, recent press coverage has focused on issues within the mortgage foreclosure process and its impact on the securitization markets. Indeed, some have called for a national moratorium on all foreclosures until these issues have been addressed.

Let me be clear: imposing a system-wide foreclosure moratorium would be catastrophic to the housing market and to the economy.

The mortgage market, investors and the health of the economy are all inter-related. Investors in the housing market include American workers with pension funds, 401(k) plans, and mutual funds. These hardworking Americans would unjustly suffer losses in their savings from a foreclosure moratorium.

A foreclosure moratorium would create increased uncertainty in the already weak securitization and housing markets, further constraining consumer credit and spending and dampening our already unhealthy economic situation.

If mistakes have been made in relation to foreclosure processing, SIFMA firmly believes such mistakes should be corrected accurately and fairly.

While each situation may have variations, we believe the customary loan transfer and assignment practices used in securitization are legally sound an in accordance with generally accepted and settled legal principles. We believe sweeping generalizations regarding endemic defects are not accurate.

Foreclosures are in no one’s best interest, neither the bank nor the homeowner nor the investor, but in some cases are unavoidable. In those situations, moratoriums and similar actions will only delay the inevitable, and lengthen the timeline for housing recovery.

Capital Gains and Dividends Taxation

Investors also need certainty with respect to tax issues as nearly all of the Bush era tax cuts are set to expire at the end of this year. As to capital gains and dividends, without Congressional action—soon—the tax rates on capital gains will increase by 33 percent and the rates on dividends will increase by 164 percent—that’s right 164 percent— this coming January 1. Seniors on fixed incomes will be hit particularly hard by these increases, resulting for many in significant decreases in their discretionary spending. And higher tax rates on investment income will lead to fewer jobs, lower take-home pay and even slower economic.

January 1 is not far off, and that’s a very big change. Right now, the lack of action is already having a negative effect on investors. Investors like certainty, and they’re not getting it. Congress should provide that certainty by extending the current 15 percent tax rates in capital gains and dividends before the end of 2010.

Conclusion

The financial industry and federal regulators are faced with an unprecedented task over the next 2 to 5 years. Many of the agencies tasked with making these rules are taking on responsibilities outside their historical purview; the expertise needed to get these regulations right doesn’t necessarily reside within their walls. However, there is a robust rulemaking process that encourages comment. Again, we are committed to being a valuable resource during this rulemaking process, providing content-rich, fact-based commentary, drawing on the expertise of SIFMA’s member firms, And, when needed, we are moving beyond even that, contracting for third-party, in-depth economic analysis of the effects of proposed regulations.

We’re also concerned with how our new regulations will coordinate with similar efforts internationally. And how all of these new rules, working together, will affect capital formation, credit availability, economic growth, and ultimately the prosperity of consumers.

We’re doing all this because we must get these regulations right; the stakes are too high to do anything less. Unintended consequences of poorly crafted regulations could slow economic growth and stifle job creation; it could create capital market winners and losers.

This is not what any of us wants. We’ll be living with these regulations for decades. Let’s look back at the next two to five years as the time when we laid a foundation for growth and safety—as the time when we all got it right.

-30-

The Securities Industry and Financial Markets Association (SIFMA) brings together the shared interests of hundreds of securities firms, banks and asset managers. SIFMA's mission is to support a strong financial industry, investor opportunity, capital formation, job creation and economic growth, while building trust and confidence in the financial markets. SIFMA, with offices in New York and Washington, D.C., is the U.S. regional member of the Global Financial Markets Association (GFMA). For more information, visit www.sifma.org.

TABB Group: Reinventing the Credit Default Swap: CDS on CCP

By Kevin McPartland, Senior Analyst, TABB Group

Whatever you think of credit default swaps after the financial crisis and global recession that ensued, they did have some worth: those that bought them were left protected against what turned out to be a real risk - “credit events.”

So what if we were to take their intrinsic value and lay that over what’s rapidly developing in the OTC derivatives market today?

To wit: OTC derivatives clearinghouses act as an outsourced risk management department for market participants who use them. Rather than managing the counterparty risk internally via collateral and other mechanisms, clearinghouses mitigate counterparty risk for its members via margin requirements, guarantee funds and other tools in their decades-old toolkit.

Clearinghouses, however, though built with the sole purpose of reducing risk, do not completely eliminate risk for OTC derivative transactions. By the nature of the clearinghouse model, clearinghouse member firms are still left exposed (although less so) to other member firms. But perhaps even more importantly, members are exposed to the clearinghouse itself. What if the clearinghouse fails? To that point, the New York Times recently published an article that called clearinghouses “the next too-big-to-fail.”

The last few years (hopefully) have taught us to never say never. Regardless of how unlikely they are to occur, systemically risky events can’t be ignored and must be mitigated. So although clearinghouses are built to never fail (they are not investment banks after all, and don’t seek to take on risk), an economic calamity no one has yet to think of could indeed cause the unthinkable.

So what’s a market participant to do? Dealers today use credit value adjustments (CVAs) to hedge the risk that their counterparty in a bilateral OTC derivative deal fails by adding a few basis points to the cost of the trade for the buyer. Among other things, this CVA calculation takes into account the current CDS spread for the counterparty to predict the potential loss due to counterparty risk.

But theoretically, this practice is unnecessary in the centrally-cleared world since there is no risk that a counterparty will default. But that’s not really the case. Enter the CDS on CCP.

I’m no financial engineer, quant, PhD or trader, but I’m quite sure one of the aforementioned individuals can find a way to create an instrument to hedge the risk of a clearinghouse default. So why not a CDS on the CCPs? We already have CDS on U.S. Treasuries (the ultimate too-big-to-fail, right?) so it only seems logical. Maybe even a CDS CCP Index product that hedges against the risk of any CCP in the world failing.

Alas, the idea creates a huge paradox however – who’s going to clear them?

See the entire report here: 
Reinventing the Credit Default Swap: CDS on CCP (Login required)

Aite Group: Interest Rate Swaps Trading Expected To Change Modestly

Press Release.

Boston, October 12, 2010 – A new report from Aite Group examines interest rate swaps (IRSs), the changes expected from regulatory reform in this space, and regulators’ determination on requirements for swap execution facilities (SEFs). Based on a number of Aite Group interviews with IRS market players, the report cites the applications this mature product confers upon banks’ risk management strategies and issuer needs.

Though similar to the credit default swap, IRSs’ oft-mentioned OTC derivative counterpart, interest rate swaps are much more frequently used, and serve as part of banks’ interest rate risk management and debt issuances. The IRS market will change under legislation outlined in the Dodd-Frank Wall Street Reform and Consumer Protection Act (aka FinReg) and new rules implemented by the CFTC/SEC. This change, however, will fall well short of legislators’ hopes.

A major issue at play is how the regulators will determine the ownership structure of a swap execution facility and what related reporting requirements will be implemented. A new, proprietary-shop-backed entrant, Eris Exchange, may challenge the traditional liquidity providers. Outside of this threat, interest rate swaps trading is expected to change modestly given that the nature of this mature product will ultimately determine its market structure.

“The interest rate swaps market is unlikely to experience large-scale changes in the near to medium term,” says John Jay, senior analyst with Aite Group and co-author of this report. “Within the context of regulatory reform, the structure of IRSs and their usage will determine how the IRS market will evolve.”