Market Participants Weigh Centralized Swap Hubs to Achieve Clearing Certainty

Peter Barsoom, COO at credit default swap (CDS) clearinghouse ICE Clear Credit, recently sat in on a panel discussion about clearing certainty in a swap execution facility (SEF) world. He says the industry shouldn’t rely on one "central magic hub" to handle all parts of every transaction. Such a hub, he says, could propel costs into the stratosphere. "If we get to the point where we've achieved certainty of execution but it costs $500 to process that trade, I'm not sure we've succeeded at anything," Barsoom says.

Costs can be absorbed by retaining a flexible infrastructure with standard protocols, and leveraging the models already in place in other markets, he says.

Other panelists say, however, that they like the idea of centralization for a number of reasons.

Supurna Vedbrat, co-head of electronic trading and market structure at asset manager BlackRock, points to the potential hazards of fragmentation and the effect it could have on a client like her firm. "If there is a trade break because of fragmentation of credit limits [with various futures commission merchants (FCMs)], it's a default to pay model. So do we want to risk market loss because of the fragmented way credit limits are handed to an asset manager or a client like us?"

Mihail Nikolov, an executive director at UBS, sees fragmentation as the biggest risk presented by the new landscape—not just in terms of risk management, but also costs. "The more fragmented the structure becomes, the larger the cost both in hooking everything up to that structure, but also the cost per trade. It's a very significant issue, and the less fragmentation that the industry ends up with, the beneficial it is on the risk front and the cost front."

Building multiple SEFs and multiple central counterparties (CCPs) is going to increase uncertainty, says Peter Borstelmann, director of OTC clearing at Barclays. FCMs will have to choose which SEF and which CCP to use. Barclays clients would prefer having everything in one centralized location. So while Borstelmann says a hub would increase costs, he says he still advocates for it from a strategic point of view.

Steven Mahoney, managing director of prime services at Credit Suisse, says clearing certainty will be the most important part of clearing going forward. Certainty breeds confidence, which will cultivate the creation of a deep and liquid swaps market, and a cheaper market, says Christopher Perkins, global head of derivatives clearing at Citigroup Global Markets.

"The worst case is if I give my client a limit, and that client trades within the limit, and the CCP ‘don’t-knows’ (DKs) that trade for some reason—and they have very flexible ability to DK trades coming in from FCMs, " he says. "I bear that risk when I say yes to the client and the CCP says no to me. That's going to be very expensive. I'll have to price that risk into my fee schedule. If we can come up with good protocols, pre-execution checks, where I also have transparency from the CCPs, that risk can be averted."

A potential problem is that one of the protocols observed by ICE Clear Credit is the presence of a kill switch, where credit providers can revoke the credit limit of a participant and cancel all outstanding unfilled orders by that participant. Kill switches inject uncertainty, says Vedbrat. A T+1 trade may go through, but what about a T+2 trade? On the other hand, Perkins says there should be kill switches on both sides. Because FCMs act as intermediaries between the client and CCP and carry twice the counterparty risk, he wants to be able to kill a trade as well.

The Bottom Line

- Clearing certainty may be the most important part of clearing in the new world of swaps under Dodd-Frank.

- While ICE Clear Credit's Peter Barsoom said a single centralized hub will greatly increase costs, representatives of trading firms and FCMs believe a single hub would increase clearing certainty.

- Fragmentation of SEFs and CCPs will only cause further problems for a swaps market that is still finding its way in the new landscape.

- The CCPs will likely possess kill switches to shut off trades for clients that have exceeded their credit limit, but such switches could subtract from execution certainty.