Discussion of Credit Check Procedures in Cleared Swaps Markets

Transcription

1 FIA Special Report: CFTC Discusses Credit Check Procedures in Cleared Swaps Markets April 5, 2012 The Commodity Futures Trading Commission held an all-day meeting of its Technology Advisory Committee on March 29 to discuss a range of topics including high-frequency trading, data standardization and credit checks in the cleared swaps markets. This special report describes the key points from the discussion on credit checks in the cleared swaps market. The FIA circulated a separate report on April 2 summarizing the discussion on high-frequency trading ( %20discussion%20March% pdf). The final TAC panel discussed various solutions for conducting customer credit checks on over-the-counter derivatives transactions conducted through various execution facilities, including swap execution facilities. Much of the discussion centered on whether these trades, which are executed for central clearing, should pass through credit filters before or immediately after execution. In addition, the panelists discussed the challenges in applying a customer s credit limit in a marketplace that will likely have multiple execution and clearing platforms. CFTC Commissioner Scott O Malia, the chairman of the TAC, started the discussion by stressing his interest in hearing industry views on how to make the trading and clearing process work effectively and efficiently. For that reason, he explained, he invited four panelists from different sectors of the industry to offer their views on how the industry should address the issue of applying credit checks to swaps trading in the post- Dodd-Frank environment. During the course of the discussion, the panelists referred frequently to an industry effort to reach a consensus on these issues through a working group sponsored by the Futures Industry Association and the International Swaps and Derivatives Association. This working group has been meeting for more than a year to discuss market infrastructure issues for cleared swaps, and in particular the challenge of building systems for managing credit risk without compromising trade certainty. The four panelists were: Randall Costa, managing director at Citadel, representing a buy-side firm; Paul Hamill, a managing director at UBS representing a sell-side firm; Jeffrey Maron, managing director at MarkitServ, representing a confirmation entity; and Jim Rucker, head of credit and risk at MarketAxess, representing an execution facility. No panelist directly represented a clearing firm. While the meeting was chaired by O Malia, CFTC Chairman Gary Gensler attended the meeting and was actively engaged in the discussions. Applying Credit Checks: Before or After Execution? Hamill, the first speaker, explained that this topic has been discussed within the industry for approximately a year as market participants began thinking about the implications of mandatory clearing. The key problem is that trades subject to clearing are not done until they have been cleared, and that introduces a new element of uncertainty into the trading process. Hamill noted that initially the industry addressed this issue through trilateral documentation but more recently the discussions have

2 focused on technology solutions. Hamill added that the FIA-ISDA working group is in the process of finalizing consensus on the principles for addressing the trade certainty issue. Costa then outlined two operational models one based on post-execution clearing acceptance and one based on pre-execution clearing guarantees. Costa commented that the issue of applying credit checks on cleared trades is not a new challenge and noted that it has been solved in a range of existing cleared derivatives markets. He highlighted in particular the post-execution approach for credit checks used in the CME ClearPort model. He said that in the Clearport system, this process happens in seconds and trades are rejected very rarely. Regarding the pre-execution approach, Costa said this prevents parties from entering into trades unless they first pass through a filter that assures that they have sufficient credit within the limit set by their futures commission merchant. This model is how trades are processed on CME s Globex, he noted. The parties to a trade know that the trade will be cleared because the clearinghouse can rely on the FCM to stand for the client. He cautioned, however, that if there were a delay between execution and clearing acceptance or rejection, there would be the risk of breakage. Hamill stressed that the majority of the market participants involved in these discussions want assurance that they have a trade at the point of execution. There s just simply too much concern out there that people have around doing trades and finding out later that they don t exist, the UBS executive said. Having a big trade rejected could result in big losses because the swaps market is relatively illiquid, he added. What we certainly don t want to do is introduce sort of another layer of risk--a lack of certainty around execution as an unintended consequence of the way in which we choose to clear the trades. Central Hub Solution? Panelists then debated the pros and cons of various models for where the credit limits set by the clearing firms for each customer would be held and managed. Hamill explained that there are four potential locations: the central counterparty, the swap execution facility, the futures commission merchant, or a single central hub that would be constructed for this purpose. Although he acknowledged that the hub idea has some appeal, Hamill said the industry is focused on using the existing infrastructure to reduce costs and time to market. Costa then discussed some of the mechanics of the process for checking customer credit limits and the pros and cons in terms of the amount of time it takes to go through that process. The Citadel executive commented that if the credit limits are maintained at SEFs, that would take less time than if the credit limits are maintained at CCPs. That is particularly important for firms that need lower latency in their trading, he explained. Rucker, the MarketAxess executive, said his company has built pre-trade credit limits into its trading platform. Clearing firms upload limits for their clients at the beginning of the day, and the platform monitors trading activity against those limits over the course of the day. In addition, the platform has the ability to ping an FCM to confirm whether a particular order is within the limit set for that client.

3 So far MarketAxess has spent approximately $200,000 on programming these solutions into its platform, he said, and is preparing to spend another $100,000 to finish the project. At the moment, however, it has halted development waiting for the industry to decide on what model should be used. He added that his company s view is that using a central hub to maintain and record customer credit limits would be a more workable approach than messaging out to each FCM for confirmation. We would be supportive of an industry solution that creates some sort of central method for checking credit limits, said Rucker. Maron, the MarkitServ executive, also expressed support for the central hub idea. Maron explained that his company operates the messaging system that participants in the swap markets use from execution to clearing to trade repository. He observed that one advantage of housing credit limits in a central hub would be that valuations would come from a single source rather than multiple SEFs, and added that Markit, one of the two companies that own MarkitServ, already has expertise in valuations. The central hub would work as follows: every time a bid or offer is entered into a SEF, the SEF would reach out to the hub and check the limit at that point in time. So this would allow credit checks before execution, Maron explained. To reduce the latency of this process, he said his company is talking to companies that build and operate exchange trading platforms, with the goal of adding only a few milliseconds to the trading process. He also said the cost of building a hub would be less than the total cost of every FCM connecting to every CCP and every SEF. In addition, running credit limits through a hub would have certain advantages for FCM risk management. Maron explained that there would be a global kill switch that would allow an FCM to turn off a particular client across all SEFs. The hub model also would address a concern raised by FCMs that in the new electronic trading environment for swaps, a client posting orders on many platforms could be swept and have all the orders executed at the same time, taking them far above their credit limit. CFTC Chairman Gary Gensler asked the presenters how the proposed credit check models fit into the rules recently approved by the agency relating to customer clearing documentation, timing of acceptance for clearing, and clearing member risk management. In particular he asked if anonymous trading is feasible under the various models being discussed and if the central hub model would satisfy the obligations of FCMs under those rules. Let s hope that the FCM is managing it in a way more than hope that they are really managing it in a way that works, he said. Costa noted that the CFTC s rules require that trades must pass through a credit filter either pre-execution or immediately after execution. In addition, he said there are challenges for FCMs and clearing members because they will have to manage credit filters across multiple execution platforms. O Malia turned to Chuck Vice, president and chief operating officer of IntercontinentalExchange and a member of the TAC, and asked for an explanation of its plus one solution for managing credit limits. Vice explained that under this model, ICE maintains credit limits at its clearinghouse. As trades come in from various SEFs or other sources, ICE checks both sides of the trade against the limits. The first trade that goes over the limit will be accepted thus providing trade certainty but ICE will send a

4 message to all the SEFs that the account is disabled until the positions are reduced or the limit increased. The advantage of this approach, he commented, is that it poses less operational risk than building gold-plated solutions with a lot of moving parts. He added that it draws on ICE s experience in running trading platforms for swaps for the past 10 years, and noted that it is very, very rare that a trade is rejected because it hit a limit. Garry O Connor, chief executive officer of International Derivatives Clearing Group and a member of the TAC, joined the debate with a comment about the costs of building a new model. O Connor expressed his support for instantaneous post-trade certainty and cautioned that it would be very costly for a clearinghouse to adopt the pre-trade credit check model. The cost of making that very small leap is significant, he said. And I think it s important that we think about what benefit we are getting from taking that extra step. Bryan Durkin, chief operating officer of CME Group and a member of the TAC, stressed that the existing models for dealing with credit checks should not be dismissed, especially in light of the deadlines for complying with new rules for trading and clearing swaps. I do think we shouldn t dismiss what s out there today and what is working very well as we move toward that direction, he said. Hamill countered by saying that operational issues should not override the risk of not having trade certainty. If you ask someone who trades credit default swaps, at the point of execution would you rather know then [that] your trade is done or would you rather wait a little bit of time? The answer is, I d rather know my trade is done. He agreed that it is complicated to build a system with pre-trade credit checks but stressed that this would be safer. He also commented that his firm would be more likely to trade on a SEF that has pre-trade credit checks than one that does not. Standard Messaging Protocol The presenters all agreed that the use of standard messaging protocol is necessary in a multiple execution platform environment. A standard messaging protocol would clearly be a significant benefit to us in ensuring that the work in connecting all of the individual FCMs was minimal, said Rucker. Costa added that a group of technology experts has been formed to establish this protocol, and commented that having such a protocol would minimize investment costs for all market participants and eliminate barriers of entry across multiple SEFs. Click Here for TAC Meeting Agenda, Presentations and Archived Video Copyright 2012 by the Futures Industry Association. Members of the Futures Industry Association are allowed to distribute this publication within their own member organizations or to other members of the Futures Industry Association so long as this copyright notice and the FIA disclaimer are not removed. As to all other instances, no part of this publication may be copied, photocopied, forwarded, redistributed, modified or duplicated in any form or by any means without the prior consent of the Futures Industry Association. Unauthorized copying of this publication is a violation of the U.S.

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