Regulators Look to Ease Entry in Derivatives Clearing

By Katy Burne


U.S. regulators seeking to overhaul the $583 trillion market for privately traded derivatives have proposed lowering the bar for membership into clearinghouses, which guarantee swaps.

The move would force big banks to share profits relating to over-the-counter derivatives business with non-incumbent firms under the new regulatory regime—a business opportunity estimated to be several billion dollars, according to consultants at Booz & Co.

The Commodity Futures Trading Commission last week voted in a proposal that derivatives clearing organizations, or DCOs, wouldn't be permitted to set capital requirements on new members above $50 million—significantly lower than the existing hurdles.

"The proposed participant eligibility requirements will promote fair and open access to clearing," CFTC Chairman Gary Gensler said last Thursday at a hearing. The proposal "promotes more inclusiveness, while allowing the clearinghouses to scale a member's participation and risk, based upon its capital."

The CFTC proposal, which won't be implemented until next year after a 60-day public comment period and subsequent vote, also would prohibit a clearinghouse from requiring members to maintain a swap portfolio of a particular size or from setting transaction volume thresholds.

The Securities and Exchange Commission, which was tasked with implementing the derivatives overhaul along with the CFTC, hasn't yet made a recommendation on clearing member requirements, a spokesman said.

The CFTC will regulate swaps, and the SEC security-based swaps. They will jointly regulate swaps that don't fall cleanly into either category.

All derivatives that are standardized enough to be accepted by a clearinghouse must be cleared under the Dodd-Frank financial-overhaul bill signed over the summer. Early estimates suggest as much as 80% of the swaps market could be cleared.

The U.S. has two big horses in the swaps clearing race: ICE Trust for credit derivatives, which is owned by Intercontinental Exchange Inc., and CME Clearing, owned by the Chicago Mercantile Exchange, or CME Group Inc.

ICE Trust, which says it will comply with whatever the new rules are, now requires members processing trades through clearinghouses on behalf of customers—commonly referred to as futures commission merchants—to maintain a minimum of $1 billion in adjusted net capital. Other participants not acting as those agents, or FCMs, have to have $5 billion in Tier One capital to clear credit derivatives through ICE. Tier One capital is a measure of a firm's financial strength used by regulators.

CME Clearing, which also continues to work with regulators on the proposed rules, requires members that aren't banks to maintain a capital adequacy of $1 billion and members that are banks to have minimum tier-one capital of $5 billion.

CME's minimum contribution to its interest-rate swaps guaranty fund alone is $50 million—over and above its membership requirements. Like ICE, it also clears credit derivatives and its minimum capital requirements for that asset class of swaps are that members have access to at least $500 million.

Aside from capital requirements, clearinghouses also have restrictions that address the potential clearing member's creditworthiness, operational capabilities, and its ability to make markets in swaps—something not required of clearing brokers in other markets.

Would-be new market members—some of which are in the business of clearing other derivatives already, and some of which are dealers of cash instruments—say the incumbent dealers are finding excuses to keep them out of central clearing.

Because under the new regulations the majority of swaps will have to be centrally cleared, all firms offering to make markets in swaps will need a way of clearing those trades. Since they can't self-clear trades and aren't members of clearinghouses, they would have to go through the incumbent dealer members, which control the risk committees of the swaps clearinghouses.

They further accuse the incumbent dealers of denying firms clearinghouse membership as a way of preventing them from being competitors in swap dealing, since clearing and execution go hand in hand under current clearinghouse rules.

Together the independent firms have formed a trade group called the Swaps and Derivatives Market Association, now at least 20 members strong, to fight for equal access.

"Some of these requirements are arbitrary and designed to impede competition and transparency, not to foster it," said SDMA co-founder James Cawley.

But the incumbent dealers contend that the CFTC's plan to lower capital requirements for new members will put clearinghouses further at risk and create an incentive for all members to allocate as much capital as the weakest member because that would level the playing field. Clearinghouses, having unlimited access to federal funds, could then need costly bailouts from taxpayers or else they could prove a shock to the financial system.

"It creates new Fannie Maes and Freddie Macs for derivatives and the economic effect is very similar to a big subsidy for derivatives, even though [clearinghouses] don't have a federal charter," said one industry official.

Dealers also say it is a problem for new entrants that don't maintain a trading desk, because they aren't comfortable about how a distressed firm's trades could be passed onto a smaller member without a trading operation in the case of a liquidation scenario. They are also suspicious of end-of-day swap prices that these would-be members say they can provide, since these prices would often be coming from a third party trading desk.

One dealer representative said the notion of having a two-tier membership in clearinghouses has been considered, but there is still a concern about how to ensure all members would be treated fairly if there was a default and a subsequent auction of a distressed participant's positions among the other clearing members.

SDMA members argue that such auctions are far better served when there are more bidders involved and that, while some of them may not have trading desks, others do and are able to provide actionable and tradable end-of-day swap prices through joint venture arrangements with independent clearing brokers so that clearinghouses can price their books.

Mr. Cawley wrote to the CFTC last week to complain about ICE Trust's clearinghouse application, saying ICE wasn't in compliance with provisions of the Dodd-Frank Act which call for fair and open access. He said ICE is using capital requirements on outsiders as an "anticompetitive weapon" to prevent independent agents from being able to profit from the business of clearing.

He also complains that ICE requires all trades to go through a "participant" of ICE Trust—meaning one side of every trade has to be executed with an incumbent dealer in the clearinghouse, and trades between customers or dealers who aren't members are not allowed.

"Since participation in these auctions is a precursor to qualify to clear OTC swaps, this artificial construct of linking clearing to execution is deployed to limit independent clearing firm's participation," he wrote in the letter.