CME Group Inc., the world’s largest futures exchange, plans to begin clearing interest-rate swaps next week in a race to dominate what a London competitor has called a “battleground” U.S. market.
The exchange’s clearinghouse will guarantee U.S. dollar- denominated rate swaps starting Oct. 18, according to people familiar with the decision who asked not to be identified because it hasn’t been made public. Chicago-based CME Group will compete with a unit of Nasdaq OMX Group Inc. and LCH.Clearnet Group Ltd. of London for clearing trades in the $349 trillion market. Rate swaps make up the biggest class of over-the-counter derivatives.
“You’d expect it to be a highly competitive market because this is the biggest over-the-counter clearing opportunity,” said Richard Repetto, an analyst at Sandler O’Neill & Partners LP in New York. “CME has an advantage because of the capital offsets they could offer” due to the interest-rate futures they already provide, he said. Margin payments on cleared interest- rate swaps and futures can cancel each other out if the positions oppose each other, for example.
Repetto said CME Group showed its customers the rule book for its interest-rate swap clearing a few weeks ago, before the start.
LCH.Clearnet is the world’s largest interest-rate swap clearinghouse. Its SwapClear service has been guaranteeing the trades between banks since 1999 and began offering bank customers, such as money managers, the clearing service in December. Andrew McGuire, a vice president in the clearinghouse’s U.S. office, said in July that LCH.Clearnet sees the U.S. market “as the battleground for the next two years.”
Beginning as soon as 2012, derivatives exchanges and clearinghouses worldwide may earn $190 million a year from clearing interest-rate products, according to Morgan Stanley analysts led by Celeste Mellet Brown.
“We continue to work with buy- and sell-side participants to bring an interest-rate swaps clearing solution to market,” said Allan Schoenberg, a CME Group spokesman. He declined to comment on the start of clearing next week.
CME Group’s new plan would follow the failure of its Swapstream system for interest-rate swaps that the exchange halted in September 2008.
The International Derivatives Clearing Group LLC, majority- owned by Nasdaq, has been open to clear rate swaps since December 2008 and has $393 million of open-interest, or active trades, in it clearinghouse as of yesterday, said Alan Sobba, an IDCG spokesman.
The Dodd-Frank Act, signed into law by President Barack Obama in July, mandates that most interest-rate, credit-default and other swaps be processed by clearinghouses and traded on exchanges or similar systems, taking business from the Wall Street banks that pioneered the transactions. All trades in the $615 trillion market will be reported to regulators. Dealers and their biggest clients will face higher capital requirements to use the market.
The push to overhaul the banking industry follows the collapse of the housing bubble that caused the financial crisis after credit markets froze, Lehman Brothers Holdings Inc. went bankrupt, and more than 8 million U.S. jobs were lost. Private swaps complicated efforts to solve the crisis when regulators and market users couldn’t easily determine how interconnected banks had become through trading the contracts.
Clearinghouses, which are capitalized by their members, increase stability in over-the-counter derivatives markets because they lessen the effect of a default by sharing the risk among the membership and use daily margining procedures to keep accounts current. They also allow regulators to see market positions and prices.
CME Group is working with bank partners Bank of America Corp., Barclays Plc, Citigroup Inc., Credit Suisse Group AG, Deutsche Bank AG, Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley, Nomura Holdings Inc. and UBS AG on its rate swap clearing plan, according to the company’s website.
There are different levels of readiness among the bank partners to start clearing rate swaps next week, according to two of the people. CME Group has pushed for the start of the clearing plan against resistance from some of the banks because of the competitiveness of the market, they said.
LCH.Clearnet’s system for clearing trades for U.S. customers should be ready by the end of the year, McGuire said in July.
The U.S. Federal Housing Financing Agency, which oversees Freddie Mac and Fannie Mae, has expressed reservations about how collateral for users of non-U.S. interest-rate swap clearinghouses is treated under bankruptcy law, according to McGuire.
Customers such as Freddie Mac and Fannie Mae represent an opportunity to move more than $1 trillion of bi-lateral rate swaps into clearinghouses. Freddie Mac has $646 billion in outstanding rate swaps as of June 30, while Fannie Mae has $552 billion outstanding, according to their most recent quarterly filings.
Another potential issue for CME Group’s plan is that the exchange is considering creating a separate default fund for rate swaps that would be separate from its futures default fund, Repetto said. This could limit small participants who don’t have enough cash to contribute to the new default fund, which is used in case the clearinghouse has to pay to make whole on a defaulted member’s positions.
There may not be as much margin offsets between the futures and swaps with a separate default fund, Repetto said. Offsets are also known as cross-margining.
“I was told by CME pretty vehemently they can still be cross-margining, but that’s the debate,” Repetto said.
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