ICE Clear to Offer First Credit Default Swap Clearing for Sovereign Debt

Intercontinental Exchange Inc., owner of the world’s largest credit-default swap clearinghouse, said it will start guaranteeing contracts on sovereign debt for the first time.

The company, owner of ICE Clear Credit, will begin backing swap trades on Brazil and Mexico on Oct. 31, with transactions for Argentina and Venezuela to follow, it said in a statement today. These will be the first sovereign contracts to be processed by a clearinghouse, the Atlanta-based company said.

Clearing swaps on Latin American nations is a first step in overcoming one of regulators’ and banks’ biggest hurdles to curbing the risks that $28.5 trillion in outstanding contracts pose to the global financial system. While banks have moved many of the contracts linked to corporations into clearinghouses, they’re struggling to do the same for contracts on themselves and countries in which they’re based without having to require collateral postings that would make the trades uneconomical.

“There are some very thorny risk issues,” Jeffrey Sprecher, chief executive officer of Intercontinental Exchange, said in an Oct. 11 interview, referring to the issue of clearing swaps on the banks that are members of his clearinghouse. “We haven’t wanted to touch that one until we figure out the sovereigns,” he said.

Dealer Swaps

The complexity of housing some of the most volatile and correlated credit swaps in a clearinghouse capitalized by the same lenders whose debt is protected by the contracts has prevented their inclusion in the risk-mitigating service. The obstacle extends to contracts linked to countries in which the banks are based. The issue is one of the derivatives industry’s biggest challenges, Sprecher said.

The risk has been underscored in recent months as Europe’s sovereign debt crisis pushed the average cost of protecting credit swaps on dealers and their home nations to a record.

Contracts on financial companies and government entities account for the largest part of the so-called single-name credit-default swap market, accounting for $6.2 trillion, or 41 percent of the total $15.4 trillion in outstanding single-name contracts as of Oct. 14, according to the Depository Trust & Clearing Corp. Of that, $1.5 trillion is linked to banks that back the clearinghouses and the countries in which they are based.

‘Need to Manage’

Regulators and clearinghouse owners have yet to act as European concerns are causing a surge in demand for the debt protection.

“The banks and sovereigns are where people are concerned about risk the most today,” said Kevin McPartland, director of fixed-income research in New York at Tabb Group, a research and advisory firm. “This is an exposure people need to manage, so we need to figure out a way to manage it.”

There were $812.4 billion of credit swaps outstanding on the 16 banks that are members of Intercontinental Exchange’s clearinghouses in the U.S. and Europe. An additional $714 billion of swap contracts protect against default by six of the home countries of those banks: the U.K., U.S., Germany, France, Italy and Japan. Switzerland, home to clearing banks UBS AG and Credit Suisse Group AG, isn’t included in the top 1,000 credit swaps contracts disclosed by DTCC.

The data is a gross figure, meaning it doesn’t subtract trades that offset each other.

Sufficient Margin

The problem for the credit swaps written against the dealers and their home counties is how to set sufficient margin levels and still make the contracts attractive to users, McPartland said. Margin is the collateral investors must provide to back adverse price movements in their trades.

“The correlations seem so high the only way they can manage the risk is to get the margin higher,” he said. “But if they become economically unusable, then what happens?” The ripple effect from a home country of a major dealer defaulting is also a thorny issue, he said.

He estimated that margin for credit swaps on the dealers who are members of Intercontinental’s clearinghouses would have to be 20 percent to 25 percent of the notional value of the trades, a very high level.

“There aren’t many people who would do that,” McPartland said. “It might suddenly become more economical to short the bond than do the credit-default swaps.”

Record Costs

As regulators and Wall Street debate how to clear bank and sovereign swaps, the cost of protecting against defaults with the contracts reached a record this month amid Europe’s fiscal turmoil.

The average credit swap on the 16 banks and six nations climbed to as high as 297.3 basis points on Oct. 4, surpassing the 295.6 basis points reached in March 2009, when the global economy was in the midst of the worst recession in seven decades and credit markets had seized up in the wake of the September 2008 bankruptcy by Lehman Brothers Holdings Inc.

A measure of price swings for those swaps over a 30-day period jumped to as high as 82.5 last month, from 19.4 at the start of June.

By comparison, volatility for the Markit CDX North America Investment Grade Index, a benchmark that is tied to 125 companies in the U.S. and Canada and doesn’t include the swaps dealers, peaked at 64.7 on Sept. 13, from 19 on June 1.

Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

‘Capable of Failing’

There were $432.1 billion of outstanding contracts on the governments of Brazil, Mexico, Venezuela and Argentina as of Oct. 14, according to DTCC. After subtracting trades that offset each other, the net amount of protection bought and sold on the countries was $31.2 billion, DTCC data show.

ICE Clear Credit received approval from the Securities and Exchange Commission to back the sovereign trades, it said in the statement. The company’s application to the U.K.’s Financial Services Authority to be allowed to clear credit swaps on the sovereign debt of European countries is pending, Sprecher said.

As for credit swaps on the dealers and their home countries, Sprecher said regulators need to weigh in.

“We need the regulators to work with us and agree on how to do the risk management,” he said. The issue of processing the credit swaps on the dealer members of his clearinghouse is “concerning,” he said. “We have to look at each member as if they’re capable of failing at any time.”

To contact the reporters on this story: Matthew Leising in New York at mleising@bloomberg.net or Shannon D. Harrington in New York at sharrington6@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

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