Chicago's Swaps SweepstakesDavid Greising
For months, the Chicago Board of Trade and the Chicago Mercantile Exchange have coyly courted one another, trying to merge their separate clearinghouses into one huge trade-matching entity. The courtship busted up abruptly in late May, though, when the Merc announced that it had wooed another exchange, the New York Mercantile Exchange, into a partnership to develop a new limited trade-clearing system. The Merc says the CBT had plenty of warning about the New York deal, but an aggrieved Patrick Arbor, chairman of the Board of Trade, says "we were completely blindsided."
Just another fracas between the two Chicago commodity exchanges? Hardly. Behind the latest ruckus in the pits is an unseen prize: the potentially enormous business for clearing swap transactions. A clearinghouse would give both parties to the swap protection against the risk that they might not receive agreed-upon swap payments, much as the futures clearinghouse guarantees that both sides of a wheat contract will meet their obligations. A swap clearinghouse could also reduce risk to the financial system and expand the roster of swap dealers. "A clearinghouse is the next logical step in the evolution of the swaps market," says a Fed official who has studied the question of systemwide risk arising from swaps.
CUSTOM-MADE. Swaps--the high-finance contracts used to manage interest-rate and currency risks--have rocketed in a few short years into a $4.8 trillion market. In a typical interest-rate swap, one party agrees to pay a variable interest rate to another party in exchange for receiving a fixed rate payment. For example, say a company that has issued $100 million in 10-year, fixed-rate 7% bonds thinks interest rates will fall. It could enter into a swap contract where it agrees to make variable-rate interest payments for 10 years to another party, equal to three percentage points over the two-year Treasury rate of 4%. In exchange, it would get fixed payments of 7%--equal to the interest payments it is paying bondholders. If rates fall, so do the company's payments--even though its bondholders are still receiving 7%. The other party to this deal, say an insurance company, may have issued floating-rate notes and wanted to protect against a rise in rates. The swaps dealers--mostly banks--that create, market, and broker these deals have made billions.
Creating a clearinghouse has proved to be tough sledding so far. More than a year ago, outgoing New York Fed Chairman Gerald Corrigan warned that the loosely regulated swaps market could generate problems for the financial system. Fed statistics show that at the end of 1992, Citicorp alone had swaps credit exposure of $26.6 billion. But there has been no substantive move to address the problem of swaps-related credit risk. The big New York banks that dominate the domestic swaps market have discussed forming a clearinghouse, but they have yet to take action. And the industry's lobbying arm, the International Swap Dealers Assn., won't take a position on the question. "The idea has been bantered around before, only to die a slow death," says Fredrick J. Chapey Jr., head of derivatives origination and strategy at Chase Securities.
Why no progress? Supporters and opponents of a clearinghouse agree that eliminating systemwide risk is a laudable goal, but coming up with a workable system to do so is hard. For one thing, clearing works best on standardized contracts, such as contracts on wheat or shares of IBM stock, and swaps are custom-tailored to meet the specific requirements of the two parties.
And while clearing would reduce the importance of creditworthiness between parties, swap dealers already adjust for the lack of a clearinghouse, demanding collateral when they trade with less creditworthy counterparties. What's more, customers aren't willing to give up customization in exchange for reduced concerns about credit quality. And some worry that using a clearinghouse could add to the cost of using swaps. "Any time you add an extra link in the chain, you add cost," says Keith McBride, associate treasurer of Mead Corp.
Big swap dealers worry about a threat to their established market position. Centralized clearing would broaden competition between swaps dealers--hardly a popular concept with current dealers making huge profits. Dealers now limit their trading with one another based on their assessment of each others' creditworthiness. The safety provided by a clearinghouse would open the market to new participants and expand the activities of existing dealers.
"SOCIAL BENEFIT." Some dealers even think fears about swaps are overblown. There have been few failures in the swap market, and those that have occurred don't justify apocalyptic visions of financial gridlock. Drexel Burnham Lambert Inc. and Bank of New England both had sizable swaps portfolios, and companies that had swap contracts with them were plenty nervous when the troubled institutions collapsed. But even in those extreme cases, there was no panic in the market because the companies' contracts were eventually settled.
Others, though, recognize that regulators are still concerned and think a centralized clearinghouse is needed to avert new market regulation. RMJ Options Trading Corp., a New York options and securities firm, has tried to sell dealers on its own plan to clear swaps. And though the big New York money-center banks haven't agreed on anything, Chase Manhattan Corp. has discussed the possibility of forming a clearinghouse with other dealers, while Bankers Trust Co. is now developing a plan, market sources say. Chase's Chapey says his bank discarded the idea because it prefers to deal with its clients one-on-one. Bankers Trust could not be reached for comment.
But despite the wrangling, Chicago's exchanges may still be the best home for a clearinghouse. The CBT and Merc will try to get their clearing talks back on track this month. The exchanges' primary aim is to unify the clearing of futures and options trades. But the prospect of clearing swaps trades is also there. "The opportunity for swaps clearing is great," says Merton H. Miller, the Nobel laureate economist who sits on the Merc's board of governors. "And it would bring a social benefit, as wellas being a successful private venture."Of the two, the CBT is more interested in clearing swaps. Board of Trade Clearing Corp., its clearing unit, is acknowledged as one of the world's foremost clearing entities. And despite its failed effort to launch swaps trading in the CBT's pits two years ago, the exchange still wants to serve as a clearinghouse for swaps dealers. "If we don't make a move, we're going to find some other consortium of banks--or someone else-- will jump in and do it," says Arbor.
Sources at the CBT believe a joint clearinghouse would get a lot more use than one run by CBT alone because the Merc has stronger ties with the swap dealers. Those dealers generate a quarter of the trading in the Merc's Eurodollar futures contract. But the Merc is approaching the clearing issue gingerly. It's afraid of offending the swap dealers. "Clearing could embellish the market. But we don't want to compete in swaps trading," says John F. Sandner, chairman of the Merc. One high-ranking Merc official says the exchange leadership also believes Merc members would be leery about the potential costs of a swaps clearinghouse. That's because each member of a swaps clearing association would pay a fee for each cleared trade and agree to shoulder part of the cost of any defaults. "Members want to know why they should pay up capital they've worked all their lives to earn because there's been a default on a swaps contract," says the officer.
True, the exchanges work together effectively in Washington to lobby against higher taxes and more regulation. But on day-to-day business issues, they rarely agree. That distrust was exacerbated by the recent dustup over the Merc's NYMEX overture. If the Chicago gang doesn't agree to cooperate on swap clearing, they could wake up to find that an extremely lucrative business has been snatched from under their noses.