CDS intermediation doesn't die, just gets put on ICE

As the CDS product undergoes changes, the way that the CDS trading participants interact with each other is changing as well. Here is some background.

In recent years some dealers have become what are called "derivatives prime brokers" (or derivatives intermediation providers) for buy-side derivatives users. The idea was the one can execute a derivative transaction (usually a CDS) with any dealer and effectively "give-up" the trade to their derivatives prime broker.






A hedge fund could trade CDS with multiple dealers, but at the end of the day they would face just one counterparty on all their trades (some funds had a couple of derivatives prime brokers). The advantage was that by facing only one dealer, the fund would have a single consolidated margin account that would take into account all the longs and shorts, making the margin process more efficient. Also the derivatives prime broker would provide independent pricing on the whole derivatives portfolio that could be integrated with the fund's portfolio systems.

Some hedge funds would select a large bank rather than a broker dealer to face on their CDS trades, thus reducing counterparty risk. A fund could do a 5-year CDS trade with Lehman a day before it defaulted, give it up to a large bank the same day and have no exposure to Lehman.

But the derivatives intermediation business mostly died with the crisis as Goldman and several others exited the business (some dealers are still providing this service for their top clients). If you look at he diagram above, a give-up simply means that a derivatives intermediary steps in between the fund and the original counterparty. And what made dealers exit the business had more to do with facing another dealer than the hedge fund. The dealers charged funds sufficient margin to avoid major losses. However if the other side (Dealer-A) was Lehman, the intermediary has a problem. The whole model no longer worked when it turned out that it wasn't the hedge funds but the dealers who pose a major risk to each other. The intermediary (Dealer-B) just wasn't getting paid enough by the hedge fund to take other dealers' risk. Plus with the clearinghouse idea looming, it made even less sense to be in this business.

But as ICE North America CDS clearinghouse went online earlier this year, funds and banks started looking for a solution that resembles the give-up process. Recently ICE announced a process that would allow this to happen.

ICE: Credit derivative trades between a buy-side firm and an executing dealer are typically executed and legally confirmed on a bilateral basis. This requires buy-side customers to have ISDA documentation in place with each executing dealer and to take counterparty risk to executing dealers when conducting CDS transactions. Trade date clearing eliminates the need for this documentation between buy-side firms and executing dealers. Instead, a buy-side firm may trade with any executing dealer who is a clearing member, and may clear the trade at ICE through their designated "derivative clearing member" or DCM.

Hedge funds can not be members of the clearinghouse (ICE wanted only the massively capitalized banks to participate). That means that funds would still face banks on CDS trades. But they would be able to trade with multiple dealers and at the end of the day be facing only one, their "designated derivative clearing member". The clearing member would face ICE on the other end instead of another dealer.






Right now ICE only has a couple of index CDS trading, but over time major single name CDS product should start going through the clearinghouse. The hope is this will improve liquidity and make participants less nervous about counterparty risk.

SNAC on this: the standardization of single name CDS

A number of Sober Look readers have asked about the structure of single name credit default swaps that would be settled via a clearing house. Here is some background.

The cleaing house for CDS that has gotten the most traction is operated by ICE (the Intercontinental Exchange). CME is trying to get in the game as well. So far however only some index credit derivatives have been settled on ICE, while single name CDS settlement is still in the works.

As with any standardized contract, one tries to limit the number of variables. With single name CDS, the contractual variables are usually maturity, spread, points up front (upfront premium), and settlement mechanics. In the past all of these could vary. That created problems for active traders.

If you buy 100 futures contracts and sell 100 of the same contracts later, you are flat and have no further obligations. However if you buy and sell the same notional CDS with slightly different maturities (even by a few days) and/or slightly different spread (which is almost always the case), you now have two different contracts. And until they mature or get unwound (which is expensive), you will have to manage two different contracts. So if you actively trade these, you may end up with thousands of positions that may be neutral (buys and sells with the same amounts), but the contracts are still outstanding. That's why when the media quotes "trillions" of outstanding CDS contracts, a large part of these are long and short of very similar contracts that can not be netted. You could be flat and have locked-in gains on a bunch of CDS, but your trades were with Lehman, you've lost the bulk of these gains. That's where a clearing house becomes helpful.

The idea is to standardize maturity dates, spread, and settlement mechanics, while leaving points upfront as a variable. Settlement in the past gave one a choice of physical delivery (the protection buyer could deliver the defaulted security and get paid par for it) or an auction settlement. A corporate restructuring could be considered a credit event under some contracts. There were other variations as well. All of that has been standardized to auction settlement, with credit events now decided by a committee (which becomes binding under the new documents.)

Under the new standard, the maturity dates will be only March 20th, June 20th, September 20th, or December 20th. The spread will be either 100 or 500 basis points (100 bp for investment grade names and 500 bp for non-investment grade). Thus the spread will be constant and only points upfront will fluctuate. Now if you buy protection and sell it back, you will be doing it with the same contract (same maturity and spread), and the only difference is between the points upfront you paid when you bought protection and the points you received when you got out (which will be your P&L). And given that you will face ICE on both the buy and the sell, your contract will be netted out and you will have no remaining obligations.

The coupon (spread) accrual on these contracts will be handled the same way it is for bonds (and most index credit derivatives).

These standard contracts are sometimes called “SNAC” transactions - Standard North American Credit ISDA docs. Converting existing non-standard contracts to SNAC unfortunately can not be accomplished without unwinding existing trades, which could get costly. These non-standard contracts will also quickly become illiquid. The goal is to have SNAC compliance on the bulk of CDS transactions going forward, whether or not they are settled via a clearing house.

The document below from DTCC(www.dtcc.com) discusses the detail of the clearing house standardization.