Exchange-Traded and OTC Derivatives Commingle

Terry Flanagan

Futures exchanges are innovating with swap-like products that seek to replicate the behavior of their OTC counterparts.

Reflecting the growing demand for exchange-traded futures contracts as alternatives to OTC derivatives, IntercontinentalExchange launched four credit index futures contracts in May 2013. The contracts, which are based on the Markit CDX and Markit iTraxx indices, provide customers with the benefits of the fully-regulated futures markets while also serving a complementary role to the existing credit index swaps market.

The contracts are listed by ICE Futures U.S. and cleared at ICE Clear U.S. ICE will introduce additional credit index futures contracts based on market feedback and demand.

To support the development of these products, Quantifi, a provider of risk analytics, has developed a price-spread calculator to allow market participants to better monitor and manage credit risk exposures. Available on the ICE website, the web-based price-spread calculator is designed to convert futures prices into the equivalent forward spreads for any given date.

“We are pleased to work with Quantifi to develop this calculator for our customers,” said ICE Clear Credit chief operating officer Peter Barsoom. “By leveraging Quantifi’s experience in financial analytics we are able to provide credit futures participants with a tool that allows them to assess the relative value of the index futures contract against other credit derivatives instruments and to access the information to make informed trading and risk management decisions.”

Peter Barsoom, ICE

Peter Barsoom, ICE

Regulatory reforms in the form of the Dodd-Frank Act, Emir and similar legislation have had an impact on market structures and volumes, according to a report by Deutsche Bank.

The key reform elements include requiring standardized OTC derivatives to be traded on exchanges or SEFs, be cleared through central counterparties, and reported to trade repositories. Non-centrally cleared derivatives should be subject to higher capital requirements.

In spite of the availability of specialized derivatives exchange markets, the volume outstanding in OTC derivatives markets is $633 trillion and dwarfs the volume of exchange-traded derivatives, which is $52 trillion.

“The dominance of OTC products reflects the historical origins of derivatives markets, and more importantly, the fact that users appreciate the flexibility that bespoke contracts offer,” said Orcun Kaya of Deutsche Bank Research.
“Notwithstanding these benefits, the G-20 agenda puts even greater weight on the benefits of standardized derivative contracts trading on exchange platforms.”

ICE Swap Trade, ICE’s credit default swap (CDS) execution platform, expects to register as a swap execution facility (SEF) with the Commodities Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) once final rules are implemented, and as a multilateral trading facility (MTF) in Europe.

ICE Swap Trade will offer index and single name CDS across North American and European corporates and sovereigns with a choice of trading cleared and bilateral contracts. Functionality will include request for quote (RFQ) and central limit order book.

Separately, ICE Clear Europe will introduce client clearing for European credit default swaps (CDS) after receiving regulatory approval in the U.K. and U.S.

Client clearing for European CDS is expected to launch on October 7, 2013 and will be available for 43 European index and 121 corporate single name CDS instruments. Twelve clearing members will participate in the pre-launch testing. In the U.S., ICE Clear Credit commenced client clearing in 2009 and has cleared $1.82 trillion in gross notional value for 250 clients to date.

ICE has established risk frameworks for the clearing of its U.S. and European CDS businesses that are separate from its futures markets, including independent risk models, guaranty funds and margin accounts, as well as a CDS-focused risk management system and an independent governance structure.

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