Futures Shock


Futures exchanges are gearing up for the transition of over-the-counter swaps from a bilateral model toward centralized trading and clearing.

Constructs from the futures space are being applied successfully to OTC derivatives, as regulators around the world implement reforms mandating central execution and clearing for most swaps contracts.

CME Group, which has been clearing energy derivatives for almost a decade through CME Clearport, launched an interest-rate swaps clearing service in 2010 and a credit default swaps clearing solution in 2011.

“We’re delivering a global product offering across both our OTC and listed derivatives, based on the risk-management needs of our global customer base,” said Jack Callahan, director of OTC products at Chicago-based CME.

Jack Callahan

“We’re delivering a global product offering across both our OTC and listed derivatives, based on the risk-management needs of our global customer base.” Jack Callahan, director of OTC products at CME Group

The platform used for clearing IRS and CDS is the same as that used for clearing listed derivatives.

“We utilize the same customer clearing expertise to clear OTC products, and CME Clearport has been successfully clearing OTC products across multiple asset classes,” said Callahan. “Our OTC clearing system is fully scalable and enhances our ability to clear both vanilla and bespoke OTC derivatives.”

Eris Exchange’s Interest Rate Swap Futures is a flexible futures contract that offers anonymous trading and settles independent of the daily CME Clearing interest rate swap curve.

“The contract is a cash-settled futures contract based on interest rates,” said Stephen Humenik, general counsel and chief regulatory officer at Eris. “The contract embeds the economics of a collateralized over-the-counter interest rate swap into a single futures price.”

The Eris business model incorporates characteristics of both a swap execution facility (SEF) and an exchange, bridging OTC and futures.

“The contract is flexible in that it permits participants to negotiate a contract with an effective date that is any valid business day up to 10 years from the trade date, and a maturity date that may be as long as thirty years,” said Humenik. “The contract can have a negotiated forward starting period and a negotiated maturity date.”

Eris’s business model links execution and clearing, as a trade executed on the exchange is simultaneously matched and cleared. “Eris Exchange participants receive immediate confirmation that the trade is completed, that is, execution and clearing certainty,” Humenik said.

Default Risk
For futures exchanges, the migration of OTC swaps to a system of centralized trading and clearing holds implications from business and risk perspectives.

European Market Infrastructure Regulation (EMIR) stipulates that clearinghouses must have procedures for protection of collateral in the event of a default by a clearing member. EMIR is less prescriptive in this regard than Dodd-Frank, as it essentially leaves it up to the clearinghouses to devise their own methods for handling a default.

“Whereas the [U.S. Commodity and Futures Trading Commission] is currently in favor of the LSOC [legally separate but operationally commingled] as the de facto segregation model, EMIR provides greater flexibility in the models that CCPs can offer,” said Matthias Graulich, executive director at Eurex Clearing.

Eurex Clearing’s individual clearing model provides full legal and operational segregation of all positions and assets for clients of clearing members at the clearinghouse level. The service is the first building block of segregation solutions offered by the clearinghouse, and Eurex Clearing is the first CCP globally to offer full legal and operational segregation across all cleared markets, the company said.

“This is different from LSOC in that we don’t operationally commingle, but instead use separate and segregated accounts,” said Graulich. “The level of protection in the individual clearing model is higher than either omnibus or LSOC, because in the event of a clearing member default the clearinghouse has the power to transfer customer positions and collateral to an alternative clearing member, without involving the defaulting clearing member or its administrator.”

This mechanism enhances market stability by enabling buy-side firms to continue trading and hedging without big delays, said Graulich.

Eris Exchange recently received CFTC approval to become a Designated Contract Market (DCM), a designation that paves the way for end users to save on margins when trading Eris Interest Rate Swap futures alongside CME interest rate futures.

“The DCM enables our products to be handled in industry standard 4d customer segregated clearing accounts at CME Clearing,” said Christopher Rodriguez, chief sales and corporate development officer at Eris Exchange. A 4d segregated account holds funds of customers trading futures and options on U.S. exchanges. Such an account is held separately from the FCM’s own funds.

Back to Futures
Eris Exchange is a futures exchange, first and foremost.

“The [Interest Rate Swap] contract begins and ends its life as a futures contract,” said Humenik. “It does not have periodic cash flows like standard OTC swaps, but instead replicates the economics of accrued and expected cash flows in the futures price, resulting in cash transfers through the daily variation margin process.”

Operationally, the Interest Rate Swap Futures contract is the same as other futures contracts, utilizing the same back-office systems and processes, FCM model, and associated documentation.

“The same CME settlement curve that is used for the standard suite of interest rate swap derivatives cleared by CME is used to settle Eris Exchange contracts,” said Humenik.

The new Eurex Individual Clearing service is being offered in addition to the existing Eurex Clearing services. Eurex Clearing plans to launch an Omnibus Segregation Model in 2012, offering segregation of client assets in an omnibus account providing additional operational efficiency for the clearing member, but with limited portability for the client.

The different levels of protection enable clearing members to offer tailor-made access to Eurex Clearing and provide choice for clients.

MiFID II states that clearinghouses shall provide access to their services to execution venues on a non-discriminatory basis, similar to Dodd-Frank. However, the thrust of MiFID II is execution, not clearing, which is the domain of EMIR.

“In Europe, there is a mixture of rules–MTFs and OTFs [organized trading facilities] are governed by MiFID II, while both EMIR and MiFID II govern access to CCPs,” said Graulich. “We are open to any kind of execution platform for OTC derivatives.”

A prerequisite for admission of an execution venue, however, is that access should be subject to risk criteria set by the clearinghouse. “We need to make sure that operational procedures and the legal framework at the execution venue are appropriate, so that we as a clearinghouse have certainty that what we get from that venue is legally sound and responsibilities are clearly agreed” upon, said Graulich.

Once a swap contract is accepted for clearing, the clearinghouse is bound for the life of the contract, which in the case of some swaps can be decades. Hence, both the execution venue and the clearinghouse owe it to the counterparties to the transaction to respect the ground rules and reduce the potential basis risk to a minimum.

“There has been a great deal of discussion” regarding access criteria, said Graulich. “There’s awareness that a CCP needs to be comfortable with a relationship to an execution venue, such that if a trade can’t be [cleared], there’s an agreed and transparent fallback mechanism.”

With its approval as a DCM, Eris Exchange is in a position to address demand by swap end users seeking to tap new liquidity pools and maximize capital efficiency in advance of the Dodd-Frank clearing mandate.

Multiple to Single
“Our product design collapses multiple cash flows associated with OTC swaps into a single futures price and cash flow which transfers through variation margin in a futures clearing account,” said Rodriguez.

Eris Exchange applies clearing firm-established credit limits in real time prior to trade matching. Participants and clearing firms are able to view their real-time overall limits and status on Eris; should a credit event occur, Eris provides the participant and clearing firm with a real-time message and email notification.

As an additional risk-management feature of the futures model, CME Clearing, as the clearing house, is responsible for monitoring and modifying the clearing firm’s credit limits. This permits management of the overall credit exposure of the clearing firm.

Uncertainty over the timing and scope of regulations is raising a torrent of complex issues for market participants about which rules will apply.

Noted Eris’s Humenik, “the U.S.-based and European-based regulations are not yet finalized, so it is difficult to evaluate the impact on market participants. Over the next few months and into the beginning of next year we should get a clear picture of the CFTC’s final rules.”

It is expected that the European regulations will be finalized after the U.S. rules, which could present a uniformity issue for market participants who trade on both continents.

Eurex Clearing handles some of the world’s most liquid futures and options contracts, including interest rate derivatives such as Euro-Bund Futures and equity index derivatives such as Euro Stoxx 50 Index Futures and DAX Futures.

A substantial portion of the Eurex Clearing infrastructure that was built for listed derivatives and the clearing for credit default swaps can be deployed for additional OTC products, said Graulich.

“We have now entered the simulation phase of our OTC interest rate swap clearing service, which will go live in March 2012,” he said. “Using the same infrastructure across asset classes provides operational efficiencies, which consequently benefits customers in that they aren’t required to maintain multiple systems and interfaces.”

Volume Rising
The volume of cleared transactions has been on the rise. CME cleared $61.9 billion in OTC IRS and CDS volume in November, up from $45.5 billion in October and $41.9 billion in September. As of November 30, 2011, CME had cleared more than $153 billion in OTC IRS and CDS through open clearing; open interest stood at $77.3 billion in IRS and $7.9 billion in CDS.

“CME Group provides its global customers with an open and agnostic clearing solution and we are working with almost 20 different affirmation platforms and SEFs to allow our customers full flexibility to execute and submit trades to CME Clearing,” said Callahan.

CME expanded its CDS offerings on November 7 with the launch of the CDX high yield indices, which cleared $644 million in its first two days. This new offering is in addition to the launch of Euro-denominated IRS on October 17, which cleared more than euro 4.5 billion as of early December.

CME’s IRS offerings include the British pound, Japanese yen, Swiss franc and Canadian dollar-denominated IRS. According to data from the Bank for International Settlements, these six currencies account for 94 percent of the plain-vanilla IRS market.

To be sure, there are technological and computational hurdles that an exchange needs to overcome when OTC products are introduced.

“Calculating margins is much more complex for interest-rate swaps or credit default swaps compared to futures,” said Graulich of Eurex. “It is planned for all those computations to be performed on a single risk calculation engine.”

Eurex Clearing is rolling out a portfolio cross-margining system between Eurex’s listed derivatives and OTC interest-rate swaps and equity derivatives, which is designed to offer buy-side and sell-side firms significant margin and collateral efficiencies.

Eurex Clearing is also broadening its geographical reach beyond Europe. “While our main focus on the product side is Euro-denominated products, the distribution of our products is global,” Graulich said.

Eurex has applied with the CFTC to become a designated clearing organization, which will enable it to distribute clearing services in the U.S. “As a DCO, we will be able to connect U.S. clearing members and by extension, to their clients,” said Graulich.

The global swaps market, which has largely been unregulated, will soon be subject to the Dodd-Frank Act in the U.S. and MiFID/EMIR in the European Union.

“Almost all large market participants are global in nature, so issues arise when there are different rules in different jurisdictions,” said Graulich. “Which rules should apply when a U.S.-based market participant engages in a transaction with a Germany-based counterparty?”

Eurex Clearing’s approach is to register its clearing service in multiple jurisdictions “to reduce legal uncertainty for our members and become the global orientated partner our members’ needs,” Graulich said.

Related articles