Among the ripple effects of the trading debacles at Barings PLC and elsewhere, is a race to set up a central depository for collateral between bank counterparties.
The Chicago Mercantile Exchange's Depository Trust Co. appears to have an early lead.
Rapid growth in the over-the-counter derivatives markets, combined with a series of highly publicized losses this year, has raised concerns among dealer banks about the credit of their counterparties. To overcome these concerns, many have turned to requiring their bank counterparties to post collateral as security.
While many dealers privately say the Mercantile Exchange's effort is the most sophisticated, both the Chicago Board of Trade and Cedel Bank of Luxembourg are also developing capabilities for a centralized depository for the collateral.
For John McPartland, president and chief executive of the Chicago Merc's unit, which was incorporated in September, the business could solidify the exchange's financial futures market.
"We thought it was important to portray the Chicago Mercantile Exchange as the choice of dollar-denominated interest rate swaps traders," he said.
So far, it is the big domestic and European dealers who are enthusiastic about creating a depository. Smaller regional banks are less impressed, and some have expressed doubts that the exchange could develop a system that could compete on a cost basis with their internal systems.
But Mr. McPartland said he thinks he can compete. He estimates his system will be able to deliver at a cost of $5,300 per $1 billion of notional amount per year - about one-20th of a basis point.
The depository will use a trade confirmation system to match both dollar-denominated and cross-currency interest rate swaps. Mr. McPartland said this capability will allow the depository to give third-party reporting - and valuations - on trades to dealers and their counterparties.
When operations begin in April, the system will also net the positions of counterparties against each other - leaving participants to either make or receive payments in one lump sum, instead of making numerous payments to counterparties.
"We came up with a business model where we have a centralized collateral depository that would receive data on the trades from dealers," he said.
But these are not the only cost savings the system is expected to provide.
Joseph Schwaba, who headed the derivatives business for Continental Illinois Corp. before its acquisition by BankAmerica Corp. in 1994, said the system could reduce the amount of capital banks will have to hold against their derivatives positions.
"It allows you to net on a bilateral basis in a collateral depository framework," said Mr. Schwaba, who supported the Merc's efforts as an independent consultant. "All the cash flows are collateralized in some way, so the regulatory capital charge on the positions can be substantially reduced."
But the system also permits counterparties to repledge collateral among themselves. As a result, the system can net payments across a number of counterparties, allowing a bank to take advantage of new capital rules issued in September by the Comptroller's office.
According to those rules, contracts subject to netting agreements reduce the capital at risk.
"This is an easy way of controlling the variable of credit exposure to another dealer," said Chip Goodrich, a Merrill Lynch managing director who is chairman of the International Swaps and Derivatives Association's documentation committee.
Nonetheless, the system is not expected to have any effect on the standard netting agreements the trade group has created for the over-the- counter derivatives markets. Mr. Goodrich said the depository will be subject to all existing netting agreements.
"We've been supportive of these efforts because we think they will help solve the continuing issue of credit in our markets and at the same time will enhance the liquidity of the market," he said.
Few people are expecting the project to catch on immediately. Mr. Schwaba said a depository system will likely take off once the use of collateral becomes more common.
He added that government agencies already require collateralization of over-the-counter derivatives deals. And with one of the biggest players in the market requiring such security, it is considered likely that an increasing number of private trades will follow suit.
"It's something that will probably start slowly and will eventually become a competitive advantage to those institutions who have it in place," he said.
While some may say any effort is ambitious given that the business is nonexistent, Mr. McPartland said one was bound to be created. Besides, he said the exchange is just giving banks what they asked for.
"We're standardizing the service somewhat, but we're automating to a great degree and putting it back to the ISDA constituency at a fraction of the cost," he said. "I am not dissatisfied with the reception from the dealer community."
