Counting down the days until CDS clearing begins

December is upon us-make way for the credit-default swap clearing houses! American Banker has described some of the obstacles remaining for the two major U.S. efforts to establish central clearing parties for CDS. But will European groups complete their projects any faster?

A note this week from Aité Group takes a look at no fewer than five separate clearing initiatives underway around the world. Senior analyst John Jay hasn´t made a call as to which effort will be the most successful, but he concludes: "Whichever clearing solutions are adopted, they will work best for vanilla structures with widely followed underlying reference assets. The proposed solutions do not directly address legacy CDS positions and custom-made CDS structures."

Here are excerpts from Mr. Jay´s descriptions of the initiatives.

The Chicago-based CME Group is teaming up Citadel Investment Group to offer a clearing house based on the exchange model.

"The CME [and Citadel]...have invited major CDS market participants as Founding Members by offering them market-making privileges as well as allocating up to 30% of the venture´s equity. Standardized contracts with fixed coupons for CDS indexes and their underlying constituents will also be offered, with over the counter market conventions, including credit event procedures."

Things aren´t all rosy with the CME effort:

"Incentives and operational issues aside, current CME members...are concerned that the $101 billion in capital already pledged for CME´s existing futures and options business will be commingled with capital for the CDS business. In addition, they are concerned about finding contract replacements for a relatively illiquid instrument ("jump risk") upon the default of a CDS trading firm. In response, the CME Group will require CDS trading accounts to have higher margin requirements (based on two- to five-day potential loss) than for futures accounts (based on potential one-day loss)."

Another effort based on the exchange model is in the works in London, through a project by NYSE Euronext.

"In order to attract banks and inter-dealer brokers...to its CDS initiative, the firm´s derivative unit, Liffe, has offered them a five-year revenue sharing plan. They will rebate 40% of revenues...from trading and clearing to participants, including a bonus for the top 10 firms who bring in the most business. Liffe member firms include Citigroup, Credit Suisse, JPMorgan Chase, and Citadel Investment Group LLC."

Some CDS contracts could be eligible to be cleared through NYSE Euronext´s clearing party by Dec. 22, using a system that, Mr. Jay notes, "has to this point been used for the processing and clearing of OTC equity derivatives only."

IntercontinentalExchange, Inc. is leading the other US initiative and is forming a bank holding company, ICE U.S. Trust, to operate its clearing house. ICE is also buying The Clearing Corp., its partner in the project.

"ICE has moved quickly to capture a piece of the CDS processing and clearing pie," Mr. Jay writes. "This effort is further supported by nine major CDS dealers: Bank of America, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Merrill Lynch, Morgan Stanley and UBS." ICE´s clearing house won´t combine its members´ capital for futures exchanges with what is submitted for the CDS clearing house.

In Germany, Eurex is launching a two-stage clearing effort. It will first standardize CDS contracts; then create a clearing house for CDS contracts written under the standardized form set out by the International Swaps and Derivatives Association. "Eurex has already received support from the European System of Central Banks and Deutsche Bundesbank," Mr. Jay writes.

A fifth clearing project has begun through NetDelta, a subsidiary of the New Jersey-based firm Knight Capital Group. It´s different from the other four, Mr. Jay says, in that "There is no "pot" that serves as a credit backstop to defaulting parties, as in an exchange model. As such, each participating firm´s own capital will be at risk." It is an electronic trading platform that will handle compensation procedures for participating firms. It will also provide a structure for collateral deposits and withdrawals. "This setup...will find vanilla CDS structures (index-based and single-names) a ready fit," Mr. Jay writes.

Steve Sadoff, Knight Capital´s chief information officer and managing director, told BankThink that DeltaNet is already open for business. "Because of our credit party approach, we don´t need regulatory approval," he said, adding that Knight Capital had engaged in "lots of dialogue with regulators and outside counsel" before reaching its decision. "We´re in dialogue with a dozen potential clients."