As the launch dates for the central counterparty clearing structures for OTC credit derivatives near, many DerivSource members have expressed interest NetDelta’s new settlement solution. DerivSource editor, Julia Schieffer offers a run-down of this new solution and why some are touting it as the ‘alternative’ to a CCP for credit derivatives.
The race to launch the first central counterparty clearing structure for credit default swaps has captured most of the media attention in the last six months. For some, a central counterparty is viewed is the main solution for reducing system risk in the short-term, but slowly market participants are beginning to question if the industry is being too quick to install such a major change and departure from the bilateral trading and processing of OTC credit derivatives. Sure, a CCP is a familiar structure and can be re-invented in a way to accommodate OTC credit derivatives, but what are the other options?
According to some market participants, there is another option out there that is an innovative solution which promises the same benefits of increased transparency, improved liquidity and reductions in counterparty risks – Net Delta.
NetDelta came onto the scene last November. A majority owned subsidiary of Knight Capital, NetDelta is a settlement solution for credit derivatives which provides automated matching and netting of trades between participants and streamlines post-trade processing. Structurally, the settlement solution maintains the bilateral trading model of the traditional OTC markets whereby each participant trades against its own capital and within the credit limits set by the NetDelta participants. Users of this system-wide netting and post-trade processing functionality collectively benefit from reduced counterparty risks and other downstream operational improvements.
How it works?
The NetDelta solution relies on fungible OTC contract surrogates and converts these trades into the underlying derivatives at a scheduled conversion date. Mandatory conversion eliminates any basis risk between NetDelta surrogates and the underlying derivative. This process nets the exposures of trades and facilitates portfolio margining. The reliance upon and creation of fungible contracts means that the contract is always valued at market rate, not contract rate, which eliminates the discrepancy between these rates and consequently reduces the risks related to this discrepancy in value. Furthermore, NetDelta execute a daily truing facility which ensures a max of a one day adverse effect on the trades and their collateral deposit requirements and related activity.
The reliance on market value of positions when settling trades means that participants get paid per value of the trade when it goes flat in a position, which renders functions such as assignments and novations (functions to avert risks) obsolete. Unlike current proposals that may split single name contracts into two contracts 400bp apart from each other to create a fungible instrument, NetDelta’s contract rates are reset daily to remain at market and obtain fungibility. Additionally, NetDelta has pre-defined all the key variables in long form ISDA derivatives so it essentially can merge a four-step process of affirmation, confirmation, settlement and credit risk management into a single process, and one that takes seconds to complete processing.
Centralizing also means concentrating: pooled credit vs. CCP
NetDelta maintains the bilateral trading of credit derivatives and introduces a centralized credit structure, which they refer to a ‘pooled credit’. In this model, the participants trades against it’s own balancesheet and within the credit limits established by the pool of NetDelta participants. In this model, participants still maintain their ability to manage their own risks (a.k.a. deciding who and to what degree (credit limits) they want to trade with). The netting of all trades within the NetDelta system reduces the counterparty risks of all included trades.
By contrast, a CCP structure centralizes clearing by introducing a third counterparty – the exchange or clearing house. The benefit of this structure is the guarantee of trades by the exchange which works as a safeguard for participants against defaulting parties and therefore, reduces counterparty risk among participants. However, one could argue that centralizing all trades to face a single counterparty instead of multiple players is essentially concentrating the counterparty risk to a single entity, and one that you cannot buy protection on!
Another major difference between the CCP and NetDelta’s ‘pooled credit’ structure is the initial margin required to get involved. Again, in the NetDelta model, a participant is putting its own capital at risk and still has the controls in place to choose which counterparties to deal with and what credit limits to apply. A CCP, on the other hand, requires capitalization by participants and could require a large initial margin since the CCP has to have the wherewithal (a.k.a cash) to guarantee the trades. In short, for CCP to guarantee everything the users have to be prepared to fund it.
Keeping control of risk management
By maintaining the bilateral nature of the credit derivatives market, NetDelta is also keeping the risk controls and risk management within each participating firm, only offering the netting and support to streamline post-trade operations. Users, for example, can continue regular risk management practices, including controlling and hedging specific exposures, and keeping a close eye on credit limits and collateral requirements for trades. NetDelta’s benefits extend to both the buy and sell side based on market maker’s willingness to afford their peers and clients credit limits.
In a CCP structure, the dealer has fewer controls. In a CCP, the aim is to get as many participants (counterparties) on board as possible because these participants fund the entity and this funding is what is used to operate – a.k.a. guarantee trades. In this model, the participating firm does not get to determine the specific counterparties it deals with and what credit limits are applied. While there are benefits to centralizing this counterparty management function, one could argue a firm is outsourcing some risk management practices to an entity which is not liable for the performance of its trades.
Performing and failing: the question of ‘free option’
Another major difference between the CCP and NetDelta structure is can be drilled down to ‘free option.’ In a CCP model a defaulting party has the ‘free option’ to walk away from its obligations in defaulted contracts without any imposed losses on its positive Mark-to-Market positions. In this case, the performing party still has to ‘pay’ because its participant in the CCP requires it to fund the entity in the first place. This situation clearly puts the performing parties at a disadvantage, which really disincentivizes performance.
By contrast, NetDelta’s structure benefits the performers because when a trade fails, the performer not only has the option to tear up the contract or settle with the participant bilaterally and outside of NetDelta, but it can also keep its positive positions with the defaulting party.
Innovative or re-invented?
It is never well-advised to place all of one’s eggs in one basket and it seems that the industry is gravitating towards this strategy. Increasingly market participants are voicing concerns about clearing CDS products via a central counterparty – the concentration risk imposed cited as the item of most concern. NetDelta’s solution may not be a familiar post-trade processing structure like a CCP is for market participants, but the current state of the financial markets makes this an ideal time to consider all options – both innovative solutions as well as the re-invented.
*Analysts from the top research consultancies in the financial industry have penned reports that provide more in-depth details of the topic of central counterparty clearing for credit default swaps. Below are links to some of these reports…