Clearing certainty is a concern for many market participants as the industry moves towards central clearing. Lynn Strongin Dodds explains the three different models – push, ping or hub model – on offer, and the pros and cons of pre-trade acceptance and post-trade guarantee models.
Although new regulation is looming ever closer, the thorny issue of reducing risks before a trade is accepted for clearing is still being debated. Different solutions are being floated for both the pre-trade acceptance and post trade guarantee models with each having its own proponents. A winner has not yet emerged except perhaps the technology vendors who are busy developing products across the spectrum.
“I think the swap execution facilities (SEFs) will need to accommodate all approaches,” says Jim Rucker, the credit and risk officer at MarketAxess, provider of an electronic fixed-income platform that plans to become a SEF. “It is unlikely that there will be a one size fits all solution. There is no consensus and you will get a different view depending on who you talk to and what their perspective is.”
Jeff Gooch, chief executive officer of MarkitSERV, a joint venture company of DTCC and data company Markit agrees, adding, “There are different camps but there is no consensus over the different models. At the moment, the working group of the Futures Industry Association (FIA) and the International Swaps and Derivatives Association (ISDA) are looking at the various options.”
These include the push, ping and hub models. Settling upon one has proven difficult because there is no distinct stance on how the clearing certainty should be addressed. The worst-case scenario is that each participant will develop and check credit limits in their own way, which will cause fragmentation and confusion. A more likely outcome is that they will use one of the models put forward. “When you get 90 people in a room from across the industry, progress is slow, but we have a framework and multiple ways to get to the same point, “says Peter Barsoom, chief operating officer of ICE Clear Credit. “There are pros and cons to each model but now is the time for market professionals to go out, build their systems and differentiate themselves.”
Advocates for the push archetype argue that it will allow SEFs to know how much business a firm can transact without needing to check with other parties. This is because it provides a form of clearing guarantee, in which a future commissions merchant (FCM) breaks up its credit limit for each client and apportions it to the SEFs on which cleared OTC trades have to be executed. This could accelerate clearing acceptance but FCMs warn that it may also mean clients have lower overall limits as well as less flexibility.
The ping or pre-trade execution/clearing model involves the SEF checking whether the client has a credit limit with the clearinghouse and FCM before the trade is displayed and negotiated. If the client has exceeded its credit limit, then the clearinghouse can refuse to accept the trade. Overall, many banks and brokers favour this proposition because of the potential reduction in trade breakage. Their asset managers and institutional investor colleagues, however, are concerned about the IT investment that would be required to build the necessary infrastructure between the SEFs, dealers, FCMs and clearinghouses.
“No one wants to be in a position where the trade fails but pre-trade is more complex than post trade,” says Matt Woodhams, head of e-commerce at interdealer broker GFI Group. “Firms will need robust mechanisms to ensure there is certainty and it is complicated because there is more than one venue.”
Other challenges include latency and administration, according to Jamie Lake, management consultant at consultancy Greyspark Partners. “There is an assumption that there will be perfect timing and all firms will need to do is flick a switch. However, in 99% of the cases, this is unlikely to happen because the messages being sent are going to different organisations in different countries.”
Not everyone though believes speed will be that big a factor in the decision making process. “As our service operates in milliseconds, I do not think latency is such a concern today as high frequency trading is not an issue yet,” says Nick Solinger, chief marketing officer at Traiana, a post-trade services business owned by ICAP. “This may change as the SEFs mature and volumes increase but that is two to three years down the road.”
Tom Dodd, head of product management at SunGard’s Front Arena, a trading solution serving a range of financial institutions, argues that the volumes of interest rate and credit default swaps is lower than FX or exchange derivatives.
Dodd says, “Even the very biggest individual banks globally rarely do more than 1,000 trades a day in all swaps and the big question they have to ask is whether the lower volume of business justifies the investment in the technology spend needed to build the infrastructure for the pre-clearing acceptance.”
In the post-trade model, the trade is executed between the parties and submitted to the clearinghouse who has responsibility for running the checks and verifying the trader is within his/her limits for clearing. “The argument is that if you have all the connectivity in place, then you can do the post-trade check in real time although the risk is that the trade won’t clear once it is executed,” says Rucker. “If you are starting from a blank page though, then the pre-trade acceptance model makes most sense.”
Another angle is that central hubs which can be used in either the ping or post trade world would be an ideal solution to help provide certainty that a trade will clear because it acts on behalf of all FCMs, clearing clients, central counterparties (CCPs) and SEFs. For example, in the pre-trade sphere, every time a bid or offer is entered into a SEF, the execution facility would reach out to the hub and check the limit at that point in time. This would allow credit checks before execution. The theory is that it would not only be more efficient but the cost would also be lower than the total expenditure of every FCM connecting to every CCP and SEF.
Hubs would also address FCM’s main worry that in the new electronic trading environment for swaps, a client posting orders on several platforms could have all the orders executed at the same time, taking them far above their credit limit. The flip side is that a central hub could leave the market at the mercy of a single, central utility that has yet to be created or tested.
Technology vendors have more than willing to step into the breach to address that problem. MarkitServ, for example, is hoping to roll out its central credit checking hub by the end of 2012. “I think we will see a mixture of solutions to begin with but the hub will eventually win out as it is the more efficient model,” says Gooch. Traiana is also cranking up the gears and adapting its existing CreditLink platform, a real time cross product limit monitoring service, into a full-service credit-checking hub for derivatives markets. The platform is leveraging its experience in the foreign exchange markets for interest rate and credit default swaps (CDSs). It aims to notify individual clearing members not only when a limit breach takes place, but also as clients or the FCM itself approach a limit.
“The concern many have is the impact new regulations and processes will have on market structure and liquidity,” says Solinger. “Even though there is no central utility embraced by all market participants or agreement on how to tackle limits, we have a platform already in place which can be used for both the pre and post trade models. We are already working to simplify the technical challenges of connecting to a myriad of venues to manage limits even as the industry looks to find common ground on how to address trade certainty.”
Exchanges are also working on home grown solutions with ICE planning at the end of the year to launch its Plus One service which aims to stop trades breaking–or failing to be completed–before they are processed and guaranteed by its central clearing arm. It involves giving FCMs two choices – they can connect directly to the SEF and manage those credit limits for each customer in real time, or the clearinghouse will keep a credit limit facility that the FCM can sign off on for different customers
“Plus One gives you the best of both the pre and post trade worlds,” says Barsoom, “It offers clients certainty when they trade that those trades will be accepted for clearing as is required under the new rules.”