Ready for CDS Clearing?

ICE Clear Europe is the most recent clearinghouse to receive EMIR authorisation from the Bank of England and it is now focused on supporting the industry as it prepares to move to mandatory clearing of OTC credit default swaps (CDS). ICE Clear Europe’s Mark Woodward explores where CDS clearing stands today and the challenges market participants face as they prepare for the deadlines next year and beyond.

DerivSource:  ICE Clear Europe recently received EMIR authorisation from the Bank of England. The authorisation came later, compared to other CCPs. What was behind this delay?

Woodward: ICE has been working with regulators in recent years to ensure harmonisation and equivalence between US and European rules governing margin requirements for the clearing of OTC and futures and options.

Initially, there was a significant difference between CFTC and EMIR rules with regards to the margin period of risk used as an input to margin calculations for exchange-traded derivatives products. We worked extensively to highlight the need for harmonisation across global derivatives regulation. As a result, today, there are no material differences between derivatives margin requirements in the US and Europe. The European Commission published an amendment to EMIR RTS Article 26 (Regulatory Technical Standard 153/2013) on the Margin Period of Risk in May this year which came into force in June. Following this amendment, we have worked on achieving EMIR authorisation which we received on 19 September 2016.  Additionally, ICE Clear Credit has been recognised as a Third-Country Clearing Counterparty (CCP) under EMIR for CFTC regulated products. These permissions are particularly important for ICE’s CDS clearing services with the frontloading period ahead of the OTC CDS clearing mandate rapidly approaching.

DerivSource: The industry is now progressing towards fulfilling the central clearing mandate for OTC derivatives; what does this mean for ICE as the leading CDS clearing provider, having just received EMIR authorisation and recognition?

Woodward:  After the financial crisis, there was a need to find a safer, more transparent means for trading, clearing and settling OTC CDS. In 2009, ICE responded by creating the world’s first two clearing houses for CDS – namely ICE Clear Credit in the U.S. and ICE Clear Europe in Europe. Both clearing houses were established in conjunction with the industry as the benefits of central clearing became more widely recognised.  We have evolved our CDS clearing service to cover nearly 600 instruments today.

In recent years, there has been further industry support to reduce risk and increase liquidity in the CDS market. For example in the U.S., market participants from both the sell- and buy-side are voluntarily clearing corporate single name CDS at ICE Clear Credit, despite a lack of clearing mandate. By clearing single name products alongside indices, participants can benefit from ICE’s portfolio margining methodology which facilitates capital efficient clearing by providing offsets between related index and single names positions.

In Europe, as the clearing mandate approaches, EMIR recognition and authorisation for ICE Clear Credit and ICE Clear Europe is relevant for our services to both clearing members and clients.  It is important for clearing houses to be authorised or recognised under EMIR in order that Clearing Members and users receive the right capital treatment under applicable capital rules.

The first significant date in the European timeline for clearing CDS is the frontloading of CDS contracts on 09 October 2016 and then early 2017, new capital rules come into effect and the clearing obligation for Category One entities commences.

“We have been working with the industry for a number of years to develop our CDS services and demonstrate the benefits of clearing. Today, ICE is the leading clearer for CDS in North America and Europe, with significant client cleared volumes.”

Timeline for CDS Clearing Mandates in Europe

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DerivSource: What’s next for your clearing members and end users as they prepare for clearing, and the challenges in terms of capital management that come along with that change?

Woodward: The main challenge, or opportunity, for Clearing Members and end users is adopting the most capital efficient margining model possible that provides for offsets between index and single name products, creating a single margin requirement for a portfolio. Under Basel III and CRD IV, market participants will receive more efficient capital treatment if they clear trades.

Portfolio margining for CDS clearing is a way for market participants to achieve efficiencies and address capital requirements that come with central clearing. ICE has designed and implemented a proprietary index decomposition margin methodology which provides benefits to long/short index and single name positions.  Capital efficiencies are achieved by allowing market participants to clear index and single name CDS in a single customer account while maintaining strong risk management protections. So in addition to clearing index CDS which is already mandatory in the U.S. and will become mandatory in Europe next year, voluntarily clearing single names alongside CDS indices subject to the clearing obligation also gives market participants the ability to secure capital efficiency.

ICE CDS Portfolio Margin Example

For example, for a $1,000 million Index Arb portfolio (Bought SN/Sold Index), the margin requirement can be reduced from $16.25 million if margined separately to $5 million if margined together in a portfolio approach.

DerivSource: There’s been a lot of talk in the industry of late about account segregation. Can you tell me a little bit about how ICE supports this in Europe?

Woodward: We provide customers with a choice as to the level of protection of positions and assets by offering a range of individually-segregated and omnibus accounts.

Customers are able to choose the model that best meets the risk profile they would like to achieve. An Individually-segregated account provides a higher degree of position and asset segregation following default of their Clearing Member; but it is also more costly than an omnibus account solution, where positions and assets are co-mingled with those of other customers.  It is really down to customer choice over the level of fellow customer risk they are willing to adopt in the event of insolvency of their Clearing Member. Customers have to determine the balance of risk and cost that suits them and, where applicable, their investors.

DerivSource: Can you give us a little bit of background into how ICE’s post-trade services have come about?

Woodward: ICE was established in 2000 to provide an electronic trading platform for the OTC energy markets, but with the acquisition of the New York Board of Trade (NYBOT) in 2007, we gained a U.S. based clearing house for agricultural markets, extending our services to clearing for the first time. Subsequently – and in order to respond to demands from our global energy customer base for access to more efficient clearing services and more cleared energy products –  we decided to invest in the development of our own UK-based clearing house, ICE Clear Europe. ICE Clear Europe launched in 2008 and was the first new clearing house in the UK for 100 years. ICE Clear Europe is now a core part of the network of six clearing houses that ICE operates across the globe.

While our initial clearing services were based around our energy markets, we quickly moved to launch CDS at ICE Clear Europe in 2009 and then assumed the clearing for Liffe’s futures and options markets in 2013. We continue to develop new services across our network of clearing houses, based on what our customer’s needs are at any point in time.

ICE’s Network of Clearing Houses

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Further information on ICE’s CDS clearing services can be found at: theice.com/clear-europe/cds and   theice.com/clear-credit.