Central counterparties (CCPs) are facing regulatory delays in efforts to provide margin efficiency between single-name and index credit default swaps (CDSs). This is an issue that could cause liquidity in the CDS market to evaporate unless it is resolved, dealers claim.
CME Group is also looking to provide cross-margining on single-name and index credit derivatives. It currently clears index trades, and says it is working with regulators to ensure it can deliver margin offsets once it begins clearing single-name CDS contracts. “Providing margin offsets between the single-name constituents and an index is something that makes complete sense and it is something that should be done, but it’s not yet do-able until we get approval on the methodology by both regulators. We are in the process of working through that right now,” says Laurent Paulhac, senior managing director of financial and OTC products and services at CME Group, based in New York.
Index and single-name credit derivatives trades are typically collateralised on a portfolio basis in the bilateral market – and market participants claim it would be relatively straightforward to extend that to the clearing world. “Typically, asset managers and other market participants will take a view on a credit and then decide whether to express it in cash or derivatives form. So there’s a strong interplay between the bonds and the CDSs, and being able to capture that will hopefully be well-received and put us at a competitive advantage,” says Barsoom at Ice Clear Credit.
Sources close to the matter suggest that co-ordinating the efforts of the CFTC and SEC has been tricky. Barsoom believes the agencies agree with the idea in principle, but says the burden of writing myriad rules under the Dodd-Frank Act is having an impact on their ability to move forward. “Both commissions are stretched with having to complete rules they are required to write under Dodd-Frank. We’re taking every avenue to work with them and prioritise it. In principle, it’s definitely something they understand and get,” he says.
“The submission is being worked on by the CFTC and SEC,” confirmed a Washington, DC-based spokesman for the CFTC. A spokesman at the SEC says the agency recently requested more information from Ice Clear Credit, but would not comment further.
The hold-up does not augur well for other efforts to provide margin efficiency – a critical issue for OTC derivatives market participants given the huge amount of collateral that will be required for use as margin at CCPs and elsewhere. “There’s definitely a need for margin efficiencies. One of the ironies is that the stampede to clearing is going to have the effect of undoing those efficiencies, especially given the extent to which CCPs are specialising in different parts of the product space,” argues Craig Pirrong, professor of finance at the University of Houston.
The lack of margin efficiency in the CDS market may also have a deeper impact on liquidity in single-name credit derivatives once mandatory clearing requirements are in place. If trading indexes against single-name CDSs becomes less capital efficient, it could cause liquidity in single-name contracts to dry up, says Rafi at Citi.
“There is a fair amount of participants that trade index arbitrage, where you go short the index and long the single name CDS, or vice versa. If mandatory clearing comes into place and you aren’t able to get offsets between the two, that would make it too inefficient for buy-side participants to trade this strategy – and that could really reduce liquidity in both single-name and index CDSs,” she says.
This article was first published on Risk