Streetwise Professor

There are at last count five major initiatives to create a credit derivatives clearinghouse. The two leading contenders are a CME-Citadel (CIG) initiative, and a collaboration between the Clearing Corporation (and hence the major banks that own it) and ICE (further proof that ICE is firmly aligned with the major banks, as its CBT foray also indicated). This Reuters article gives the CME-CIG venture the inside track. I don’t handicap things quite the same way.

I see two big obstacles to the CME, both essentially political in nature. First, the big banks and CME have been in a cage match for the last couple of years, and the banks will resist transfer of additional power to the CME. The CME will have to depend on buy side support, b/c the buy side hates the banks worse than the CME.

Citadel’s alliance with CME very interesting in this regard. CIG is with the banks in the ELX initiative to compete with the CME in futures trading , but with the CME and against the banks in this effort to compete with the latter. It seems that CIG is trying to play balance-of-power games here, leaning against the dominant party in the exchange and OTC spaces.

Second, the DOJ concerns about CME market power (expressed in the infamous February letter) will become more acute. Their precedent in the CBT merger tied their hands in NYMEX, but it would not do so in contesting CME market dominance in OTC clearing.

The big bank opposition to the CME is probably the biggest hurdle. All of CME’s OTC clearing initiatives have focused on the buy side, and probably for good reason. But support from the big OTC dealers–as long as any of the latter exist–is probably vital for any venture to succeed. But at the same time, the CME has a lot more credibility than the major dealers and the (until recently moribund) Clearing Corp. I would therefore expect some sort of uneasy alliance involving both CME and the dealers and important buy side participants, perhaps resulting from a shotgun wedding arranged by the NY Fed and the Treasury.

It is also interesting to note that both the CME/CIG and CC/ICE ventures plan an execution platform piece to go along with the clearing piece. The execution platform is probably more essential for the CME venture because it has to pry away transactions from the dealers to succeed.

A more transparent pricing and execution system is also an important element of a successful clearing venture. As I have laid out in my academic work, and will discuss further in soon-to-follow SWP posts, clearinghouses don’t create price transparency, they depend on price transparency. Clearinghouses can improve position transparency by collecting and aggregating position information. But clearinghouses use prices determined in the execution market. They do not create these prices. Price information is vital for marking positions and managing collateral, and also for calibrating risk models used to establish collateral levels and monitor clearing member risk. Therefore, initiatives to improve price information are essential to making clearing work. One way to do that is to move trading onto centralized platforms. Another is to centralize the collection and dissemination of price information through the creation of a data hub, a subject I’ve discussed on SWP before.

It will be interesting to see how this will all play out. There will be a political component here, as the sums at stake are immense–as the Reuter’s article discusses. Moreover, the economic issues are quite fascinating. Over the next couple of days I will focus on those issues in more detail in upcoming SWP posts.