CDS market faces iTraxx clearing obstacle

Derivatives market participants are trying to solve a problem that could prevent the clearing of credit default swaps (CDSs) on the Markit iTraxx Europe index – one of two index families the Commodity Futures Trading Commission (CFTC) plans to include in its initial clearing mandate, which is expected to take effect during the first quarter of 2013.

The issue prompted the International Swaps and Derivatives Association (ISDA) to argue in a September 6 comment letter that iTraxx clearing should be delayed. However, CDS clearing house Ice now says it has a fix – assuming regulators buy into the idea.

The fears arise because the 125 names in the Markit iTraxx Europe index also trade individually under the terms of European CDS contracts, which include debt restructuring as a credit event. That differs from standard US contracts, which only include bankruptcy and failure to pay as credit events.

When a restructuring event occurs, both the buyer and seller of protection have the option to trigger the contract, but that option also has to be reflected in the terms of index. The industry collectively chose to tackle the issue by breaking affected iTraxx trades into two pieces following a restructuring event – counterparties would hold an index consisting of the 124 names unaffected by the event, plus a single-name CDS with the choice to trigger or not.

Isda pointed out in its comment letter that no central counterparty (CCP) currently offers clearing for all iTraxx reference entities, meaning counterparties could see non-clearable single-name contracts carving away from cleared index trades. That comes with a number of practical challenges. For one thing, cleared and uncleared trades will be subject to different margin standards and capital rules. For another, the two contracts are regulated by different agencies – the CFTC is responsible for broad-based indexes, while the Securities and Exchange Commission regulates single-name CDSs. There is also no mechanism for determining the counterparties for a single-name trade that falls out of a CCP.

Ice Clear Credit has suggested a simple solution: it will immediately seek regulatory approval to clear any new single-name contract that it doesn’t already handle.

“In some cases where we don’t clear the name in question, we might be concerned about the liquidity in that contract. So from a risk management perspective, we would retain the option to fully collateralise those positions so there’s no risk to the clearing house. We think that’s an elegant solution – it keeps it in the cleared space and allows people to enter into contracts if they want to hedge out those risks. Other options that involve moving it into the bilateral world are fundamentally flawed, we think,” says Peter Barsoom, chief operating officer at Ice Clear Credit in New York.

It is not mandatory in the US to clear any single-name CDS contract that spins out of the iTraxx index – unless the specific name is already mandated for clearing. However, one industry source says participants will probably want the single-name CDS to be cleared in order to avoid a single trade suddenly splitting into two, each with different margin and capital requirements.

Given the spun-out entity would likely be under stress, there could be a significant jump in collateral requirements, one hedge fund manager says. On the flip side, it would probably end up representing a significant amount of open interest.

“Everyone who holds the index will hold the single name. You could argue it would probably show up on the charts as one of the single names with the most open interest the day after it gets spun out. It’s on a reference entity that’s going through some financial distress, but nonetheless one that will be held by a large number of market participants,” says the hedge fund manager.

Ice has spoken to the CFTC about its proposed solution and is waiting for feedback, Barsoom says.


This article was first published on Risk

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