The criticism of over-the-counter (OTC) interest rate swaps trading has been that it was conducted opaquely by an old-boys club, which kept spreads wide and profits flowing to the investment bank dealers. The criticism of the CME Group cleared OTC interest rate swaps appears to be the same.
In October, CME Group announced its clearing solution for OTC interest rate swaps, which raised the ire of non-dealer futures commission merchants who had been anticipating getting into the game (see "Top 50 Brokers," page 54).
CME’s solution will include a separate clearing structure and default fund and requires clearing members to have $1 billion in adjusted net capital.
"We spent a lot of time discussing this with a lot of market participants to ensure the proper safety and soundness of our offering, so one of the key criteria is net capital requirement," says Laurent Paulhac, CME Group managing director, OTC products and services. "The net capital requirement is related to the strength of the balance sheet of the clearing member. That is very important to us because ultimately what introduces systemic risk in our clearing solution is the potential failure/bankruptcy of a clearing member; the stronger the clearing member, the safer the model."
He adds, "$1 billion is the right level because of the risk and liquidity factors related to that instrument. Interest rate swaps, even though it is a very large market, it's a market that has instruments up to 50 years out so they will stay on somebody's books for that period of time (initially the CME solution will only cover 31 years). "
He also notes that, "Liquidating a portfolio of swaps is a very different process than liquidating a portfolio of fx, eurodollar or Treasury futures products."
In addition to the capital requirement, firms must have expertise in interest rate swaps and be able to participate in an auction in case of a default.
"What CME is focused on is, what does it take to build a safe and sound clearing solution for executing swaps," says Paulhac. "Our solution is an open agnostic platform with respect to electronic execution venues, so that anybody who executes can clear with CME if they are a qualified clearing member."
CME has identified five buy-side participants: BlackRock, Citadel, Fannie Mae, Freddie Mac and Pimco; and 10 sell side participants: BofA Merrill Lynch, Barclays Capital, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs, J.P. Morgan, Morgan Stanley, Nomura and UBS.
Paulhac expects more clearing members as they move forward.