Intercontinental Exchange Inc. has put on hold plans to clear some credit-default swaps for hedge funds and money managers after the U.S. Securities and Exchange Commission doubled the amount of collateral the traders need to post, according to two people familiar with the decision.
Intercontinental, owner of the world’s largest credit-swap clearinghouse, and investment firms agreed to wait to begin clearing so-called single-name trades after the SEC’s March 8 decision made them too costly, said the people, who asked not to be named because the decision was private. Investors were hoping the rule would reduce margin because those contracts often are offset by opposing trades linked to indexes, lowering risk to clearinghouses.
The development underscores the complications of having two regulators overseeing separate parts of the $639 trillion over-the-counter derivatives market. The SEC and Commodity Futures Trading Commission are imposing new rules under the 2010 Dodd- Frank Act, including requirements for margin backing trades that Finadium LLC said may contribute to as much as $6.7 trillion in additional collateral needs for market participants.
Dodd-Frank gave the SEC jurisdiction over swaps linked to individual debt issuers while the CFTC has oversight of all other swaps, including contracts on indexes of companies and countries and interest-rates swaps. The unregulated market contributed to the financial crisis and made it difficult for regulators to determine how interconnected banks had become after Lehman Brothers Holdings Inc., one of the largest swap dealers, collapsed in September 2008.
Split Deadlines
The SEC has yet to set a deadline for when credit swaps tied to individual companies and governments must be cleared, while the CFTC began mandating it on March 11 for dealers and large investors that trade contracts linked to indexes.
Under the bifurcated regulatory oversight of the credit- swaps market, many large investors are mandated to clear their index trades, while they’re not required to do the same for the single-name trades they hold because the SEC hasn’t completed its rules, the Managed Funds Association, an investor lobbying group, said in a Feb. 11 letter to the SEC.
Risk magazine reported Intercontinental’s decision to shelve clearing for single-name swaps done by bank customers on March 18.
‘Key Element’
Had the SEC decision offered cost reductions on trades using offsetting single-name and index contracts, a process known as portfolio margining, investors were expected to begin clearing voluntarily before any mandate, according to two of the people.
The SEC initially said in a December decision that it intended to approve portfolio margining under certain conditions.
That led Intercontinental to say in February that the anticipated approval would increase its business with swaps investors.
Portfolio margining “was the key element of the buy-side offer,” Scott Hill, chief financial officer, said on a Feb. 6 conference call. “It’s our full expectation that as we get to the mandatory clearing later this quarter, and certainly throughout the rest of the year, that you’ll see a quick acceleration in the buy-side’s clearing.”
Kelly Loeffler, an Intercontinental spokeswoman, declined to comment.
‘Prudent Margin’
“We exercised our authority and responsibility to protect all investors who are customers of the dealers by requiring prudent margin levels,” John Nester, an SEC spokesman, said in an e-mailed statement. “We continue to work with the firms on a longer term solution.”
The SEC decision is temporary and may be revised after the agency completes its review of how broker-dealers and futures brokers handle risk management, according to a separate person familiar with the matter who asked not to be named. The SEC hasn’t said when it will set its mandatory clearing deadline for single-name credit swaps.
Intercontinental calculates its initial margin for cleared credit swaps using a five-day time span that’s meant to cover 99 percent of the possible price moves in the contract.
The SEC decided to require margin covering the equivalent of 10 days of price moves because there is currently no way for swaps to be traded on an exchange or similar electronic system, according to the person familiar. Intercontinental, which did its own analysis of the SEC margin requirement, determined the regulator’s mandate effectively requires margin equal to 20 days of price swings, one of the people said.
Swaps Trading
Both the SEC and CFTC have yet to finalize rules for the trading of swaps, including rules for so-called swap-execution facilities. Once those systems are in place the SEC may reduce its margin requirement, the person said.
Portfolio margining is based on the cost savings from combining positions to allow long and short positions to cancel each other out. Some hedge funds, for example, buy credit swaps protecting against the default of companies in an index, and then sell protection using contracts linked to the individual companies, profiting from gaps between the two sides of the trade.
The banks that are the clearing members of Intercontinental’s credit swap clearinghouse have been allowed portfolio margining on index and single-name trades since January 2012. The SEC granted that because banks must impose capital charges on their balance sheets related to those swap trades that set aside cash against losses, according to the person familiar with the matter.
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