Will financial reform melt the ICE Trust monopoly?

Introduction

Wall Street has taken its share of licks in the past three years, but the big banks haven’t forgotten how to hedge their bets.

One of the more heralded provisions of the financial reform bill requires banks to trade credit default swap (CDS) contracts and other derivatives through a third-party clearinghouse so regulators can evaluate the trades and monitor the market for systemic risks. Banks have lobbied furiously against increased scrutiny, and it’s a sure bet that they will keep up the pressure on regulators who must write specific the rules once the bill is signed into law by President Barack Obama.

Last year, however, without much fanfare, many of those same banks teamed up with Atlanta-based Intercontinental Exchange, Inc. to launch ICE Trust, a clearinghouse for CDS trades that stands to be a prime beneficiary of new regulations.

A CDS is essentially an insurance policy — and a hedge — against corporate default. By 2007, the market had grown to $70 trillion for these over-the-counter, unregulated swaps often traded by parties with no control over the underlying debt. Insurance giant American International Group’s exposure to the CDS market brought the company to its knees, leading to a taxpayer bailout. The failure of Lehman Brothers investment bank also occurred at least partly because of the bank’s exposure to CDS contracts.

Since it came online last year, ICE Trust has dominated the market for CDS trades and recently announced it had cleared $10 trillion in CDS obligations. The company grew out of ICE’s 2008 acquisition of The Clearing Corp., a financial derivatives clearinghouse with technology to monitor CDS trades. The Clearing Corp. was partly owned by 10 major banks, which kept a stake in the new ICE Trust entity. Those banks – which now number 14 and include heavyweights like Goldman Sachs & Co., JPMorgan Chase & Co., and Bank of America – share in half of ICE Trust’s profits.

But some have criticized ICE Trust’s virtual monopoly in CDS trading and its cozy relationship with member banks.

Is ICE Trust a dealers-only club?

Robert Litan, an economist at the Brookings Institution, says he worries that the broker-dealer members could use ICE Trust to “blunt the competition” from competing clearinghouses and will keep it a dealers-only club with high margin requirements. ICE Trust currently requires all clearing members to have at least $5 billion in capital to join.

Another concern is ICE Trust’s 11-member board of directors, of which five members are either ICE managers or are broker-dealer representatives. Litan says ICE Trust should have a wholly independent board of directors. In a recent interview with the Center, Litan said he hopes that regulators, under the financial reform bill will begin to push for the governance issues he has championed, Litan said.

An ICE Trust spokesman said that membership requirements were developed in consultation with, and ultimately approved by, the Federal Reserve and other regulators. ICE Trust’s management is independent of the dealers and all board members are approved by the New York State Banking Department. The Federal Reserve reviewed, and continues to monitor, all key aspects of ICE Trust, including governance, the spokesman said.

For regulators, such as the Commodities Futures Trading Commission and the Securities and Exchange Commission, which are given broad, if somewhat vague, new authority to oversee the CDS market, the existence of a working clearinghouse like ICE Trust may seem like a relief. After all, as the Center has previously reported, regulators will have their hands full with at least 42 different studies mandated by Congress, as well as dozens of new rulemaking procedures.

Segregating CDS market may carry risks

Darrell Duffie, a professor of finance at the Stanford Graduate School of Business, and a member of the Financial Advisory Roundtable of the New York Federal Reserve, supports using a clearinghouse for credit default swaps. But he cautions that segregating the CDS market from the rest of the $500 trillion market for over-the-counter (off-exchange) derivatives runs counter to the risk-reducing purpose of using such an exchange.

Ideally, all derivatives would be cleared through a central market so that the parties could see the full benefit of “netting” all of their trades and swaps, Duffie said.

Take, for example, a scenario in which JP Morgan Chase is exposed to Citigroup for $150 million owing to a credit-default swap, and in which Citigroup is exposed to JP Morgan for $50 million due to an interest-rate swap. Netting these two different types of derivatives means that JP Morgan Chase’s exposure is $100 million. But by funneling all credit default swaps through CDS-only clearinghouses like ICE Trust, the opportunities to reduce risk through netting plunge, Duffie said. A market with a notional value of about $25 trillion might not seem small, but compared to the $600 trillion market for all derivatives, it amounts to just a slice, he added.

For now, the only competitor to Ice Trust’s market dominance is CME Group, one of the world’s biggest derivatives marketplaces. Last summer, BlueMountain Capital Management, a hedge fund that helped pioneer the derivatives market, accused the dealer community of “filibustering” the launch of CME’s credit-default swap market “to protect its oligopoly.”

The CME clearinghouse went live in December. So far, however, CME has been largely shut out of the CDS market. According to its own data, the CME clearinghouse has cleared just two CDS trades with a notional value of $48 million.

Financial reform bill requirements

The financial reform bill gives the SEC and CFTC broad new powers to monitor and control the market for derivatives clearing. Under the bill, most derivatives contracts, including credit default swaps, must be cleared or traded on exchanges. The SEC and the CFTC must also pre-approve certain categories of contracts before clearinghouses can clear them.

The bill also requires that derivatives exchanges publicly disclose the terms and conditions of derivatives contracts cleared on exchanges.

And, as with much else in the financial reform bill, regulators are also directed to initiate new rule-making proceedings. Most of these involve setting new organizational and governance standards for exchanges that want to clear trades.

But a barrier to further competition is that there simply aren’t many market players with the patience and money to create a counterparty trading system like ICE Trust. The Federal Reserve and four other regulators had to sign off on ICE Trust prior to completion, said Bradley Sabel, a partner at the New York corporate law firm Shearman & Sterling, who worked on the project.

“Getting through the regulatory process is an expensive and daunting task,” he said. And ICE Trust was in development at a time when the regulators desperately wanted a clearinghouse to get off the ground, Sabel said.

What are the regulators interested in now? Sabel, who spent 18 years at the Federal Reserve Bank of New York, can guess.

“This is not their number one concern,” he said. “From their perspective, there’s already a central clearer. And they have scads of rulemaking studies to focus on.”