Wednesday, September 30, 2009

CDS intermediation doesn't die, just gets put on ICE

As the CDS product undergoes changes, the way that the CDS trading participants interact with each other is changing as well. Here is some background.

In recent years some dealers have become what are called "derivatives prime brokers" (or derivatives intermediation providers) for buy-side derivatives users. The idea was the one can execute a derivative transaction (usually a CDS) with any dealer and effectively "give-up" the trade to their derivatives prime broker.

A hedge fund could trade CDS with multiple dealers, but at the end of the day they would face just one counterparty on all their trades (some funds had a couple of derivatives prime brokers). The advantage was that by facing only one dealer, the fund would have a single consolidated margin account that would take into account all the longs and shorts, making the margin process more efficient. Also the derivatives prime broker would provide independent pricing on the whole derivatives portfolio that could be integrated with the fund's portfolio systems.

Some hedge funds would select a large bank rather than a broker dealer to face on their CDS trades, thus reducing counterparty risk. A fund could do a 5-year CDS trade with Lehman a day before it defaulted, give it up to a large bank the same day and have no exposure to Lehman.

But the derivatives intermediation business mostly died with the crisis as Goldman and several others exited the business (some dealers are still providing this service for their top clients). If you look at he diagram above, a give-up simply means that a derivatives intermediary steps in between the fund and the original counterparty. And what made dealers exit the business had more to do with facing another dealer than the hedge fund. The dealers charged funds sufficient margin to avoid major losses. However if the other side (Dealer-A) was Lehman, the intermediary has a problem. The whole model no longer worked when it turned out that it wasn't the hedge funds but the dealers who pose a major risk to each other. The intermediary (Dealer-B) just wasn't getting paid enough by the hedge fund to take other dealers' risk. Plus with the clearinghouse idea looming, it made even less sense to be in this business.

But as ICE North America CDS clearinghouse went online earlier this year, funds and banks started looking for a solution that resembles the give-up process. Recently ICE announced a process that would allow this to happen.

ICE: Credit derivative trades between a buy-side firm and an executing dealer are typically executed and legally confirmed on a bilateral basis. This requires buy-side customers to have ISDA documentation in place with each executing dealer and to take counterparty risk to executing dealers when conducting CDS transactions. Trade date clearing eliminates the need for this documentation between buy-side firms and executing dealers. Instead, a buy-side firm may trade with any executing dealer who is a clearing member, and may clear the trade at ICE through their designated "derivative clearing member" or DCM.

Hedge funds can not be members of the clearinghouse (ICE wanted only the massively capitalized banks to participate). That means that funds would still face banks on CDS trades. But they would be able to trade with multiple dealers and at the end of the day be facing only one, their "designated derivative clearing member". The clearing member would face ICE on the other end instead of another dealer.

Right now ICE only has a couple of index CDS trading, but over time major single name CDS product should start going through the clearinghouse. The hope is this will improve liquidity and make participants less nervous about counterparty risk.

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