Although five exchanges will soon vie to clear credit default swap trades in Europe and the United States, the number is likely to dwindle to one on each side of the Atlantic in the next couple of years, according to analysts and industry participants.
The competitive pressure that will knock all but two exchanges out of the $27.5 trillion credit default swap market stem from economies of scale and the quest for efficiencies by dealers that trade on multiple platforms, they said.
“Liquidity naturally follows liquidity,” said Benn Steil, director of international economics at the Council on Foreign Relations in New York. “Dealers at the end of the day will move to wherever is cheapest to trade.”
The main obstacle to a single international clearinghouse for the international credit default swap market is likely to be turf conflict between regulators and government agencies on the two continents, the experts said.
Still, the clearinghouses that survive will be positioned to expand into processing other unregulated derivatives trades. They will get this opportunity when regulators inevitably turn their sights to the larger over-the-counter market, experts said.
“The winners of the credit default swap race will be in a good position to broaden their services for all over-the-counter contracts,” said Phil Bruce, senior strategy adviser for New York-based NYSE Euronext Inc.’s Liffe derivatives market in London.
Credit default swaps account for just 11% of the unregulated OTC derivatives market, according to the Basel, Switzerland-based Bank for International Settlements data cited in a report this month.
About 86% of this market is made up of interest rate and currency swaps, according to the report, by Kevin McPartland, a senior analyst with The Tabb Group LLC, a Westborough, Mass., research firm.
Clearinghouses were spurred by regulators in an effort to manage risk on the CDS market after Lehman Brothers Holdings Inc.’s bankruptcy and American International Group Inc.’s near-collapse. Both firms are based in New York.
Analysts estimate that an exchange can generate between $100 million and $400 million in annual revenue.
Credit default swaps are a bond derivative that functions like an insurance contract. Dealers typically purchase them privately from other dealers to protect against a bond downgrade or default.
Analysts differed in their predictions of which clearinghouses would win in the CDS market.
“It’s too early to tell which will come out on top,” Mr. McPartland said in an interview “All the solutions are viable, yet all have their own disadvantages.”
The Securities and Exchange Commission gave final regulatory approval this month to the Intercontinental Exchange Inc. of Atlanta and CME Group Inc.
Intercontinental started guaranteeing trades this week in a partnership with Clearing Corp., a Chicago-based clearinghouse owned by dealers including Frankfurt, Germany-based Deutsche Bank AG and UBS AG of Zurich, Switzerland.
Chicago-based CME, the world’s largest futures exchange, has joined with hedge fund
Citadel Investment Group LLC, also of Chicago. The exchange is still trying to settle on terms with potential participants, including dealers, banks, hedge funds, pension funds and asset managers.
“We expect to start sometime later this year,” CME spokesman Allan Schoenberg said.
Some analysts said that Intercontinental’s dealer membership gives it an inherent advantage in a market where 80% of the trades are between dealers. Others cite CME’s efficiencies, liquidity and brand name.
In Europe, the clearinghouses have reached agreement with the European Commission to start processing transactions by the end of July.
European clearinghouses are taking longer to get off the ground than those in the United States because “there are technical obstacles in Europe, and it’s more complex than the U.S.,” Mr. Bruce said.
NYSE Euronext’s Liffe derivatives market started offering to clear trades in December, though no contracts are likely to be processed until about June, he said.
Eurex, owned by Deutsche Boerse AG in Frankfurt and Switzerland’s Six Group AG in Zurich, is due to start exclusively in continental Europe before July.
London’s LCH.Clearnet Group Ltd., which is teaming up with Liffe in the United Kingdom, has another business in Paris that plans to start clearing trades on its own by December.
Intercontinental also plans to start a European operation by June.
Clearinghouses add stability, transparency, independent valuation and risk management to markets by becoming the seller to every buyer and the buyer to every seller.
Their most important benefit “will be providing a central repository for trade information and pricing that will be useful to analysts and regulators alike,” said Brian Yelvington, an analyst at CreditSights, a New York-based research firm.
They typically ask member firms to pay fees, put up collateral and pay into a guaranty fund.
While the clearinghouses will do a better job of managing risk, they won’t end it, in part because many customized contracts will still be negotiated privately, analysts said.
“Clearinghouses work best with standardized instruments, but it’s the non-standardized ones that will trade bilaterally and are most risky,” said Charles Taylor, a fellow at The Wharton School at the University of Pennsylvania in Philadelphia.
Analyst estimates of the portion of the credit default swap market that will continue to trade bilaterally range from 10% to 45%.
