The Challenge of Central Clearing forOver-The-Counter Interest Rate SwapsRobert O'MaraTracy PridgenSmita VemulapalliInterest Rate Swaps NYU SCPS X51.9240June 2010

OverviewOTC Interest Rate Swap MarketCentral ClearingBenefits of ClearingOther Markets that use ClearingChallenges for Clearing OTC IR SwapsInternational Derivatives Clearing House (IDCH)Benefits of Clearing IR Swaps through IDCH

What is the OTC Interest Rate Swap Market?TheOTC interest rate swap market is the largest derivative asset class in the world.As of June 2009, the notional amount outstanding in OTC interest rate swaps was $342 trillion. [Source: Wikipedia] It is estimated over a trillion dollars in notional trades every day.

IR swaps are OTC.Unlike older derivative asset classes such as forwards and options, interest rate swaps do not trade on exchanges.Consequently, they are referred to as trading "over-the-counter

Interest rate swaps are an integral part of the fixed-income market.

What is Central Clearing?

Clearing: In banking and finance, clearing denotes all activities from the time a commitment is made for a transaction until it is settled Processes included in clearing are reporting/monitoring, risk margining, netting of trades to single positions, tax handling, and failure handling.

Settlement:Settlement (of securities) is the transfer of securities or cash in order to fulfill the contractual obligations. Settlement is facilitated by clearing processes such as netting and novation.

The clearing of the OTC transactions is called OTC clearing.

A clearinghouse is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions.

What is Central Clearing?A modern clearinghouse serves as the central counterparty to each member.The"buyer" for every sellerThe "seller" for every buyerTypically, a clearinghouse is capitalized by its members and provides a standard template for trade contracts, pricing and dispute resolution.It can be traced back to the 18th century.Central or multi-party clearing is a means of trade settlement that mitigates the risk that one party to the trade will fail to perform (i.e. default).

What is Central Clearing?Services provided by a clearinghouse include:Netting/offsetting transactions from multiple counterpartiesProvide independent trade price and valuation of collateralMonitor the creditworthiness of member firmsCollect and maintain margin on existing tradesEstablish and maintain a guarantee fund

What is Central Clearing?The diagram below shows an OTC market without central clearingAll parties can trade with every other partyTerms vary depending on bilateral agreementDealer defaults borne by direct counterpartiesNotionals are double-counted (in the case of offsetting trades)Regulators have limited view of true exposureLimited pricing data available

What is Central Clearing?The diagram below shows an OTC market with central clearingClearinghouse is the counterparty to every tradeDealers negotiate bilaterally but clear centrallyTerms are standardizedMembers report prices regularlyMembers contribute to a guarantee fund and post margin on individual tradesDealer defaults borne by all membersNotionals netted automaticallyCLEARING HOUSE

What Are the Benefits of Clearing?There are multiple benefits to central clearing, however, policymakers tend to focus on the following three:

Mitigation of systemic risk

Operational efficiency

Improved transparency

What Are the Benefits of Clearing?Mitigation of systemic riskCentral clearing mutualizes counterparty risk. All members face the default risk of all other members. This incentivizes members to limit the risks taken by the clearinghouse.The clearinghouse is capitalized with contributions from all members and, consequently, has lower counterparty risk than any individual member.The default of a single counterparty is unlikely to trigger the default of another counterparty because the losses are borne by all members.

What Are the Benefits of Clearing?Operational efficiencyClearing facilitates netting, reducing the total number of contracts and the notional amount of outstanding trades.Clearing requires contract standardization.Fewer trades to track and greater standardization would speed settlement time and reduce the number of errors.

What Are the Benefits of Clearing?Improved transparencyThe net position of the clearinghouse as well as net exposures of each member is known.Both regulators and risk managers would benefit from this.Regular price reporting from all clearinghouse members.

What Other Markets Use Clearing?Clearing is an important part of markets worldwide, both on-exchange and off-exchange.

Examples of major clearing operations include:The Options Clearing Corporation: equity and bond derivativesLCH.Clearnet (formerly the London Clearing House): a broad range of asset classesThe Intercontinental Exchange (ICE): a broad range of asset classes including energy and credit derivatives

What Are the Challenges for Clearing OTC Interest Rate Swaps?The biggest challenge for clearing OTC interest rate swaps is the non-standardized nature of the product.

Terms are highly negotiated for:TenorRateNotional valueCalculationsAssumed Rate Curves

The First Interest Rate Swap Clearinghouse

International Derivatives Clearing House (IDCH)Wholly-owned subsidiary of the International Derivatives Clearing Group (IDCG), founded by Vincent Viola, the former Chairman of NYMEX Holdings, Inc., the parent company of the New York Mercantile Exchange, Inc. (March 2007)Filed a Derivatives Clearing Organization (DCO) application with prospective regulator, the Commodities Futures Trading Commission (CFTC) (August 2008)Clearinghouse operations went live (December 2008)Majority equity position acquired by NASDAQ OMX Group, Inc. (December 2008)Minority equity position acquired by Bank of New York Mellon Corp. (June 2009)Clearing volumes exceed $1 Trillion (September 2009)Clearing volumes exceed $3 Trillion (December 2009)

International Derivatives Clearing House (IDCH)IDCH, as a CFTC-regulated derivatives clearing organization, provides a transparent forum for its members to clear and settle Interest Rate Swap derivatives.

Trading, investment, and market-making firm members of IDCH can clear and settle new and existing OTC interest rate swap contracts traded bilaterally with dealers. IDCH converts the members existing OTC Interest Rate Swap contracts into economically equivalent, listed IDEX USD Interest Rate Swap Future contracts with maturities up to 30 years, using a proprietary Exchange of Futures for Swaps (EFS) process via SwapDrop.com. The contracts are then cleared and settled through IDCH, provided both parties to the original agreements confirm the novation of the contracts to IDCH.SwapDrop.com allows members of IDCH to execute an OTC transaction off-exchange for clearing through IDCH.

By utilizing the EFS process, IDCH is able to provide customers the benefits of central clearing while maintaining the principles and economics of the OTC market.

Exchange Listed IDEX USD IRS Future contractsIDEX USD 3 Month &1 Month Interest Rate Swap FuturesIDCH centrally clears 3 Month (IRS-3M) and 1 Month (IRS-1M) Interest Rate Swap Futures contracts designed to be economically equivalent to plain vanilla IRS contracts currently traded in the OTC market. IRS Futures are contracts on USD denominated interest rate swaps with a notional value of $100,000, requiring the exchange of periodic semi-annual fixed rate payments based on the futures price in exchange for quarterly & monthly floating rate payments.

IDEX USD 3 Month &1 Month Forward Start Interest Rate Swap FuturesIDCH centrally clears 3 Month (FS-IRS-3M) and 1 Month (FS-IRS-1M) Forward Start Interest Rate Swap Futures contracts. The FS-IRS are contracts on USD denominated interest rate swaps with a notional value of $100,000 and a deferred Effective Date, requiring the exchange of periodic semi-annual fixed rate payments based on the futures price in exchange for quarterly & monthly floating rate payments based on the USD LIBOR.

IDEX USD 3 Month & 1 Month Forward Rate Agreement FuturesIDCH centrally clears 3 Month (FRA-3M) and 1 Month (FRA-1M) Forward Rate Agreement Futures contracts. The FRAs are contracts on USD denominated Forward Rate Agreements with a notional value of $100,000 and a deferred Effective Date, requiring the exchange of a quarterly & monthly fixed rate payment based on the futures price in exchange for a quarterly & monthly floating rate payment based on USD LIBOR.

IDEX USD OIS Interest Rate Swap FuturesIDCH centrally clears OIS Futures contracts (OIS). The OIS Interest Rate Swap Futures are contracts on USD denominated interest rate swaps with a notional value of $100,000, requiring the exchange of periodic annual fixed rate payments based on the futures price in exchange for annual floating rate payments based on the Fed Funds Effective Rate compounded over the life of the contract.

Benefits of Clearing IRS Contracts through IDCHMarket participants who use the EFS process to convert their OTC interest rate swaps to cleared IRS futures through IDCH reduce bilateral counterparty credit risk and simplify the ongoing processes required to manage such relationships.The substitution of bilateral counterparty credit risk with a regulated clearinghouse enables a much greater number of market participants to interact with one another with greater confidence.Additional potential benefits to centrally clearing IRS futures contracts through IDCH include:

Standardized valuations for cleared IRS futures contractsContracts are margined in a transparent, standardized processIDCH cleared contracts qualify for 60/40 tax treatment, similar to other futures contracts Reduction to capital reserves required for bilaterally settled OTC derivative contracts, synthetically increasing market participants available free capital

IDCH Benefits from Marketing Materials

Transaction Comparison

Q & A

*$460 trillion in notional outstanding as of June 2008 [more recent number? This wiki article puts the number at $342 in 2009: http://en.wikipedia.org/wiki/Interest_rate_swaps#Market_size ]