Competition In OTC Clearing Comes With Its Own Risk

The top executive of IntercontinentalExchange Inc. (ICE) warned Thursday that price competition among clearinghouses could increase market risk in over-the-counter derivatives markets.

ICE, CME Group Inc. (CME), Deutsche Boerse's (DB1.XE, DBOEF) Eurex unit and other futures exchanges are jostling to grab a piece of the potentially lucrative business of clearing OTC transactions, an attempt to reduce systemic risk in off-exchange markets.

ICE has taken the early lead, clearing more than $3 trillion in credit default swaps since launching its service in March, but it is facing competition from rivals looking to offer similar services at a lower price.

In an interview on the sidelines of an industry event in Chicago, ICE CEO Jeffrey Sprecher warned that this could leave some clearinghouses dangerously undercapitalized, raising the prospect that the Federal Reserve or other central banks could be forced to step in if a crisis breaks.

But with multiple exchanges and clearing entities targeting the market, Sprecher said, "I don't know how we avoid a race to the bottom."

Clearinghouses serve as the buyer to every seller and the seller to every buyer, and the model is seen as an antidote to the risk posed by swap transactions, which are typically arranged privately between two parties.

Collateral must be pledged to the clearinghouse to back up positions in the event of a default, but Sprecher said that the pressure to compete could prompt some clearinghouse operators to require less collateral, making it cheaper for customers to do business.

Clearing over-the-counter products is the single biggest growth prospect for the derivatives exchange industry, which has struggled with a broad downturn in trading volume spurred by the global financial crisis.

While the current focus is on constructing clearing services for over-the-counter markets as they exist now, Sprecher said the standardization necessary to move OTC products into clearinghouses will bring on a new wave of listed futures products based around swaps.

He noted that the size of the credit default swap market has shrunk by about 50% since its peak, another product of the financial meltdown.

Credit default swaps are privately negotiated agreements that pay out in the event of defaults.

While Sprecher said that trading credit default swaps currently is similar to "selling hurricane insurance in the middle of a hurricane," he said the lessons of the financial crisis have underscored the importance of such products for managing credit exposure.

Sprecher said he anticipates the market will rebound in the coming years, and as activity returns there will be more demand for futures products based around swaps.

Despite the hit the global derivatives industry took as banks and hedge funds deleveraged over the last year, overall volumes seem to have stabilized, raising the potential for exchange consolidation to begin anew, Sprecher said.

"We're hearing more rumor and back-chat," said Sprecher, with a nod toward talk this week that CME is considering an acquisition of the Chicago Board Options Exchange.

"That's indicative of the fact that the industry seems pretty healthy," Sprecher said.

-By Jacob Bunge, Dow Jones Newswires; (312) 750 4117; jacob.bunge@dowjones.com

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