Slow Build Seen In Clearing Buy-Side Credit Derivatives

Hedge funds and asset managers have made a cautious start in clearing credit default swaps on new exchange-owned platforms, despite a push from U.S. regulators.

The response of the buy-side far lags the transition of dealer-brokers from bilateral deals to central clearing in the $25.6 trillion CDS market.

IntercontinentalExchange Inc. (ICE), the market leader in clearing sell-side CDS deals, has handled just $190 million in client-to-dealer transactions since launching the expanded service last month. ICE's inter-dealer service handled $27 billion in the first weeks after its March 2009 launch, this month passing the $5 trillion mark.

CME Group Inc. (CME) has cleared approximately $184 million in credit derivative transactions since mid-December via its own service aimed at buy-side participants, with the majority of that business done on the first day of operation.

"The buy-side is still evaluating what clearing will mean to them and how they'll use it day to day," said Scott Hill, ICE's chief financial officer.

Exchange operators have rushed in the past year to bulk up their clearing services for complex swap instruments as one way to tap into the $605 trillion over-the-counter derivatives market.

U.S. regulators have pushed exchanges to expand central clearing--which effectively mutualizes risk--to asset managers and pension funds, though buy-side firms represent only about 10% to 15% of the dealer-dominated CDS market.

Market participants expect buy-side CDS traders to make a slower move into clearing.

"You'll rapidly start to see the buy-side start participating this quarter," said Susan Kobayashi, director of fixed-income portfolio and trading for Mellon Capital Management. "We certainly think it's a positive for the market and intend on participating."

Kobayashi said that Mellon Capital, which manages $177.9 billion in assets, is evaluating both ICE and CME platforms with an eye toward clearing its CDS business by June.

The cost of linking with a clearinghouse is a big hurdle for asset managers, noted Rohan Douglas, chief executive of credit market analysis company Quantifi Inc. He said many lack the personnel and resources of the dealer banks.

CME is also maintaining a cap on the level of client business cleared on its platform, as it finalizes details of its clearing rules and risk model, according to people familiar with the situation.

"We are in the very early stages--the proof-of-concept phase--of clearing for these products and we are working very closely with all of our customers to understand and meet their needs," said a CME spokesman.

The Chicago exchange operator is also awaiting regulatory approval for rules that would allow it to co-mingle CDS and futures collateral, a move that could boost the attractiveness of central clearing for customers.

The lack of a single overseer for the buy-side also makes it hard for them to be compelled to clear, says Quantifi's Douglas, unless the government opts for a broad mandate to enforce such a move.

Mellon's Kobayashi said that as clearing becomes easier to use and more widespread, hedge funds and other investment firms that trade credit default swaps will increasingly adopt it in the spirit of "best practices."

"Investors would prefer a fund that's using clearing to one that isn't," she said. "There's no reason for any buy-side firm, in my opinion, to reject clearing."

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

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