Citadel Defends CME's Credit Derivatives Clearing Structure

Citadel Investment Group has defended plans by CME Group Inc. (CME) to include credit default swaps, or CDS. into the same clearinghouse the exchange operator uses to protect customers' futures positions.

The hedge fund manager's comments in a letter to U.S. regulators come amid fresh concerns from brokers about so-called "commingling" of reserves pledged in the event of any defaults by clients.

A growing chorus of major CME customers has called on the company to create a separate clearinghouse for credit derivatives. CME executives argue that the current structure, incorporating a series of backstops, diversifies risk and reduces customer costs.

"Based on our understanding of the risk management systems that CME has developed for its cleared CDS, we believe the addition of CDS to the CME guaranty fund will not adversely impact the safety and soundness of CME Clearing," said Citadel Chief Legal Officer Adam C. Cooper, in a letter to the Commodity Futures Trading Commission.

CME in December launched a long-planned service to clear CDS trades, one of several efforts by exchanges to apply futures risk controls to the products and wring profits from the estimated $25.5 trillion CDS market.

Citadel worked closely with CME in the development of a CDS clearing and trading platform, called CMDX. The project was shelved last year in favor of a clearing-only service seen as more acceptable to the dealer banks that dominate the CDS market.

While CME wrangled over the structure of its offering, rival IntercontinentalExchange Inc. (ICE) secured the support of dealers and gained the early lead in CDS clearing, having handled more than $5.5 trillion in business as of February.

Unlike ICE's offering, CME's service brings CDS risk under the same roof as futures and options. The two product groups are separated by a series of tranches, although the default of a major trader in either asset class could ultimately draw on the collateral of customers on the other side.

That prospect troubles executives of futures and options brokerages doing business at CME, including Thomas Peterffy, chairman of Interactive Brokers Group Inc. (IBKR).

"[C]learing members that limit their activities to exchange-traded futures should not have to bear the risk presented by credit default swaps or other [over-the-counter] products in which they choose not to participate," Peterffy wrote in a letter the CFTC Friday.

Futures brokerage Rosenthal Collins Group LLC also submitted a letter warning of "catastrophic results" if the products are mixed.

CME is seeking permission from the CFTC to commingle customer funds tied to credit default swaps and listed derivatives, which the exchange operator sees reducing customers' cost to clear both types of business.

Citadel, a major participant in CME's futures markets and a trader of credit derivatives, said that CME's approach would effectively reduce systemic risk by diversifying customer risk across a broader array of asset classes.

CDS indexes--the basis for the most liquid swap transactions--have a low correlation to futures contracts cleared at CME, wrote Citadel's Cooper. Some of these products boast more liquidity than certain futures products, according to Citadel.

"Thus, Citadel believes that in the aggregate the assets relating to customer futures, options and CDS positions will constitute a more diversified pool of assets with less systemic risk," Cooper wrote.

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

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