Deconstructing Derivatives Disclosure - Part 4, Derivatives Positions Of Futures Exchanges

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Includes: CME, ICE
by: Kurt Dew

Summary

The exchange clearing firms -- Clearnet, CME Group, and Intercontinental Exchange -- are in trouble.

Yet they appear quite complacent.

I list several problems they face in the coming year, all soluble.

Sell CME Group.

To complete my discussion of derivatives disclosure for now, this article focuses on derivatives reporting, pricing, and risk management of the Exchange management companies clearing derivatives and regulated by the Commodities Futures Trading Commission (CFTC).

The derivatives markets cleared by exchanges: financial futures markets and OTC dealer swaps markets, are best described separately.

Financial Futures Markets
Futures contracts are the less risky of the two and the easiest to follow. Traders of these markets, like traders of stocks, run the gamut from individual traders, trading for their own accounts, to large dealer banks.

A financial futures contract is an agreement between buyer and seller, at a specified purchase price, to settle a contract by seller's delivery to buyer of the underlying security specified by the futures contract, on a specified future date. This is called settlement by delivery.

Alternatively, as with the two largest futures contracts by volume traded, the Eurodollar contract and the S&P 500 contract, the seller and buyer make payment of variation margin (value at final settlement less value at previous settlement) based on the value of an externally provided price index. This is called cash settlement.

The futures exchanges provide four primary functions:

  1. Matching buyers and sellers.
  2. Recording market prices.
  3. Collecting and paying variation margin.
  4. Replacing any credit risk between counterparties with that of the exchange.

The terms of futures contracts require both holders of long and of short positions to mark their positions to market in cash by payment of variation margin at least once each business day. A long that sells out has exited the market, a characteristic of futures and securities trading called offset.

The clearing house serves as the counterparty to both long and short positions. The futures exchanges also capture market prices of trades which are used to determine variation margin payments, and settlement prices for futures contracts closed by physical delivery. The same mechanism determines daily variation margin payments for cash settlement contracts, except for final settlement.

I have earlier argued, here, that CME Group (NASDAQ:CME), the larger of the two United States exchanges, has shown no creativity for 35 years. This I consider an adequate length of time to give them. Before the Exchange, which has already lost its OTC interest rate swaps franchise, loses the rest, management should be changed. CME has underperformed the other major futures exchange, Intercontinental Exchange (NYSE:ICE) - in spite of its great tradition of innovation which came to a screeching halt when it went public.

I find this lamentable for two reasons, one parochial; the other, global. Parochially, London is taking OTC interest rate swap clearing away from the United States. Ultimately this will further enhance London's position vis-à-vis that of the New York-Chicago trading axis. This competitive threat from London has a history that begins with the capture of Eurodollar and Forex trading in the early 70's due to British regulator's preoccupation with commercial business at the expense of market safety on one hand, and United States' foolish attempt to maintain Regulation Q deposit ceilings on the other.

The competition between the United States and London has everything to do with both financial innovation and lax regulation - in short, a two-edged sword. But the source of creativity has always been American financial institutions; the ability to actually implement these creative concepts, sourced in London thanks to lax regulation there.

The bottom line is this: Although the United States could take back OTC interest rate swaps trading with the right innovation, explained here, the exchanges' innovative spark has gone out.

Combined with the stiff competition the stock index futures are getting from exchange-traded funds (EFTs), I am afraid CME's days are numbered. And ICE, about to become an energy products clearer only.

OTC Clearing Counterparties
OTC Clearing Counterparties ("OTC CCPs") are similar to futures exchanges, but far less efficient, more expensive, and risky. There are two OTC derivatives cleared in substantial volumes: OTC interest rate swaps (on LCE: Clearnet and CME Group ); and credit default swaps (ICE Clear Credit and ICE Clear Europe ).

As I indicate above, OTC interest rate swaps, the simpler and "cleaner" of the two OTC derivatives products, will - absent a wake-up call to CME - wind up subject to the tender mercies of combined British and Continental European regulation. Good luck with that!

Credit default swaps, the other significant OTC cleared derivative, is a thicket. In my third article on derivatives reporting of financial institutions, "Deconstructing Derivatives Reporting Of Banks - Part 3, User Banks," I discuss the problems of bank OTC credit default swap reporting. For a thorough discussion of the coming crisis in credit default swap clearing see "Can the Credit Default Swap Market be Salvaged? Issues for Borrowers and Investors," from Kroll Group, here. This Kroll Group article describes the market's slow retrenchment, identifies the underlying flaws of the market, and recommends some sound regulatory fixes.

But while the financial world fears a sudden blow-up, such as those narrowly averted in the AIG-bailout and the bankruptcy of Lehman Brothers, I suspect (as does Kroll) a slow lingering death. I have no remedy for credit default swaps, unlike the ones I propose for interest rate swaps.


Slow, lingering death.

Overriding any improvement in the dire condition of these markets is the clearing management firms' evident complacency, and the dealer banks' determination to maintain the status quo.

Elsewhere I indicate the telltale signs of the OTC markets' decline. In short, there are fewer derivatives dealers, processing fewer trades. This in spite of indications of rising demand for hedging by commercial hedgers such as user banks and nonbank customers on the demand side of the market; accompanied by an increased appetite for risk on the buy side. As the dealer banks vacate the intermediation process, hedge fund managers such as Citadel appear prepared to step into the void.

In summary, the clearing of financial futures is pressed by stock exchange vehicles such as ETFs, while OTC clearing seems to be suffering from rapidly declining dealer participation, perhaps due to falling profitability of clearing brokerage. All of which could be reversed by a little creativity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.