November 14, 2008

(The Desk) Those International Derivatives Clearing Group guys (IDCG) were probably thinking a couple months back that the timing on their new electronic exchange was god-awful. Banks were dropping out of the sky. Congress was trying to slam through all sorts of misbegotten laws in the financial and energy sectors, derivatives and anybody associated with them were essentially bad guys, and the election loomed. Nobody wanted to know about another electronic exchange, whether it was focused on energy or interest rate swaps. The market was saying, "Go Home." Or so we thought. Amid the chaos, however, a growing voice in the wilderness on Capitol Hill continued to chant the accursed "T" word. Transparency. None of them really knew what it was, but by God, they were gonna get some. And quick. "We need more transparency in the OTC derivatives space," the members crowed, "because more transparency means less risk and less manipulation…" And so the story goes. By Summer's end, we reckon IDCG CEO Chris Edmonds and the rest of the crew in NY were thinking that perhaps the timing of their forthcoming launch might actually have been spot-on. More OTC clearing? More transparency in the derivatives space? Less risk? Check, check and check.

Perhaps it takes a good market meltdown to ensure a truly successful derivatives exchange launch in US markets. We're reminded that ICE and NYMEX Clearport rose from the ashes of Enron and the post-9/11 world. The new exchange takes its process lead more or less from NYMEX. It is offering market participants the ability to replace their existing portfolio of bilateral interest rate swap contracts "with economically equivalent listed IDEX Swap Future contracts." Converting swaps for futures. Sound familiar? The contracts will be cleared and settled through International Derivatives Clearinghouse. In addition, members of the exchange will also be able to clear and settle new OTC interest rate swap contracts traded bilaterally with dealers. This market will be enormous.

We hooked up with Edmonds late last week for more detail.

"This is the only many-to-many market out there that I'm aware of for these contracts. We're offering full democratization of the market – equal access by way of the credit component. You want to talk about transparency? This is it. We're going to be offering futures here. Cleared swaps that trade just like they do in the OTC world, yet with the ability to manage the risk as a future. More importantly, I'm going to know every day with certainty who's in and who's out. If a company can't make margin calls, the rules will kick in," he says.

Transparency in OTC? You mean, the market is fixing itself? We reckon we'll be hearing Edmonds speaking before House committees before too long. He says during the development stage they presented the business model to FDIC Chairman Sheila C. Bair. "She got it. They realized that the regional and subregional banks, whose deposits they guarantee, have to deal with money center banks and dealers for getting prices to hedge their interest rate risk– yet they have no idea how or what these guys are doing on the other side of the trade. And until the other side is actually insolvent, they have no way to react. Our exchange will have large trader reporting and other elements you'd expect to see from a regulated clearinghouse/exchange," he says. "Transparency in a huge market that's never really known any."

The technology behind the exchange is fully OM-designed and developed. In the exchange world, this means it's gold-plated. Also behind the exchange, besides a lot of former NYMEX glitterati, is NASDAQ, a sizeable investor in the new operation. According to the application on fi le at the CFTC, the exchange will have a sizeable guarantee fund from the get-go, which should also grow accordingly.

We had to ask the obvious about why the exchange is focused on interest rate swaps when most of the guys driving this thing have spent years on the energy side. Edmonds himself was a longtime senior exec with ICAP's huge energy commodity group. Low hanging fruit? "Well, there are a lot of people chasing CDSs right now. Interest rate swaps markets are about eight times larger notional value-exposed than the CDS market. And it's not centrally traded or cleared anywhere."

Edmonds agrees that parallels can be drawn between the current market and the period following the fall of Enron. Just as Clearport helped bring sanity back to the energy market seven years ago, he sees his exchange helping to bring some sanity back to the broader marketplace. Shorten the market doldrums? "I would have to agree."

Buried somewhere inside some filing by the company is the implication that interest rate swaps are possibly just the beginning. Edmonds says they plan to open the offering with plain vanilla, US-denominated interest rate swaps and, as an encore, to march through the G-7 currencies, then Latin American (investment grade) currencies. "Once we establish the traction of the plain vanilla products, the commoditization of these products, then you can see the opportunity for some more exotic products, which have more homogenous components. We may see swaptions and the like."

We wondered why CDSs never entered into the discussion. Another big market in need of a solution like the one planned here. Edmonds more or less dodged the question, suggesting that the interest rate market is plenty big by itself. But based on the current open combat over clearing CDSs, we reckon that at this point the IDGC crew is more interested in watching the ICE and CME eat each other over CDSs market… and perhaps take another look in the future. One never knows. Harking back to all the changes that evolved from the rise of cleared OTC energy a few years back, Edmonds says he expects to see similar changes in the OTC derivatives space in the near term with the creation of more exchanges like his. Lots of new players, new systems and countless new linkages between a widening array of markets, interests and geographies. "Imagine this. If we had the same systemic risk we're experiencing now, but spread out not across 19 dealers, but rather spread across 2,000 counterparties in an all-to-all marketplace, we might have been able to swallow many of the problems we see now."

For the voice broker community, Edmonds says "there will be incentives" to drive business his way. He wasn't specific. The exchange is expected to open for business in early '09, according to reports.

Reprinted with permission of the publisher. Scudder Publishing Group, LLC, copyright 2008.

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