Follow the leader

After Amundi became the first buy-side member of LCH’s credit default swap (CDS) clearing house in March, will this encourage other asset managers to follow suit? Writes Sarfraz Thind.

When LCH announced that Europe’s biggest asset manager Amundi had signed up as its first buy-side member for credit default swap (CDS) clearing in March, it marked something of a watershed.

Until now, buy-side firms have been inveterately shy of becoming signed up members of CDS central counterparties (CCPs). These are early days but some believe the move could be the first step for a return to liquidity in the single name CDS business which has languished since the financial crisis.

Amundi went live on LCH’s CDSClear platform and has already been clearing trades through its clearing broker BNP Paribas. Christophe Marcilloux, deputy head, fixed income dealing at Amundi, says there are some significant benefits to joining up as a direct clearing member.

“Before clearing we had the legal documentation in place with counterparties and traded bilaterally with them,” he says. “Now we have got a model that’s closer to what you’re seeing in the listed futures world. The combination of having both a strong CCP and being a clearing member helps to mitigate risk and makes the workflow easier while associated costs are reasonable.”

The move comes in preparation of the central clearing mandate under the European Market Infrastructure Regulation (EMIR) which requires clearing of certain index CDS products by August. While participants have looked at bringing in other initiatives to promote liquidity—the introduction of CDS futures is one such—getting the regulatory kick is something that, it is hoped, can really spur interest in CDS use.

Indeed Europe needs only look to the US for its lead. Central clearing of index CDS received its biggest boost in the US in 2013 with the clearing mandate issued under the Dodd-Frank Act. And, since then, clearing has soared. According to the Intercontinental Exchange (ICE), which operates ICE Clear Credit, the biggest CDS clearing house (CCP) globally, total notional volumes of cleared index CDS for the buy-side stood at $6.9trn in 2016, almost double the $3.7trn cleared in 2013, the year the mandate was issued.

A constant drive

In truth, CCPs in Europe have been attempting to get more buy-siders involved in clearing for a number of years now. LCHs drive to involve more buy-siders onto its own service actually began in 2012 but it has taken a while for this to bear fruit. The first stage was getting increased dealer liquidity.

“Reducing systemic risk is a goal for the whole market, so it makes sense for a CCP to serve both dealers and clients,” says Frank Soussan, global head of CDSClear at LCH. “We reshaped our CDS clearing model a couple of years ago to help grow our interdealer liquidity and market share. In turn, we have now reached a certain liquidity threshold that makes us more attractive for clients.”

Despite being better known as an interest rate clearing house, LCH does have a stronger presence in Europe than its competitor ICE. Amundi’s Marcilloux says the strength in Europe was one of the prime draws of the CCP.

“It provides us comfort to face LCH as we are happy with its risk methods and the fact it is based in [continental Europe so it can access European central bank liquidity,” he says. 

Given this first substantial move, Soussan believes that the advantages of central clearing are now likely to be embraced by more buy-siders trading CDS.

“The capital cost and funding benefits makes it worth the effort for institutions to clear,” he says. “There are also multi-lateral netting benefits by dealing directly with one CCP rather than multiple individual counterparties. Clearing brings more standardisation and increased transparency and we have seen volumes increase significantly over the last couple of years.”

Others are ready to follow Amundi’s lead. LCH has a further 10 to 20 buy-side firms ready to start direct clearing by the end of the summer on top of the 12 banks currently active on the service. This, says Soussan, will enable LCH to offer more choice to the market—the CCP has grown from 1% of cleared CDS market share in 2015 to 30% today.

Capital concerns

So could direct clearing convince more buy-side firms to trade CDS? Unfortunately it might not be that easy. Amundi’s reason for signing up to LCH was first and foremost a regulatory one rather than a means to venture into market making.

“The motivation is to comply with the EMIR regulatory obligations for buy-side accounts,” says Marcilloux. “We thought March was a good time because of the iTraxx and CDX index roll.”

The asset manager does run an intermediation subsidiary through which it deals with small and medium-sized external fund manager clients who could profit from going through Amundi’s direct membership with the CCP. But there remains much hesitancy among other European asset managers to use CDS.

“The combination of central clearing with delegating dealing to an intermediation service like our own could allow tier two and three asset managers to use CDS more extensively as it significantly reduces barriers to entry in the OTC market,” says Marcilloux. “But while the buy-side is often quoted as potentially changing from price taker to price maker so far it remains a move treated with some scepticism by our clients.”

Furthermore, clearing is an expensive business and an extra consideration to what participants had in the bilateral world. Cost considerations means clearing is not likely to be welcomed by all.

“Central clearing helps alleviate some counterparty risk but it has a cost,” says Olivier Renart, global head of credit trading at BNP Paribas. “With competing CCPs the cost of internal margining has to be taken into account. Netting is important for the market but the cost will be felt.”

Indeed, according to Martin Robertson, head of derivatives trading at Standard Life, there is a long way to go before the clearing mandate spurs volumes.

“The challenges in having a single operating model across multiple clearing members could be alleviated by buy-side firms becoming clearing members, however we believe that the capital costs involved mean that it is not a financially attractive option at the moment,” he says. “As was observed when interest rate swaps moved from bilateral to cleared, we do not expect any significant impact in volumes and liquidity when CDS move to cleared for Emir funds.”

Regulatory gaps

Despite the regulatory push to increase transparency and mitigate counterparty risk, which was seen as a major detraction of the over-the-counter market, there remain large gaps to fill across the world. The CDS market remains fragmented by regulations and domesticity. For example, the lack of a central clearing mandate on single names in the US—which in the US falls under the aegis of the Securities and Exchange Commission (SEC) and not the Commodity Futures Trading Commission (CFTC) which introduced the index mandate—has stymied growth in these contracts.

Participants have voiced the need for a single name clearing mandate which they hope will boost volumes in the product for some time. Early last year hedge fund giant Citadel, perhaps the prime buy-side player in CDS, wrote to the SEC to push through a mandate to fix the fractured CDS business. But nothing has been forthcoming so far.

Peter Borstelmann, head of corporate development for ICE Clear Credit, still believes that the single name CDS market is on an upwards curve. He says that growth in index clearing could have a knock-on effect on single names and there are new entrants coming in to make markets all the time.

“There’s been a push by market participants to have clearing become the standard,” he says. “The hope is clearing will lead to improved liquidity and enable additional participants entering the market. Despite some re-positioning by market participants, we have seen significant participation and growth in clearing of single names, especially by clients over the past two years.”

ICE cleared $142bn of single name CDS at the end of April this year compared to $10bn in 2014. It has also been clearing single name CDS for the buy-side in Europe, though volumes remain relatively small.

Josh Satten, director of business consulting at Sapient Global Markets, says the move by Amundi is a positive one—he believes that buy-side central clearing is being prompted by the desire of participants to get back into the credit market and clearing volumes should grow in the next few months as the market gains traction. However, in the wider scheme of things, getting buy-siders back into the single name CDS business will take more than a regulatory clearing push.

“You really need to see asset managers employing strategies that are CDS based to get the market going again,” he says. “CDS is similar to stocks-- you’re trading insurance on the underlying debt of a company—and you need to be able to hedge or arbitrage this. Futures aren’t a replacement, they’re a similar alternative with inherently different mechanics and modelling from swaps. You can’t arbitrage since there is no liquidity in single names.”

CDS clearing is now becoming a reality around the world. Whether it will lead to a revival of CDS trading is, however, another story.