The Challenge of Central Clearing for
Over-The-Counter Interest Rate Swaps
Robert O'Mara
Tracy Pridgen
Smita Vemulapalli
Interest Rate Swaps
NYU SCPS X51.9240
June 2010
Overview

OTC Interest Rate Swap Market

Central Clearing

Benefits of Clearing

Other Markets that use Clearing

Challenges for Clearing OTC IR Swaps

International Derivatives Clearing House (IDCH)

Benefits of Clearing IR Swaps through IDCH
What is the OTC Interest Rate Swap Market?

The OTC interest rate swap market is the largest derivative
asset class in the world.



IR swaps are OTC.



As of June 2009, the notional amount outstanding in OTC
interest rate swaps was $342 trillion. [Source: Wikipedia]
It is estimated over a trillion dollars in notional trades every
day.
Unlike older derivative asset classes such as forwards and
options, interest rate swaps do not trade on exchanges.
Consequently, they are referred to as trading "over-thecounter“
Interest rate swaps are an integral part of the fixed-income
market.
What is Central Clearing?
A clearinghouse is a financial institution that provides clearing and settlement
services for financial and commodities derivatives and securities transactions.

Clearing:



Settlement:



In banking and finance, clearing denotes all activities from the time a
commitment is made for a transaction until it is settled
Processes included in clearing are reporting/monitoring, risk
margining, netting of trades to single positions, tax handling, and
failure handling.
Settlement (of securities) is the transfer of securities or cash in order
to fulfill the contractual obligations.
Settlement is facilitated by clearing processes such as netting and
novation.
The clearing of the OTC transactions is called OTC clearing.
What is Central Clearing?

A modern clearinghouse serves as the central
counterparty to each member.

The "buyer" for every seller

The "seller" for every buyer

Typically, a clearinghouse is capitalized by its
members and provides a standard template for
trade contracts, pricing and dispute resolution.

It can be traced back to the 18th century.
Central or multi-party clearing is a means of trade settlement that
mitigates the risk that one party to the trade will fail to perform (i.e. default).
What is Central Clearing?

Services provided by a clearinghouse include:

Netting/offsetting transactions from multiple
counterparties

Provide independent trade price and valuation of
collateral

Monitor the creditworthiness of member firms

Collect and maintain margin on existing trades

Establish and maintain a guarantee fund
What is Central Clearing?
The diagram below shows an OTC market
without central clearing
• All parties can trade with every other party
• Terms vary depending on bilateral
agreement
• Dealer defaults borne by direct
counterparties
• Notionals are double-counted (in the case
of offsetting trades)
• Regulators have limited view of true
exposure
• Limited pricing data available
What is Central Clearing?
The diagram below shows an OTC market
with central clearing
• Clearinghouse is the counterparty to every
trade
• Dealers negotiate bilaterally but clear
centrally
• Terms are standardized
CLEARING
HOUSE
• Members report prices regularly
• Members contribute to a guarantee fund
and post margin on individual trades
• Dealer defaults borne by all members
• Notionals netted automatically
What Are the Benefits of Clearing?
There are multiple benefits to central clearing,
however, policymakers tend to focus on the
following three:

Mitigation of systemic risk

Operational efficiency

Improved transparency
What Are the Benefits of Clearing?

Mitigation of systemic risk

Central clearing mutualizes counterparty risk. All
members face the default risk of all other
members. This incentivizes members to limit the
risks taken by the clearinghouse.

The clearinghouse is capitalized with contributions
from all members and, consequently, has lower
counterparty risk than any individual member.

The default of a single counterparty is unlikely to
trigger the default of another counterparty
because the losses are borne by all members.
What Are the Benefits of Clearing?

Operational efficiency

Clearing facilitates “netting,” reducing the total
number of contracts and the notional amount of
outstanding trades.

Clearing requires contract standardization.

Fewer trades to track and greater standardization
would speed settlement time and reduce the
number of errors.
What Are the Benefits of Clearing?

Improved transparency

The net position of the clearinghouse as well as
net exposures of each member is known.

Both regulators and risk managers would benefit
from this.

Regular price reporting from all clearinghouse
members.
What Other Markets Use Clearing?

Clearing is an important part of markets
worldwide, both on-exchange and offexchange.

Examples of major clearing operations include:

The Options Clearing Corporation: equity and bond
derivatives

LCH.Clearnet (formerly the London Clearing
House): a broad range of asset classes

The Intercontinental Exchange (“ICE”): a broad
range of asset classes including energy and credit
derivatives
What Are the Challenges for Clearing OTC
Interest Rate Swaps?

The biggest challenge for clearing OTC interest
rate swaps is the non-standardized nature of
the product.

Terms are highly negotiated for:

Tenor

Rate

Notional value

Calculations

Assumed Rate Curves
The First Interest Rate Swap Clearinghouse
International Derivatives Clearing House (IDCH)

Wholly-owned subsidiary of the International Derivatives Clearing Group
(“IDCG”), founded by Vincent Viola, the former Chairman of NYMEX
Holdings, Inc., the parent company of the New York Mercantile Exchange,
Inc. (March 2007)

Filed a Derivatives Clearing Organization (DCO) application with
prospective regulator, the Commodities Futures Trading Commission
(“CFTC”) (August 2008)

Clearinghouse operations went live (December 2008)

Majority equity position acquired by NASDAQ OMX Group, Inc. (December

Minority equity position acquired by Bank of New York Mellon Corp. (June

Clearing volumes exceed $1 Trillion (September 2009)

Clearing volumes exceed $3 Trillion (December 2009)
2008)
2009)
International Derivatives Clearing House (IDCH)

IDCH, as a CFTC-regulated derivatives clearing
organization, provides a transparent forum for its members
to clear and settle Interest Rate Swap derivatives.

Trading, investment, and market-making firm members of
IDCH can clear and settle new and existing OTC interest rate
swap contracts traded bilaterally with dealers.




IDCH converts the members’ existing OTC Interest Rate Swap
contracts into economically equivalent, listed IDEX USD Interest
Rate Swap Future™ contracts with maturities up to 30 years,
using a proprietary Exchange of Futures for Swaps (EFS) process
via SwapDrop.com.
The contracts are then cleared and settled through IDCH,
provided both parties to the original agreements confirm the
novation of the contracts to IDCH.
SwapDrop.com allows members of IDCH to execute an OTC
transaction off-exchange for clearing through IDCH.
By utilizing the EFS process, IDCH is able to provide customers
the benefits of central clearing while maintaining the principles
and economics of the OTC market.
Exchange Listed IDEX USD IRS Future™ contracts

IDEX USD 3 Month &1 Month Interest Rate Swap Futures
IDCH centrally clears 3 Month (IRS-3M) and 1 Month (IRS-1M) Interest Rate Swap Futures
contracts designed to be economically equivalent to plain vanilla IRS contracts currently traded
in the OTC market. IRS Futures are contracts on USD denominated interest rate swaps with a
notional value of $100,000, requiring the exchange of periodic semi-annual fixed rate
payments based on the futures price in exchange for quarterly & monthly floating rate
payments.

IDEX USD 3 Month &1 Month Forward Start Interest Rate Swap Futures
IDCH centrally clears 3 Month (FS-IRS-3M) and 1 Month (FS-IRS-1M) Forward Start Interest
Rate Swap Futures contracts. The FS-IRS are contracts on USD denominated interest rate
swaps with a notional value of $100,000 and a deferred Effective Date, requiring the exchange
of periodic semi-annual fixed rate payments based on the futures price in exchange for
quarterly & monthly floating rate payments based on the USD LIBOR.

IDEX USD 3 Month & 1 Month Forward Rate Agreement Futures
IDCH centrally clears 3 Month (FRA-3M) and 1 Month (FRA-1M) Forward Rate Agreement
Futures contracts. The FRAs are contracts on USD denominated Forward Rate Agreements
with a notional value of $100,000 and a deferred Effective Date, requiring the exchange of a
quarterly & monthly fixed rate payment based on the futures price in exchange for a quarterly
& monthly floating rate payment based on USD LIBOR.

IDEX USD OIS Interest Rate Swap Futures
IDCH centrally clears OIS Futures contracts (OIS). The OIS Interest Rate Swap Futures are
contracts on USD denominated interest rate swaps with a notional value of $100,000,
requiring the exchange of periodic annual fixed rate payments based on the futures price in
exchange for annual floating rate payments based on the Fed Funds Effective Rate
compounded over the life of the contract.
Benefits of Clearing IRS Contracts through IDCH

Market participants who use the EFS process to convert their OTC
interest rate swaps to cleared IRS futures through IDCH reduce
bilateral counterparty credit risk and simplify the ongoing
processes required to manage such relationships.

The substitution of bilateral counterparty credit risk with a
regulated clearinghouse enables a much greater number of
market participants to interact with one another with greater
confidence.

Additional potential benefits to centrally clearing IRS futures
contracts through IDCH include:



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Standardized valuations for cleared IRS futures contracts
Contracts are margined in a transparent, standardized process
IDCH cleared contracts qualify for 60/40 tax treatment, similar to
other futures contracts
Reduction to capital reserves required for bilaterally settled OTC
derivative contracts, synthetically increasing market participants’
available free capital
IDCH Benefits from Marketing Materials
Transaction Comparison
IDCH
Current OTC Bilateral
Pre-Trade
 Establish relationship with a clearing
member
 Provide initial margin
 Negotiating master agreements is a
prerequisite
o ISDA Agreement
o Collateral Agreement
 Counterparty credit review
 Establish credit and trading limits
Trade
 Execute trade bilaterally or electronically
for clearing via IDCH
 No curve negotiation: transparent IDCG
Interest Rate Curve
 Two parties agree to transaction
o Usually over the telephone
o Potential for asymmetric
information among participants
o Yield curve negotiation
Post-Trade
 Receive trade details via SwapDrop™
 Position is marked-to-market and margin
account is adjusted
 Settlement bank handles cash flows
 Trade capture
o Manual or Automated
 Economic affirmation
o Counterparties verify key economic
details
 Confirmations required
o Either one party provides trade
details and the other verifies; or
both parties submit trade details and
both parties match confirm
Aggregate
Time to
Complete
Trade
1 Day
9 Days (2008 average)
Q&A