Q&A: John O'Neill, Liffe

The Senior Analyst for Fixed Income at Liffe talks about the exchange's OTC service - Bclear - for processing OTC credit derivatives

Q: Last year in Europe we saw Eurex try to launch a credit futures contract, within a central order book - a market where people quote bids and offers on screen and prices are matched - the conventional exchange way of doing things. How does Liffe's approach differ?

A: Early last year, when we were doing our initial consultation with the market, we got two key pieces of feedback. The first was that the market wanted to continue to trade CDS contracts and wasn't willing to fundamentally change its products to designs that exchanges could implement more easily. In addition to some of the exchange futures that had been launched, we were also seeing products from the US side like binary options, but it was also clear that the market was not going to move to this approach. Number two, the market wasn't looking for price transparency; rather it was looking to continue to pre-negotiate transactions. It did, however, want to benefit from some of the advantages that exchanges can offer, particularly in terms of processing and clearing. Bclear offers the ideal solution for this.

Q: How have you engaged with the dealer community to frame your own plans?

A: Our approach to product development is co-operative: we talk to market participants and find which services we can offer, rather than asking them to change their business models. We are very well placed to act on the feedback I've mentioned, especially the preference for pre-negotiated CDS contracts, because we have our active and successful OTC processing service, Bclear.

Q: Can you tell us a little about Bclear and what it does?

A: We launched Bclear in October 2005 for the equity derivatives market, targeting single stock and equity index futures and options. We launched the service for equity derivatives because we were seeing a significant amount of OTC business that was based on our contracts, but wasn't coming to us.

People were opting to trade OTC for several reasons. First, confidentiality: OTC contracts are private, so prices are not posted on quote vendor feeds, as they typically are in the exchange-traded arena. Second, cost: in the traditional exchange model, payment is made per contract traded, which means if you perform very large trades you can end up with larger fees. Third, flexibility and product choice: in OTC, people can negotiate deals in any way they choose and also access a wide range of underlyings.

So in Bclear we addressed these things. We provided a facility for anonymous trading. We put a fee structure in place that is per lot, but with a fee cap, making the service good value for all trade sizes, particularly larger ones. In terms of flexibility, the Bclear model allows people to agree their deals in any way they choose. Transactions are pre-negotiated and entered into Bclear. From that point on, the trades are fully processed and cleared by the exchange clearing house. It's a very efficient way of doing business and it's been hugely successful for equities - we've had more than 250 million contracts traded, with a notional value of $7 trillion and it's very widely used by the major broker-dealers.

Q: What are the advantages of using Bclear for CDS?

A: In CDS there is a big effort both by both market participants and regulators to make the market more secure and more efficient. In CDS markets it can, on some occasions, take days, or even weeks, for transactions to be confirmed. With Bclear, counterparties pre-agree the trade in any way they choose, and enter it into the system. Trades are then confirmed and processed on the same day, as standard. Dealers will receive a print of their half of the trade in their back office, typically within a few minutes. Then at the end of the day the trade will be fully cleared, making LCH.Clearnet Ltd the central counterparty.

As well as faster confirmations, this has a number of other benefits: it means the transaction is processed automatically, so things like coupon payments are paid over the life of the deal. Perhaps most importantly, central clearing means credit risk is reduced. In the current environment some banks are less secure than others, but if you use Bclear you no longer have to have concerns about your counterparty. At the moment if you have 10 different deals with 10 different counterparties you have to secure all those individual deals, but with central clearing you don't have 10 different deals - they become a single deal against a single counterparty. You can move in and out of the same deal with different counterparties. So you have a smaller exposure and you have to commit less capital to secure that exposure. It's a very capital-efficient process.

Q: That works for different deals in the same contract, but what about deals across several different contracts?

A: In any one contract you can net your exposure perfectly. Clearly that is not possible if you open positions in different contracts, but there is still a very large benefit in the form of margin offsets. Let's say you have a certain position in the Investment Grade and another position in HiVol. Two different positions, but because they're closely correlated in terms of risk, rather than having to outlay the full capital to secure both those positions you'll get a very significant reduction because of their risk correlation. So you're still freeing up capital, which in the current climate is obviously critical.

Q: Are the contracts you are dealing with the standard index CDS, or have you changed anything?

A: They are CDS contracts - we're not offering other product types such as futures or options. They have the same cashflows; index contracts in the CDS market trade on a standardised coupon level, so if you trade iTraxx series 9 today you will trade at 165bp. Our contracts will work in the same way and the coupon will be processed in the same way. Because index contracts are traded at a standardised level, all the trades on the same coupon can be perfectly netted. This means that in terms of portfolio compression, index contracts offer the perfect model for central clearing.

Q: Is this product exchange-traded?

A: It's not an exchange-traded product because people don't agree the deal at the exchange. Earlier I was stressing that the transactions are pre-negotiated and actually we describe Bclear as an OTC derivatives service. Our research shows that the credit market is not demanding a model where price transparency is introduced.

The proven success of Bclear for equity derivatives has also helped significantly. It is used by all the major institutions and is particularly popular for the buy side; that is hedge funds, money managers, real money funds. There are also a considerable number of interdealer transactions on Bclear.

The benefits are huge for the buy side. They can have their transactions processed very efficiently, they can have them centrally cleared and they can also have them risk-managed and margined in an efficient manner. This model has been very successful for other types of derivatives and the CDS market is particularly looking for these benefits.

Q: Are you planning to focus specifically on iTraxx Europe index contracts or will you offer other CDS contracts too?

A: We certainly can offer other contracts and we certainly expect to make further announcements on this soon. We already have the right approach for index contracts. The bigger challenge, and this isn't particular to the Bclear model but is true for CDS clearing solutions generally, would be clearing single-name CDS contracts. As you know, single names trade on a variable coupon level. Trades on different coupons would be held at different levels within clearing. So there are benefits from central clearing, but they aren't as immediate as for index clearing. I think the evolution of our product set will be iTraxx initially, then we'll look at other index contracts, and then we'll look at single names.

Q: Now is a time when people are really looking at this area in detail and trying to offer competing solutions. What is the environment like for launching this sort of product?

A: The climate is perfect for clearing solutions for CDS at the moment. We were confident this was the right model for the market even prior to the credit crunch, and although we've only announced our plans this year, it is something we've been working on for some time.

Q: What are the main differences between your proposal and the others that have been announced?

A: The Clearing Corporation solution is an interdealer solution where only the largest banks clear trades with each other. The main difference between that solution and ours is that we cover the dealer-to-customer market, as well as the interdealer market. We are also very happy to be clearing into a well-capitalised and active clearing house, LCH.Clearnet Ltd. That is very important - the capital required to set up a clearing house from scratch is considerable.

Q: Do you use the DTCC trade information warehouse?

A: We don't process via DTCC. We already we have a proven and successful processing route in Bclear that is present in all the major dealers. By using Bclear we can process and clear CDS transactions and enter them into clearing through our own independent route. The key point is that Bclear is proven and being successfully used within these institutions at the moment.

Q: You are seeking a broader client base rather than working with a small group of key dealers. Have you experienced any opposition to that approach?

A: Given the history of exchanges in this space you might expect there to be opposition from the major dealers, but that really hasn't been the case. We've taken a co-operative approach, consulting with them extensively before we even announced our plans.

Really, we've gone for an offering that doesn't require people to change their business models. We offer a set of services that help them. The fact that these institutions use Bclear at the moment, albeit for a different derivatives sector, gives them confidence that it's a system and approach that can work for them and link them to customers on the buy side. It is not a threat to any of the institutions, it's really a service that adds value for them.

Q: Do higher volumes due to the credit crisis create a clearer rationale for this and other solutions?

A: A few years ago there was a lot of concern in the industry at how serious confirmation backlogs had become - you even saw contracts expiring without being confirmed. At that time regulators put pressure on the CDS market to improve, and you saw, through the adoption of some electronic tools, those confirmation times reduce considerably. However, last year when market volumes exploded the confirmation times crept back up again. This suggested that, rather than fundamentally changing processing solutions, people had basically thrown bodies at the problem. Now I think there is a real determination from the regulators and from the major market participants to change the infrastructure, to make sure this market works in a more efficient way and can handle large volumes, spikes, credit events, other things that may unfold. Bclear fulfils this requirement perfectly.

John O'Neill is a Senior Analyst within Fixed Income Derivatives at Liffe, the international derivatives business of the NYSE Euronext group. He joined Liffe in 2001 and is responsible for identifying and developing new product opportunities within Fixed Income Derivatives, and working with sales and development teams across the group to turn these opportunities into reality. A graduate in aeronautical engineering from the University of Bath, he holds the SII certificates in Derivatives, Securities and Financial Regulation, and the ACI Dealing Certificate.

Liffe is the brand name of the derivatives business of Euronext - a subsidiary of NYSE Euronext - comprising the Amsterdam, Brussels, Lisbon, London and Paris derivatives markets. This notice is for informational purposes only and does not constitute an offer, solicitation or recommendation to acquire or dispose of any investment or to engage in any other transaction. Those wishing either to trade in any products available at Liffe or to offer and sell them to others should consider both their legal and regulatory position in the relevant jurisdiction and the risks associated with such products before doing so. Potential users of Liffe contracts should familiarise themselves with the full contract specification of the product concerned and any associated information.

Bclear is operated as a clearing service by LIFFE Administration and Management, which is regulated by the Financial Services Authority as a Recognised Investment Exchange. Those wishing to use Liffe's wholesale services should consider their regulatory position in the relevant jurisdiction before doing so. The Bclear service is currently not available to United States persons.

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