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

2008)

Minority equity position acquired by Bank of New York Mellon Corp. (June
2009)

Clearing volumes exceed $1 Trillion (September 2009)

Clearing volumes exceed $3 Trillion (December 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 semiannual 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:

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

Q&A