Credit Default Swaps: Growth in Clearing & Futures

Post-2008, there has been an extensive industry and regulatory effort to strengthen the credit default swaps (CDS) market. CDS instruments play an important role in hedging the credit risk exposure for bondholders and credit issuers. Because credit derivatives are a relatively new instrument and the market is still developing, there’s room to innovate and enhance liquidity and security. At ICE, we approached that opportunity on two fronts. First, we considered how to help establish transparency and rebuild trust in CDS markets and, second, we explored ways to make instruments for hedging credit exposure more accessible to a broad range of market participants. While the questions were complex, the answers were straightforward: clearing and futures.

Restoration & Expansion

After the financial crisis, there was a need to find safer, more transparent means for trading and settling CDS. In 2009, we responded by investing in the development of the world’s first CDS clearing houses, ICE Clear Credit (formerly ICE Trust) and ICE Clear Europe. What resulted is a global, market-leading clearing solution where market participants clear over 500 CDS instruments in a secure and efficient manner. This includes global CDS indices, corporate single names and sovereign debt instruments.

“Central clearing reduces systemic, counterparty and market risk,” says Stan Ivanov, President of ICE Clear Credit. “We wanted to apply the benefits of central clearing to CDS to improve transparency and liquidity for the market.”

With over $80 trillion cleared to date, we’ve seen substantial growth since being the first to launch CDS clearing in 2009. Market participants have helped shape the direction of our offering, and while the majority of cleared activity is in index instruments, buy-side demand for single name instruments is growing.

Over the past two years, the buy-side has begun to voluntarily clear single names to achieve capital efficiency and manage counterparty risk ahead of any regulatory mandate. In late 2015, 25 investment management firms signed a public letter committing to single name CDS clearing. The letter declared their intent to: (i) improve structure of fixed income markets while increasing efficiencies where possible; (ii) support single name CDS clearing with the goal of improving liquidity, transparency and market efficient pricing; and (iii) encourage broader market participation in the single name CDS market.

The shift toward cleared swaps becoming the standard is apparent. November 2016 was the strongest month on record for buy-side single name CDS clearing, with more than $27 billion in notional cleared. The previous record month was September 2016 when $24 billion was cleared. By March 2016 buy-side single name clearing had already surpassed all of 2015 both in terms of notional and number of transactions. Total 2016 notional cleared as of December 2016 is over $180 billion, five times more than the total in 2015.

“These numbers are driven by the strong commitment from the buy-side to voluntarily clear single name CDS,” continues Ivanov. “So far in 2016, over 59 new buy-side institutions have cleared single name CDS through ICE Clear Credit, bringing the total to more than 115 firms.”

When asked about the factors supporting the shift to voluntarily clear single name CDS, customers consistently mentioned the following:

  • Margin efficiency
  • Effective counterparty risk management
  • Improved pricing
  • Trading anonymity
  • Operational efficiency
  • Regulatory capital relief

We expect continued participation and improvement in liquidity as the market shifts towards clearing single name CDS as standard market practice.

Innovation

In 2015, we introduced two credit index futures instruments, backed by the patented ERIS methodologyTM. Trading on ICE Futures U.S., the cash-settled ERIS HY and IG Credit Index Futures (5 Year) replicate the economics of the underlying swap. The contracts offer the ability to express credit views in an efficient manner for investors who are unable or unwilling to trade the swaps.

Since the start of 2016, existing customers and new participants have shown heightened interest in trading credit index futures. The contracts have seen record trading volumes combined with near successive record days for open interest in recent weeks.

“There is a broad set of clients who want to hedge their credit exposure or take a view on credit without trading a swap,” says Krishan Singh, President of ICE Swap Trade. “What we’re doing with the ERIS Credit Index Futures is designed to offer a new client base access to the most widely traded underlying indices in the credit market. The goal is to increase the number of participants in the credit market and we’re excited about our recent progress.”

How ERIS Credit Index Futures Work

Replicates the cash flows and economics of analogous OTC swaps including price alignment interest (PAI)

Cash Flows are Consolidated Into a Single Cash Flow in the Form of Variation Margin

Cash Flows are Consolidated Into a Single Cash Flow in the Form of Variation Margin

Simple post-trade futures workflows

ERIS Products Remain Outstanding As Futures Until the Maturity Date (e.g., 5Y Will Remain a Futures Contract For 5 Years)

Cash settled at maturity with no risk of physical delivery
Futures clearing economics, operations, regulatory treatment throughout contract life

Replicates Swap Conventions

First trading date, maturity, coupon date and amounts, credit event

Successful Launch of ICE Swap

We continued innovating in the credit market with the successful launch of ICE Swap, a platform that enables trading cleared single name CDS in a central limit order book. ICE Swap’s electronic trading technology consolidates orders from both buy- and sell-side market participants to create a pool of liquidity for single name CDS. It’s the first platform to include both anonymous and ‘name give up’ execution in the same order book, meaning participants can choose to reveal their identities after a trade is completed.

“ICE Swap is the only single name CDS platform offering cleared-only liquidity across the credit spectrum while extending established electronic trading protocols to the entire CDS market,” says Singh.

A number of trades were executed by both the sell-side and buy-side in the first few days following the ICE Swap launch, demonstrating that the platform was a welcome addition to the CDS market.

“Ahead of the launch of ICE Swap, we worked closely with market participants to optimize our protocols to improve liquidity, transparency and confidence in this important market,” continued Singh. “We’ll continue staying close to participants to ensure we’re innovating and providing comprehensive, industry-leading CDS services as the space evolves.”

Additional Information