The ICE Age
As the financial crisis exploded with full force in 2008, it was obvious that something was gravely wrong with the huge, unregulated market for derivatives. Lehman Brothers had $738 billion of these contracts—which are based on the value of some other asset, such as a stock or a bond or a hog belly—on its books when it failed on September 14, 2008.
Lehman certainly wasn’t alone. Over the next few months, insurer AIG reported as much as $53.5 billion of derivatives losses—losses that were linked to nearly one third of its $182.5 billion federal bailout. The scope of this derivatives exposure was beyond anything investors had ever seen. Enron, which had failed just a few years before, had only $22 billion in derivatives contracts on its books.
President Obama proposed soon after he took office that his administration would crack down on derivatives, an idea that had been kicking around Washington for decades. Yet a year and a half after Lehman’s collapse, slow-moving regulators and lawmakers have made only halting progress toward imposing law and order on the Wild West of the financial world. And the problem just keeps getting worse. Derivatives are at the heart of the debt crisis in Greece, where the government, with the help of Goldman Sachs, used currency swaps to take advantage of exchange rates by making its dollar- and yen-denominated debt look like cheaper euro-denominated debt.
In December 2009, the House of Representatives finally approved a far-reaching bill to reform the financial regulatory system, including a requirement that derivatives be traded on a clearinghouse, a key plank in the administration’s reform platform. Yet the bill is making no discernible progress in the Senate, where it has been bogged down for months in a bitter partisan dispute.
As the lawmakers argued over the details of the bill, financial institutions have quietly grabbed the initiative for self-regulation. A year ago, on March 9, 2009, a group of banks began clearing derivatives on a new entity called ICE Trust US, a clearinghouse owned by Intercontinental Exchange Inc., of Atlanta, which operates futures exchanges and over-the-counter markets.
Intercontinental is hardly a household name, but it has been a major force in alternative forms of trading since it was founded in 2000 by Jeffrey Sprecher, a former power plant developer. Today, the company is listed on the NYSE and has a market cap of $8 billion.
With its deep roots in the financial world, Intercontinental was able to enter the promising new derivatives clearing market in a forceful way. In October 2008, Intercontinental acquired The Clearing Corporation, of Chicago, which provides services for over-the-counter derivatives trading. TCC’s ownership roster was like a who’s who of banks: Bank of America, Citi, Goldman Sachs, JPMorgan Chase, Merrill Lynch, Morgan Stanley, Deutsche Bank, UBS, and Credit-Suisse. TCC and ICE then formed ICE Trust US, to clear trades for derivatives known as credit default swaps, which can be used as a form of insurance against credit defaults. It focuses on trades among banks and brokers.
Intercontinental takes half of ICE Trust US profits, and the nine founding banks split the remaining profits. Over the last few months, Barclays, HSBC, the Royal Bank of Scotland, and BNP Paribas have been approved as trading members of ICE Trust US, although they don’t have an ownership stake.
While political leaders in Washington called for a new clearinghouse system and wrangled over the details, ICE Trust US was getting down to business. During the nine months between March 2009 and December 2009, ICE Trust US processed $3.1 billion in trades of credit default swaps and collected $258 million in fees—which is sort of like a car dealer saying it sold $200 million worth of cars and took in $15 million in revenue.
That accounted for 12 percent of the $26 trillion market for U.S. CDS. And ICE Trust Europe, a related company that is wholly owned by Intercontinental but includes member banks such as BNP Paribas and Nomura, cleared $1.2 billion in CDS trades.
If the Senate ever gets around to passing the clearinghouse requirement, ICE Trust US market share could explode. The big banks that belong to ICE Trust US control more than 90 percent of the U.S. market, according to the Comptroller of the Currency. And they will have the ability to steer business to their clearinghouse and profit from it.
At an operating level, ICE Trust US is just what the administration ordered, although the ownership structure already has caused some objections in Washington. Its main rival in the U.S. is the CME, in Chicago, which has yet to get off the ground. Right now, member banks can choose whether they want to put a trade on a clearinghouse. But if that becomes a matter of law, at least the banks will own the clearinghouse. That ownership structure is already raising concerns.
"You don't want clearinghouses to be captives of organizations that have incentives to keep products off," the clearinghouse, Democratic Senator Jack Reed told Reuters in an interview in January. He wants to limit a financial institution’s ownership of a clearinghouse to 20 percent. But that limit probably wouldn’t have any effect on ICE Trust US, because no single bank owns more than 20 percent.
It’s no surprise that potential rivals aren’t thrilled about ICE Trust US, either. "The dealer motivations continue to be quite clear. They have no interest in any transparency, and they're trying to limit the regulation as much as they can," NYSE Euronext CEO Duncan Niederauer said at a conference in June.
Pretty much everyone agrees that putting derivatives trades on a clearinghouse is a good idea and that it will reduce systemic financial risk. It isn’t a perfect cure: There are deals in the derivatives market—which includes everything from CDS to ordinary stock options and hog-belly futures—that are one of a kind and don’t fit into a clearinghouse system because there is no price history.
But much of the $600 trillion derivatives market can be cleared. And that will help the financial system because clearing establishes public prices and sets limits on the amount of debt financing that derivative traders can use. And, critically, members of a clearinghouse are responsible for one another’s losses. That means they are likely to set limits on one another, and in the event of a catastrophe, the odds of a public bailout are reduced.
“As the AIG situation has made clear, massive risks in derivatives markets have gone undetected…. Today, to address these concerns, the Obama administration proposes a comprehensive regulatory framework for all over-the-counter derivatives,” the Treasury Department said on May 13, 2009. It said that the Commodity Exchange Act and the securities laws should be amended to require clearing of all standardized over-the-counter derivatives through regulated central counterparties, or clearinghouses.
Nearly one year later, the administration is a long way from making sure that derivatives are traded through a clearinghouse whenever possible. And even if that requirement does become law, the big banks that created the derivatives crisis may well end up managing the process—and profiting from it too.