The Challenge of Central Clearing for Over-The-Counter Interest Rate Swaps

1. The Challenge of Central Clearing forOver-The-Counter Interest Rate Swaps Robert O'Mara Tracy Pridgen Smita Vemulapalli Interest Rate Swaps NYU SCPS X51.9240 June 2010

2. 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

3. What is the OTC Interest Rate Swap Market? • The OTC interest rate swap market is the largest derivative asset class in the world. • 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. • IR swaps are OTC. • 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-the-counter“ • Interest rate swaps are an integral part of the fixed-income market.

4. What is Central Clearing? • Clearing: • 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: • 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. A clearinghouse is a financial institution that provides clearing and settlement services for financial and commodities derivatives and securities transactions.

5. 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).

6. 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

7. 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

8. 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 • 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 CLEARINGHOUSE

9. 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

10. 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.

11. 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.

12. 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.

13. What Other Markets Use Clearing? • Clearing is an important part of markets worldwide, both on-exchange and off-exchange. • 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

14. 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

15. The First Interest Rate Swap ClearinghouseInternational 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)

16. 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.

17. 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.

18. 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

19. IDCH Benefits from Marketing Materials

20. Transaction Comparison

21. Q & A