Both the CME and the CBOT think their systems will solve collateral headaches. Probably only one will survive. But what about the banks that are already in the business?

By Simon Boughey

Neither the Chicago Mercantile Exchange (CME) nor the Chicago Board of Trade (CBOT) have launched their third-party collateral management systems yet. But controversy is already thick on the ground. A by-product of the growth in secured transactions, collateral management is an administrative task with many headaches and not just a bit of risk. The big swap banks have had to do collateral management for themselves, and some have offered the service on a third-party basis.

The need for collateral monitoring and custody is set to grow in line with the increase in secured transactions. The banks and exchanges all see it as a lucrative niche for prized fee income. The Chicago exchanges also see their systems as a way of automating the now-cumbersome swaps process. But what do clients want?

Within the next six months to a year, as the systems designed by the CME and the CBOT roll on line, it will become clear whether the derivative shops want full-service custody, clearing and monitoring or if a more targeted service is more appropriate. No matter what provision that turns out to be, it is likely that only one of the Chicago offerings will survive, if only for the simple reason that an institution will not be able to take full advantage of a third-party system without funneling all of its business through one provider. And as if these hurdles weren't high enough, the Chicago exchanges must overcome the traditional suspicion of Chicago by New York dealers.

Rival offerings

The CME's service is called the Depository Trust Corporation (DTC), while that developed by the CBOT is the hybrid instruments transactions service (HITS). The CME unveiled its final service description document for the DTC, a hefty document several hundred pages long, at the ISDA conference in San Francisco in March. A pilot phase with charter members begins in June, while HITS is expected to be operational by July 1. However, neither system has any users signed up yet.

While the virtues of both Chicago-based projects have yet to be proved, there are considerable structural differences between the two. HITS intends to cater to a wider range of clients and offers a tiered array of services. However, the DTC offers custody alongside the valuation service, so clients actually deposit their collateral with it and receive appropriate interest-rate payments. The fact that it has also produced a service description document, while the CBOT has yet to produce a similar effort, indicates that the CME is further along the road of development.

The DTC collateral management, trade matching and valuation project is a joint effort of the CME, SunGard Capital Markets and SWIFT. In 1994 the CME asked swaps dealers if they wanted it to develop a swaps clearinghouse, but major dealers don't like this idea because they fear it would undercut the advantages afforded by triple-A status. But they did ask the CME to look at how a collateral management service might be developed.

The exchanges are trying to make the whole process of swaps settlement and collateralization as speedy and efficient as the way in which futures transactions are handled. At the moment, it is a surprisingly manual business, requiring much paperwork by back-office personnel. The costliness of this labor-intensive process and its susceptibility to error shocked CME officials when they encountered it. "What puzzles us, coming from the futures business, is that it takes a long time and we came across the 'nearest to' principle," says John McPartland, president and chief executive of the CME's DTC. "In futures, everything balances to the penny. We thought, 'Jeez, what a way to run an army.'"

The whole process is rendered more complicated by the collateralization of swaps, which requires constant monitoring and additional calculations. The DTC would do all the work for the member banks. It will receive collateral from commercial banks and investment firms, match and settle deals, mark-to-market positions and report on collateral held for members. Once operational, it can evaluate and collateralize existing swaps transactions as well as new ones, and can also net payments.

The DTC utilizes SunGard's automated Devon Derivatives System to value swaps and the required collateral. The trades are confirmed through SWIFT's Accord trade confirmation comparison system. Acceptable forms of collateral are U.S. Treasuries, OATs, bunds and G5 cash, which the DTC will revalue in a U.S. dollar equivalent.

Potential members must pay out $70,000 up front for administration fees and as a gesture of sincerity. Beyond that, the cost is $10 per trade plus 63/1000 of a basis point of the size of the book. The CME hopes to make its profit from the size-of-book fee, so that the bigger the trade, the more money it makes. This consideration has driven its decision to target the biggest dealers as potential users-not second- or third-tier shops and not end-users. McPartland estimates he needs to have five or six top dealers signed up to achieve critical mass. The attraction of being among the first banks to become members is that they get to write the rule book.

No deposit

One of the crucial differences between HITS and the DTC is that HITS is not a depository: its function is one of calculation of collateral, not one of custody. HITS is run by the CBOT clearing corporation (BOTCC), also in cooperation with SWIFT. But the combination of custody and collateral is attractive to some. Says John Herlihy, senior manager of the risk management group at the World Bank: "We like that. We like the fact that the handling of collateral would be an entirely separate operation."

The CBOT's target audience is also much wider, encompassing the entire OTC derivatives universe, claims John Hiatt, the president of BOTCC. To cater to this audience, HITS offers three tiers of service. For the middle area of the derivatives market, where more plain vanilla deals are common, HITS offers a full array of accounting, deal confirmation and valuation services, and collateral and cash-flow management. HITS would function as a bridge between the OTC world and the exchanges. At the exotic, high-margin end of the market where confidentiality is all-important, HITS simply provides a collateral management service and would not be privy to the terms of any deal.

Also in the works is the third tier of operation, designed for the high-volume end of the market, and here the CBOT would function as a clearinghouse with full-credit guarantee. It would operate in the same way as it does for futures exchanges, interposing its credit between counterparties. But, as the CME discovered, it is by no means clear that the OTC derivatives market wants such a clearinghouse. Hiatt admits that the clearinghouse idea is as yet only "a gleam in our eye." If there is no market demand for it, the CBOT will not go ahead, he says.

Hiatt claims that the credit support service that is being developed by Cedel, the Euromarket's clearinghouse, is complimentary to HITS. However, he acknowledges that the DTC is in direct competition with HITS. He claims that the BOT has not yet developed a fee structure for HITS, but says that when it does, it will reflect this competition.

Although HITS is targeting banks of all sizes and end-users, Hiatt knows that it must capture a significant number of the premier derivatives houses to achieve that all-important critical mass. If HITS signs up 810 of the top 1520 shops that account for over 90 percent of U.S. volume, Hiatt will be "a pretty happy camper."

It is probably unlikely that the two management services will co-exist happily for years to come; only one will become the standard system. And in perhaps the same way that VHS video recorders overwhelmed Betamax, the pressure is on HITS and the DTC to achieve critical mass first.

Old suspicions

When attempting to woo the major dealers, both the CBOT and the CME will have major difficulties in overcoming the traditional distrust of Chicago and its attitude toward the swaps industry. Dealers remember that when HITS was first announced as a clearing system several years ago it was seen as a thinly veiled attempt to get swaps classified as futures. Then the CBOT seemed to be suggesting that if swaps could be cleared through its clearinghouse, then they were de facto futures transactions, and were not only subject to the provisions of the Commodity Exchange Act (CEA), but should also be listed on the exchange.

The swaps industry strenuously resisted these initiatives, and at the time the entire HITS project was tainted. "As soon as the market realized that it was a political ploy to kill the swaps industry, no one cooperated," recalls one senior derivatives professional. While he accepts that HITS may have been repackaged to incorporate entirely legitimate business applications, he suggests that there is a considerable credibility gap to overcome. "Dealers will be wondering if it's a wolf in sheep's clothing again. There are so many veterans around, and this will be the deciding factor," he says.

Nor will the CME escape negative associations. New York swaps dealers are suspicious of the Chicago exchanges. "It's very difficult to trust either of them," says another dealer. The CME's McPartland admits that the fear that the DTC was but an attempt by the CME to get its hands on lucrative swaps business had been expressed to him by potential users. But he reminds dealers that the CME is working closely with ISDA to defeat anti-derivatives legislation across the U.S. and that it would not be in the interest of the CME to disenfranchise one of its major constituencies.

Regulatory fears

If swaps dealers are wary of the futures exchanges, they are very worried about the Commodities and Futures Trading Commission (CFTC), the body that regulates the futures exchanges. They are worried that the Commission will revoke the exemption from the CEA that the industry currently enjoys. If revoked, it would mean that swaps would be subject to the regulation of the CFTC, which is not only expensive, but would also mean that swaps contracts would have to become standardized. The CME is aware of the concerns, and has labored to ensure that the DTC is an Illinois trust company and thus regulated by the Federal Reserve, not the hated CFTC. Suggests Mark Brickell, managing director of derivatives strategies at JP Morgan and a board member of the DTC, "Some sponsors have shown particular sensitivity to the perceived desires of swap dealers with respect to potential regulatory oversight."

Even if inherent caution is overcome, it will not be easy to persuade dealers that it is worthwhile ditching their in-house systems in favor of either HITS or the DTC. Collateralizing swaps has been around for quite a few years now, and it has reached a level of some complexity and sophistication at the major shops. It is not uncommon for top players to have more than 500 different collateral agreements, and dealers fear that these will have to be unraveled and renegotiated after signing up with HITS or the DTC. "I do not know what the incentive is to do it," says one veteran trader.

Older Systems

Bankers Trust made its in-house collateral calculation service, dubbed CTRAC+, available to clients in August 1993; at the end of 1995 it had signed up seven clients which had posted $1.5 billion in collateral on it. There is some nervousness among potential users about the safety of the Chinese Walls at Bankers Trust, but the fact that this system has been operational for three years, while competing systems at the CME and the CBOT have yet to be tried and tested, has not gone unnoticed by banks and end-users.

The World Bank is signed up as a client of CTRAC+, though it has yet to use it, as none of its counterparties-all of which are rated double-A or above-have yet to reach a threshold where collateral would be needed. At the moment it is not tempted to switch its allegiance. "BT is in place and up and running, while other systems are still in development," says the World Bank's Herlihy. However, he admits the fact that CTRAC+ does not offer a swaps valuation service in addition to the valuation of collateral is a disadvantage. "It's a plus that the CME and CBOT will offer swaps valuation. It makes the whole system more automated and avoids the possibility of disputes with counterparties," he says.

Differing valuation of swaps is an area of potential controversy. Though nearly all swaps players mark-to-market their transactions these days and the methodologies used are largely compatible, the information that is put into the systems can vary. One senior banker recalls a dispute that arose when he used the closing prices in Tokyo to value a transaction while its counterparty used the prices at the London close.

Like CTRAC+, Cedel's Global Credit Support Service does not attempt swaps valuation and is purely a bilateral service for collateral management. But it has been running a pilot system with eight banks and end-users since November 1994, and is planning to go live before the end of the first half of 1996. Cedel already completes an enormous amount of business in the Eurobond market with premier end-users and underwriting houses, and its reputation in this field puts it in a good position to clean up collateral management business. "It has a clear advantage in the European market," says Herlihy.

ISDA does not admit to favoring any one of the systems being developed currently, says Chip Goodrich, now a managing director with Deutsche Morgan Grenfell, after leaving Merrill Lynch last March, and chairman of ISDA's documentation committee. The organization is "in favor of anything that promotes efficiency and liquidity in the market," he says, and it has sponsored forums on the various systems in Tokyo, London and New York.

Some 75 percent of interdealer swaps in the New York marketplace are now collateralized. Virtually every type of derivatives transaction can and is being secured. Perhaps the Chicago exchanges are simply too far behind the curve to be able to affect development of this practice. Indeed, as several bankers have pointed out, the European and Asian markets are where the real opportunities can be found.

A brief history of collateralized transactions

Collateral is fashionable today because of the credit problems encountered across the financial industry in the last decade. Five years ago credit was the biggest problem facing any U.S. swaps dealer. American banks and investment firms had suffered successive downgrades, and Citibank slipped below investment grade status. Meanwhile, European and Japanese triple-A and double-A rated institutions were gobbling up international business with sovereigns and supernationals that operate with strict credit guidelines.

In the second half of the 1990s, U.S. financial institutions have a bit more breathing room. Returns have improved and bad debts have decreased. The gradual acceptance of netting by global regulatory regimes has had an effect. But an end of credit panic is due at least in part to the increasing use and sophistication of collateral agreements. Such agreements require weaker counterparties to post collateral to support any swap agreement. The mark-to-market value of the contract is constantly monitored, and if the level of collateral falls below a given proportion of the estimated termination exposure, additional collateral is required.

Acceptable collateral typically consists of government or other marketable assets, letters of credit or a guarantee from a creditworthy third party, which will charge a fee for such a service. The exact terms of each collateralization agreement are negotiated on a bilateral basis between the counterparties. Where more than one swap contract exists, calculation of requisite collateral is conducted on a portfolio basis, so positive and negative replacement values are netted against each other.

While the growth and sophistication of collateral technology has been invaluable to U.S. swaps marketing, the maintenance of credit support facilities has added another layer of paperwork in the back office. This is particularly true of second- and third-tier shops that have less sophisticated systems in place. "We can piggyback off our existing systems," said Chip Goodrich, in his previous job as a managing director with Merrill Lynch. "For people that would not otherwise have them it's more of a pain."

The growth of collateral agreements has allowed end-users to loosen their credit thresholds. For example, the European Investment Bank, which is perhaps the most prolific end-user of currency swaps in the world, did have a counterparty credit threshold of double-A, but is now prepared to accept A1 counterparties if swaps are collateralized. The use of collateral is "an essential part of our swap operations going forward," agrees John Herlihy, senior manager of the risk management group at the World Bank.