The question: When should fund managers, broker dealers and clearing brokers find out for certain whether or not their swap trades will be accepted or rejected for clearing by a clearinghouse. Should it be before or after a swap trade is executed on an electronic plaform?

"Certainty of clearing is top of the list of challenges or pain points for firms involved in central clearing," said Paul Rowady, a senior analyst at Tabb Group, who moderated a panel on the topic entitled "Getting a Trade Done: from SEF to Clearing."

The Dodd Frank Wall Street Reform Act requires that many "standardized" swap contracts be cleared through central clearinghouses, but that doesn't necessarily mean they will be. Asset managers must have sufficient credit with their clearing members and clearing members must have sufficient credit with their clearinghouses for a trade to be cleared after it is executed on a swap execution facility or SEF. Fall short on credit and the trade can't clear, resulting in plenty of costs -- and grief -- for the executing broker, the clearing firm and the fund manager.

SEFs are what U.S. regulators are calling electronic trading venues for swaps. European regulators, trying to implement similar legislation, are calling them organized trading facilities or OTFs.

The U.S. financial reform bill doesn't stipulate whether the credit checks should be done before the trade is executed, as is the case in the futures market, or afterwards. That means market players and clearinghouses will have to come up with answers on their own, while they are still ironing out the basics of how electronic trading platforms and clearinghouses will operate. The Futures Industry Association, the trade group for the futures industry, has created a committee to address the topic of certainty of clearing before central clearing takes effect later this year. It is reportedly favoring the post-trade risk check model.

In the world of pre-trade credit checks, an SEF would do the work and verify that a clearing firm and its fund manager had not exceeded their credit limits before allowing a trade to be executed. In the post-trade model, the clearinghouse where the trade is submitted for clearing would be resonsible for telling its member firm-- and the clearing firm would have to communicate with its fund manager client as to whether they were within their credit limits to clear the trade. That communication would have to take place in record time-- and there is some concern about latency.

Futures commission merchants [FCMs]-- aka clearing firms -- and their fund managers will likely favor the pre-trade mode for credit checking. Why?  The goal of using clearinghouses to clear swap trades is to reduce counterparty risk. But until the trade is accepted for clearing, bilateral risk will still exist.

If an executed trade cannot be cleared, the trade may have to be unwound, resulting in "breakage," explained Randall Costa, managing director of investment manager Citadel, who spoke on the Tabb Group's panel. That breakage is the difference between the price at which the trade was originally executed and the "replacement" price for the trade. Someone will have to pay that "breakage" and it might just end up being the clearing firm.

"As an FCM, we prefer the pre-trade risk check because our trading desks don't want to have to address apportioning the cost of breakage," said Hester Serafini, managing director and global head of credit fixed income brokerage clearing at Deutsche Bank.

Well-known for its savvy algorithmic trading methods, Citadel would naturally benefit from the pre-trade credit check because all of its executed trades would be cleared. So would FCMs. But that option doesn't sit well with Ron Levi, chief operating officer at interdealer broker GFI Group in New York.

"Breakage occurs very, very rarely and pre-trade risk checks are far too difficult to implement as they would require a vast amount of interconnectivity and huge computing power," said Levi.

Practical market forces would further reduce the potential for breakage. Levi believes that clearing firms would likely demotivate fund managers from breakage by not taking on their business. Yet another important reason to favor the post-trade model: the pre-trade model risks a clearinghouse favoring trades executed through its in-house trading system over others. "It could create a vertical monopoly," said Levi.

CME Group's futures trading platform Globex relies on the pre-trade model for credit checks but Laurent Paulhac, head of over-the-counter clearing for CME Group concedes that approach might not be realistic for swap contracts. The pre-trade credit check model is the "right aspirational goal" for swaps, the exchange's experience with its swaps clearing system ClearPort, proves that the post-trade model works can work just fine, particularly for voice-traded swaps.   

In a separate interview with ISS-Mag.com, electronic trading platform Tradeweb said it has come up with what it calls a "hybrid" model for pre-trade swap checks which would retain the role of SEFs in developing credit checking tools in real-time and with minimal latency when the trade occurs. Tradeweb wants to register as an SEF.

In the pure ping methodology, often cited as a way for a pre-trade risk check to take place, the SEF must notify the clearing firm of a potential trade, and the clearing member would return with a message indicating whether there is sufficient credit. Sounds easy enough to accomplish but some clearing members might not have sophisticated enough systems for the credit check to take place quickly -- within a second. In the hybrid model, said Tradeweb's vice president Elisabeth Kirby,clearing members may choose, for each account, whether to utilize the pure ping method or to upload a portion of the fund manager’s credit limit to the SEF at the beginning of each day. When the fund manager reaches a certain tolerance limit -- a figure close to the credit limit monitored by the SEF-- the clearing member can then raise the fund manager's credit limit.

"Fund managers and clearing members support the hybrid model because there is virtually no latency and for the amount of flexibility it provides," said Kirby, who leads Tradeweb’s clearing certainty initiative in the U.S. She added that Tradeweb currently has robust connectivity to all major clearinghouses and would have no trouble establishing connectivity with multiple clearing members.

Written by Chris Kentouris, Editor-in-chief (Chris can be contacted throughChris.Kentouris@hotmail.com).