Building a Better House for OTC Derivatives

Financial reform has been met with much fanfare, but will the creation of clearinghouses to bring OTC derivatives under one roof really reduce systemic risk?


Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission, has a single-minded mission: to meet the deadline imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act. By July 15, 2011, Gensler has to finalize dozens of new comprehensive rules, culled from 340 of the 2,300 pages of regulatory guidelines in Dodd-Frank, that will reshape the future of trading and clearing in the $615 trillion derivatives market, one of Wall Street’s biggest profit centers.

“Everyone wants to say I’m crazy, but this really is doable within the 360 days Congress has directed,” Gensler tells Institutional Investor.

Dodd-Frank is the biggest regulatory overhaul since the Glass-Steagall Act separated commercial and investment banking during the Great Depression. One of the key pieces of the legislation is the creation of derivatives clearinghouses, where many of the credit default swaps and other over-the-counter instruments that got the world into trouble during the financial crisis will be centrally cleared, settled and monitored.

To make his deadline, Gensler has mobilized more than 100 of his staff at the CFTC’s Washington headquarters, establishing teams to focus on 30 different areas, some of which will likely require more than one rule and involve coordinating with the U.S. Securities and Exchange Commission. In fact, he had his first meeting with all 30 team leaders to discuss the process and deadline one day before President Obama signed the bill into law on July 21, 2010. Everyone knew that the teams had to submit memos a few weeks later — even Gensler’s three teenage daughters.

“All three of them knew that each of the rule teams had to get a memo to me, and they asked, ‘Dad, did they all get them to you?’” he recalls, with a chuckle.

Laughter aside, Gensler has acquired a reputation as something of a zealot for reform and transparency in the OTC derivatives market. He’s applied this transparency to the lobbyists from the financial and corporate sectors who have been besieging his office since Dodd-Frank became official. The CFTC is posting on its web site the names and organizations of everyone who approaches Gensler with input about regulation. In the first 49 days after the law was signed, the CFTC listed 62 public meetings.

For all Gensler’s tough-mindedness, though, many onlookers worry that Washington’s grand plan for overhauling the derivatives market and curtailing systemic risk — one of the biggest catalysts for reform — could backfire. Although Dodd-Frank is promoting clearinghouses as a systemic safety net that will prevent future market crises triggered by big bank collapses, critics contend that the clearinghouse model is flawed as currently conceived, especially for credit default swaps. They argue that it doesn’t go far enough in safeguarding financial markets, in part because the Wall Street dealers who are essential to making these clearinghouses work as liquidity providers operate as an elite club focused more on protecting its profits than on safeguarding the broader market. This has led to worries that Washington is lulling the public into a false sense of security.

“Clearinghouses are not a panacea and could theoretically default as well,” cautions David Rubenstein, CFO of BlueMountain Capital Management, a $4 billion New York–based hedge fund firm that focuses on credit and equity derivatives markets. “Their strength is in large part the strength of their members. If a big member fails, it’s probably because something really bad is happening in the market. And so maybe another member could fail, and then who knows where your collateral really is?”

Many think the biggest risk for failure is in the CDS market, which at $32.7 trillion in notional outstanding is more than twice the size of the U.S.’s annual $14 trillion GDP. (“Notional” refers to the value of a derivative’s underlying assets.) CDSs are contracts that are a form of default insurance for corporations and sovereign countries. They also have the potential to blow up markets and institutions when things go wrong. That’s what happened in 2008, when CDS-related problems helped capsize American International Group, Bear Stearns Cos. and Lehman Brothers Holdings, and it is why Washington circled the regulatory wagons around derivatives, CDSs in particular.

Clearinghouses clear trades, settle trading accounts, collect and hold margin accounts and monitor trading data. Importantly, they step in as a buyer to every clearing member seller and as a seller to every clearing member buyer, serving as the ultimate counterparty for risks that pass through their doors. Until now, clearinghouses were primarily fixtures of the futures market and, notably, helped steer Chicago’s CME Group and London-based LCH.Clearnet Group safely through the Lehman crisis. For regulators, this was further proof that derivatives also should be centrally cleared.

However, critics — including academics, analysts, bankers and investors — contend that clearing derivatives will be complicated and fraught with risk. One significant concern is the notorious self-interest of Wall Street and the dealer banks’ potential to exert undue influence over the rules-writing process. Many will want to hold on to their shrinking pools of income as derivatives transition from the OTC market to clearinghouses and electronic trading platforms, where bid-ask spreads — the price difference between what a seller asks and a buyer offers — will shrink dramatically. A recent research report by Sanford C. Bernstein & Co. says that big banks such as Goldman Sachs Group and JPMorgan Chase & Co. generate roughly 30 percent of their trading revenue from derivatives. JPMorgan chief executive Jamie Dimon revealed at a September 14 investor conference that the creation of derivatives clearinghouses, which he supports for standard contracts, could cost his bank $1 billion a year in lost revenue.

Critics worry that Wall Street firms, to protect their interests, will find a way to continue crowding out competitors and control the majority of derivatives volume. This is already the case at LCH.Clearnet, the biggest player in interest rate swaps clearing, and New York–based ICE Trust U.S., which began clearing CDSs in March 2009; both are dealer-driven. Like it or not, dealers are in a position to heavily influence the market, because without them the clearinghouses can’t function. Even Goldman Sachs, in a presentation posted to the CFTC’s web site, warned that the soundness of clearinghouses will come down to the health of their members. “Management of clearinghouse positions in a member default is complicated by diversity of products (across futures, rates and credit derivatives) and requires risk-taking participation of clearing members,” Goldman wrote. In other words, the clearinghouse may be the risk-taker of last resort, but its members must have enough strength and market-making skill to cushion it in times of crisis.

There are also serious concerns about which derivatives products will qualify to be cleared, because liquidity tends to be very thin for certain ones — in particular, CDSs. What happens if a clearinghouse gets saddled with illiquid derivative contracts that it can’t trade out of when the market nosedives? Conversely, will too many products be left floating around in the OTC market because they’re not liquid enough to qualify for clearinghouses? This could prove a much bigger consideration than concentration risk in clearinghouses, some worry.

“The politicians say they will prevent another AIG with the new rules,” says Kevin McPartland, a senior analyst with research firm TABB Group in New York. “But most of the positions held by AIG that caused those collateral calls would not be clearable even today because they’re nonstandard and illiquid.”

It’s these kinds of outlying risks that concern Jeffrey Michaels, joint head of the fixed-income division for the Americas at Nomura Securities International, which joined ICE Trust as a clearing member in June. Michaels, who is based in New York, opposes clearing exemptions that keep credit risk outside clearinghouse doors, including those for corporate end users, which make up some 10 percent of the market. “The largest systemic risk will wind up with those companies that have the ability to negotiate bilateral thresholds where they may not be posting enough collateral or no margin at all based on their credit rating,” he says. “If you’re going to have a clearing corporation, you should put everyone in it that could possibly cause a systemic problem because of the size of their activity. It would be shortsighted to exclude companies given the amount of debt they have.”

Still, regulators admit they’re challenged when it comes to figuring out how much of the market is ultimately clearable. Gensler acknowledges that in the CDS sector, liquidity may be limited to a handful of single-name CDS products in clearinghouses. “The harder part is going to be what the SEC is going to oversee, which is the individual-name CDS,” Gensler says. “You could make the case that only the top 100 or 150 names have enough liquidity to be in a clearinghouse. But that’s going to be the SEC’s determination.” ICE Trust, which was created by the

IntercontinentalExchange (ICE), contends that it may eventually be able to clear as many as 300 single-name CDSs.

The interest rate swaps market, which at $350 trillion notional outstanding is the single biggest OTC derivatives sector, is far more liquid and transparent than the CDS market. Even so, it includes complicated products that dealers say aren’t easily standardized. Gensler’s 30 teams have been huddling with the SEC, the Federal Reserve, the Federal Deposit Insurance Corp. and the Treasury Department since late July. Although the SEC will oversee many aspects of the Dodd-Frank reform, including oversight for swap-security products such as single-name CDSs, the CFTC will bear the bulk of responsibility in implementing the new derivatives rules. Those rules will cover a broad range of issues, from the basics of defining what a swap is to making sure there’s enough price transparency and liquidity in every derivatives product group to determining how much margin, collateral and capital that clearinghouses need to demand from dealers and clients.

Last, there are worries that clearinghouses could try to undercut one another to win new members and users — for instance, by charging less collateral and initial margin. This is more of a concern in the interest rate swaps market, which is vastly bigger than the CDS market and already has a gathering crowd of up-and-coming competitors, including CME; International Derivatives Clearing Group (IDCG), which is majority-owned by Nasdaq OMX Group; and the Singapore Exchange.

Collateral is what helps keep clearinghouses and their members safe, serving as a financial backstop when liquidity dries up in the broader market. Getting the collateral equation right will be one of the big challenges for derivatives clearinghouses in coming months — a challenge that regulators are looking at closely as competition heats up. If clearinghouses require users to put up too much collateral, they risk choking off liquidity and driving more of the derivatives activity into the less regulated OTC market, which will continue to exist under Dodd-Frank. Conversely, if they charge too little collateral and margin, that could backfire during times of financial crisis.

Looking beyond the rules themselves, many worry whether the SEC and CFTC have the capacity and staying power to police such a vast new empire. The SEC is still under fire for oversight failures in the 2008 crisis. And the CFTC, with a workforce of 670, is seriously understaffed for its new job. “We estimate we’ll need about 1,130 people to do this,” Gensler says. “So we need over 400 more people.”

That means more money, which the government has yet to earmark. “I’m not going to be bashful,” Gensler adds. “I’m going to be very public about the need for funding. Congress can certainly choose to support it, and I hope they will. But if they don’t, come the fall of 2011, it’s going to be a challenge.”

In the u.s. derivatives have been around since the Civil War, when merchants began buying and selling contracts to hedge the risk of future changes in the prices of corn, wheat and other grains on a central exchange. In 1936, Congress passed the Commodity Exchange Act, which required the government to regulate futures and options trading and led to the eventual creation of the CFTC. In 1981 the over-the-counter derivatives market was born when IBM Corp. and the World Bank did the first interest rate swap, agreeing to exchange fixed-rate for floating-rate payments. Swaps are essentially bilateral bets on the direction of interest rates, currencies, company debt or commodity prices that trade between private parties outside the scrutiny of regulators.

The OTC derivatives market took off in the 1990s and by 1998 had swelled to some $80 trillion in notional value, dwarfing the exchange-traded futures and options market, which was just $13.5 trillion, according to the Bank for International Settlements. A large part of the OTC growth this past decade was fueled by credit default swaps, which helped transform bond trading into a highly leveraged business.

A CDS is a contract between two counterparties in which the buyer makes periodic payments to the seller for promising protection on a bond or loan. JPMorgan is generally credited with inventing the CDS in 1997 as a way to protect itself against tens of billions of dollars in loans that it had accumulated. The idea seemed simple enough: A third party would assume the risk of the debt going bad and in exchange would receive regular payments from the bank, similar to insurance premiums. That would let the bank remove the risk from its books and free up reserves and was an extension of what banks had already been doing to hedge against fluctuations in interest rates and commodity prices.

The CDS market quickly grew from $180 billion in notional value in 1997 to almost $55 trillion by June 2008. Bankers seized upon CDS trading as a way to earn easy premiums, free up capital and shed risk from their books. As a general rule, CDS sellers don’t post money up front when they enter a contract; they only pony up if the credit defaults or goes bankrupt. When that happens, the cost of coverage can jump exponentially — what’s known as “jump to default.” Still, financial firms can hedge this risk by buying CDS protection even as they sell protection to someone else. That way, when a bond defaults, they get money back as they pay out, effectively netting their loss.

By 2007, with credit risk priced at historical lows, many financial firms were selling buckets of CDSs as insurance to cover exotic financial instruments linked to subprime mortgages. When the mortgage market unraveled, however, those, like AIG, that hadn’t hedged both sides of their CDS bets demonstrated just how dangerous these instruments can be when things go wrong.

AIG, for its part, made two cardinal errors. First, it was long CDS exposure — a whopping $377 billion worth — meaning that it hadn’t hedged the protection it had sold to firms that had piled into toxic subprime-mortgage-related debt. Second, it didn’t reserve capital to cover that exposure if something went wrong. When Goldman Sachs and others came knocking for big margin payouts to cover spiraling losses, AIG didn’t have the money. If not for a $180 billion bailout by the U.S. government, AIG would have collapsed beneath its enormous CDS exposure, with potentially dire consequences for the global economy.

AIG became the poster child for why the OTC derivatives market needed to be more closely regulated. Meanwhile, Lehman Brothers, which did collapse, showed how clearinghouses could be part of the solution. On September 15, 2008, the morning that Lehman filed for bankruptcy, LCH.Clearnet woke up with $9 trillion in interest rate swaps from Lehman — trades it was able to unwind at no cost to itself. The clearing model had worked in one of the worst financial crises in history. Within weeks of the Lehman bankruptcy, the Federal Reserve Bank of New York gave major bank dealers marching orders to form a clearinghouse for CDSs.

ICE was one of the first to respond to that call. Formed in 2000 to trade and clear energy contracts, the exchange launched ICE Trust in March 2009 with a group of ten Wall Street dealers to focus exclusively on CDS clearing. About five months earlier, CME — the world’s largest derivatives exchange — and Chicago-based hedge fund firm Citadel Investment Group had announced their own plans to establish an electronic platform that would enable users to trade and clear CDSs.

The Fed’s call for a CDS clearing solution is part of a broader outcry among regulators and politicians to clear all derivatives, and has attracted the attention of new players that want to grab a piece of the pie in other sectors, such as interest rate swaps; they include IDCG, Germany’s Eurex Clearing and Brazil’s BM&F Bovespa. The biggest competitor for interest rate swaps clearing is LCH.Clearnet, Europe’s largest independent clearinghouse.

ICE Trust president Christopher Edmonds has emerged as an unlikely champion for Wall Street dealers and something of an antihero to Gensler. The crusading CFTC chairman, who spent 18 years at Goldman Sachs, is determined to claw back Wall Street’s power, while Edmonds is resolute to preserve it. They have clashed, for instance, over ICE Trust’s exclusive membership requirements, which call for prospective members to have at least $5 billion in tangible net worth and an existing swaps desk — pretty much blocking out all but the biggest Wall Street firms. Edmonds says such rules have been critical to ensure that members are able to manage outsize risks when markets hit the skids. For his part, Gensler, who is tackling his new job with the fervor of the converted, says he won’t tolerate anyone hiding behind the excuse of risk management.

“I respect it; I understand it’s profit-oriented,” he says of Wall Street. “But my job is different. It’s to comply with the law and to best promote the transparency of the markets.”

Transparency is an issue that Gensler and other regulators are articulating in the new rules — and one of several concerns that have kept Edmonds’s team in constant contact with Washington. The 41-year-old Edmonds, who began his career at Louisville,

Kentucky–based APB Energy in 1997 and was most recently CEO of clearinghouse IDCG, is worried that the new rules for clearing derivatives could end up looking too much like those that govern futures. “Clearing OTC derivatives is not exactly like clearing futures,” he says. “It’s not apples to apples. It would be incredibly dangerous for us to try to create a systemic environment where one size fits all, because what we could miss in the interim could be catastrophic.”

Gensler has extolled the futures model for helping clearinghouses sail through the Lehman crisis. There are 126 futures commission merchants registered with the CFTC. Most FCMs can be members of the clearinghouses. LCH.Clearnet, which has applied to use the FCM model, used only 30 percent of Lehman’s initial margin to close out positions, indicating that it was well margined for the loss of a top dealer. CME was also able to liquidate Lehman’s entire futures options portfolio without sustaining any losses. But this model doesn’t necessarily work for all derivatives, especially CDS contracts, which can vary dramatically in liquidity.

ICE Trust has a lot in common with its Wall Street members. It’s the only for-profit clearinghouse that shares revenue with its members, which include Bank of America Merrill Lynch, Barclays Capital, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs Group, JPMorgan, Morgan Stanley and UBS. Unlike other clearinghouses, it is registered as a bank and therefore is regulated by the Federal Reserve as well as by the SEC and now, under Dodd-Frank, the CFTC — a challenge that Edmonds has been tackling since he joined in February of this year.

Analysts expect the CDS clearing business to become an increasingly important part of publicly traded ICE’s profit model in the months ahead. UBS analysts Alexander Kramm and Christopher Johnson estimate that CDS clearing could generate some $200 million to $300 million in revenue for ICE, and 8 to 13 percent of its total estimated earnings by 2012.

Edmonds has already presided over a period of rapid growth. CDS clearing volume at ICE Trust has swelled to $8.3 trillion from just $4 trillion in notional value and $258 billion of open interest since he arrived — a far cry from the $236 million in CDSs that has been cleared at CME. Life was easier, he admits, at IDCG, a young interest rate swaps clearinghouse that is regulated by the CFTC and conforms to a more traditional, futures-style platform.

“I understand the core principles of that model and went to bed every night very comfortable in the world I lived in,” Edmonds says. At ICE, he adds, “I walked into running a bank, and that doesn’t necessarily pair well with running a clearinghouse.”

Keeping his Wall Street members happy is just one of those challenges. Most are in no mood to yield ground to outsiders when it comes to parting with market share and profits. The top five bank dealers, all at ICE, command 95 percent of the notional amount of CDSs bought and sold in the market. “We have to be realistic,” TABB’s McPartland says. “These are for-profit companies, and, yes, they’ll be working with federal global regulators to reduce systemic risk. But they also need to make money for shareholders, so they will craft models that work for them.”

In a sense, that’s what LCH.Clearnet has already managed to do under CEO Roger Liddell, a former Goldman Sachs veteran. Over the past 11 years, in its SwapClear arm, LCH.Clearnet has carved out a 40 percent market share in interest rate swaps by confining its membership to a small cadre of global and Wall Street banks. Although LCH.Clearnet has a nascent clearing business for CDSs in France, it is fighting to maintain its far more important dominance in clearing interest rate swaps as CME and smaller newcomers like IDCG advance. It could have a tough time holding that position, however, if Gensler forces clearinghouses that operate in the U.S. to loosen their membership rules.

LCH.Clearnet will be forced to go along with the new rules if it wants some of the U.S. buy-side business — a potentially significant slice of the derivatives pie that some analysts put at about $20 trillion. At the same time, like ICE Trust, LCH.Clearnet is fighting to preserve its own strict membership requirements, which Liddell says are essential to managing risk through market crises. The clearinghouse is 73 percent owned by dealers and requires $5 billion in net tangible capital as well as an existing $1 trillion swaps book. Michael Davie, CEO of SwapClear, has warned that bank dealers may quit as clearing members if they are forced to water down membership requirements and risk management rules.

CME, which was founded in 1898 as the Chicago Butter and Egg Board and today operates the world’s largest futures clearinghouse, has had headaches of its own, though not because of its membership requirements, which call for just $500 million in capital. In September 2009, CEO Craig Donohue scrapped the electronic trading platform that CME was developing with Citadel and announced that the new initiative would instead focus solely on clearing CDSs. “We moved away from the execution platform because there isn’t sufficient demand for it,” Donohue told Institutional Investor a few weeks later. “Change is hard.”

Critics say that CME miscalculated how hard the bank dealer community would strike back when the Chicago exchange joined forces with Citadel CEO Kenneth Griffin to launch a CDS trading platform. “The battle for CDS clearing supremacy was won and lost without even engaging the dealer community because of the Citadel connection,” explains the head of futures at one large broker-dealer.

In a preemptive strike, the Wall Street dealers that balked at the CME-Citadel electronic trading system withheld liquidity for the clearing platform — a problem that persists today. Although CME signed up major founding members from the buy side — including AllianceBernstein, BlackRock, BlueMountain, Citadel, D.E. Shaw Group and Pacific Investment Management Co. — it has yet to get much beyond its prelaunch stage. That could change if it succeeds in offering cross-margining of OTC products with benchmark futures. More recently, on October 18, CME scored an important victory when it began clearing interest rate swaps with the backing of five key buy-side firms: BlackRock, Citadel, Fannie Mae, Freddie Mac and Pimco. It’s also working with ten dealers, including Goldman and JPMorgan.

BEYOND ISSUES OF MEMBERSHIP and market share, there is one more pressing question: Can the clearinghouse model work for CDSs? Although the model was successful for interest rate swaps during the Lehman crisis, CDSs carry an entirely different set of risks. The CDS market is much smaller and more specialized, and less liquid and transparent, than the interest rate swap market. CDSs also have the potential for much larger losses because of their link to default; that’s why they require much higher levels of capital. Analysts estimate that cleared CDS transactions will likely be margined at 5 to 10 times the current level of other OTC derivatives. (A typical ten-year, $1 billion interest rate swap has a margin of roughly 3 percent of its notional value, depending on the clearinghouse.) Much will depend on how regulators define liquidity, which tends to be very thin beyond the CDS indexes. CDS single-name contracts trade infrequently, and many of them have five-year maturities and tend to grow less liquid over time.

“The clearinghouse has got risk with all open positions, so those have to be covered,” cautions Jeff Gooch, CEO of MarkitSERV, a joint venture between London- and New York–based Markit Group and Depository Trust & Clearing Corp. that provides global OTC derivative transaction processing. “A five-year contract might be pretty liquid initially, but in two to five years there’s no guarantee it will be. Once those contracts are in the clearinghouse, they’re not coming out. So the clearinghouse needs to collect information that will support the measurement of that risk. That raises the question, how do you measure liquidity? Honestly, measuring liquidity is very hard, because it comes and goes.”

It’s uncertain how clearinghouses will deal with the additional liquidity risk for CDSs, especially given the scarcity of regular price information. There are simply far fewer trades in the CDS market than in the futures market, where price information for natural gas, crude oil and other highly liquid commodities is available at any time. Data repositories like DTCC list some 1,000 liquid single-name swaps, but in reality very few of them trade with any frequency.

ICE Trust mutualizes risk among its members: The pool of banks acts as a financial backstop for the clearinghouse. Critics say that mutualizing CDS risk among a handful of banks, no matter how well capitalized, poses a systemic problem. Scott Hill, CFO of parent ICE, counters that ICE Trust has more than enough capital to cope with the failure of any two of its largest dealer members.

“The first big step forward is that the Titanic never leaves the dock with too few lifeboats,” Hill says, referring to the capital strength of existing members.

ICE Trust backtested its CDS risk management system against positions on September 11, 2008, when Lehman was teetering on the brink of bankruptcy. Hill says the clearinghouse would have survived without dipping into the guarantee fund, which is basically a last-resort capital cushion for defaults.

“We’re looking at a situation where the Titanic runs into an iceberg, backs up and hits another one,” he explains. “It’s the two largest clearing firms that go down.”

Hill says both regulators and third-party independent reviewers have been impressed by ICE’s risk simulation. “So we have tested it to make sure that not only do we have enough lifeboats, but we probably have more than enough to get us through,” he adds.

Still, it’s the word probably that makes some people nervous. Nobody knows for sure what will happen when the next crisis comes along. “If ICE is assuming two banks go out of business, that’s fine. But how much CDS is on their portfolios, and how negative is the profit and loss of those CDSs?” asks Robert (Bo) Collins, a private money manager and former president of the New York Mercantile Exchange. “If you have a bank go out of business, that’s one thing. But if they lose $5 trillion, you have a problem.”

Moreover, ICE Trust backtested its model with CDS indexes, the most liquid part of the CDS market. Some wonder what would happen if there was a meltdown in the single-name sector, where liquidity tends to be much thinner. Others downplay this concern, saying that clearinghouses like ICE Trust monitor concentration risk and would demand collateral increases before risk levels got too dangerous. The concern is that margin requirements could shoot higher for clearinghouse clients when the market melts down — at a time when clients can least afford to meet them — forcing those unprepared into default.

ICE Trust has been working to address these worries. In August it rolled out a margin calculator that allows clients to figure how much margin they might need for clearing-eligible instruments in their portfolios under a range of different risk scenarios. Corry Bazley, director of sales and marketing for ICE, says the new tool tells the client how much the initial margin amount would be and then breaks it down into the components of the CDS market, crunching data for spread volatility, the expected loss due to default, liquidity measures tied to the cost of unwinding CDSs, interest rate risk and concentration risk.

Still, even those who support the clearinghouse model have concerns, including Ted MacDonald, treasurer of hedge fund firm D.E. Shaw, a major user of CDSs. In the OTC market, he explains, buyers of protection can negotiate a margin requirement up front on a trade that is typically stable for the life of that trade. The clearinghouse, however, reserves the right to change the margin requirement. Though MacDonald says clearinghouses don’t have the motivation to do this randomly or to just one participant, it’s something that worries him.

“It’s part of my job to make sure our firm has sufficient liquidity,” MacDonald says. “And we do have to think about it differently in the cleared model than in the bilateral model.” Another big obstacle, he says, is that not many products are available for clearing as yet. “It’s hard to transition to a cleared market when everyone’s system is set up for a bilateral market,” he adds. “So I think it’s going to be many years to get it to [a more liquid] state.”

It will take time because a clearinghouse simply can’t afford to take on swaps it can’t trade out of quickly in a market meltdown. ICE Trust’s Edmonds says there’s a larger universe of CDSs that his firm can clear over time — about 300 single names, versus the 89 it handles today — but this will involve getting regulators more comfortable with the potential risks.

“We don’t believe the high-yielding CDS names are as risky as some of the regulators have defined them,” he says. “We think it’s an issue of price transparency, and we can help with that.”

That may be wishful thinking, depending on how tough regulators get as they develop far-flung rules covering liquidity, membership and the many other issues that will shape the future of clearinghouses and, importantly, the safety of the market. It is still unclear how effective regulators can be in making the derivatives market liquid, transparent and less risky — not to mention how they will tackle the onerous job of policing hundreds or thousands of new clearinghouse members and client entrants in coming months.

Gensler says the CFTC will probably have hundreds of swaps dealers to register, dozens of swap execution facilities and some additional clearinghouses to process, and will have to regulate those it already has in a new way. He also anticipates having five to ten swap-data repositories for price and transaction monitoring.

“We’re going to have a lot more registrants and a lot more to do,” he says.

It’s hard to imagine bank dealers passively sharing their shrinking pie with newcomers that regulators let through the clearinghouse door. Certainly, history is littered with stories of Wall Street dealers that have found ways to prevail against the odds when it came to protecting their turf. Two years ago, for example, the derivatives exchange Eurex (owned by Deutsche Börse and SIX Swiss Exchange) launched a CDS futures platform in Europe, but it failed to get any traction because it didn’t get support from the dealers, says one exchange trader who worked on the project. In 2008, CME attempted to launch FXMarketSpace, a forex trading platform that failed because the dealers killed it, contends the exchange trader, who spoke on condition of anonymity. And, of course, dealers helped derail CME’s effort to launch a trading platform with Citadel.

So while most market participants agree that clearinghouses will likely lower derivatives risk by bringing more collateral and transparency to the system, there’s potential for the bigger plan to unravel — that is, the plan to protect the market from another derivatives-linked meltdown. After all, even after the CFTC and SEC write their rules, Gensler will have to go hat in hand to Congress looking for fresh funds to hire some 400 new professionals. With budget cuts in the air following the recent midterm elections, getting that funding is far from certain, and without it, Gensler and the CFTC will face a serious problem policing their vast new territory. And even if the CFTC manages to hire everyone it needs, it still faces an uphill battle. After all, Wall Street has been chastened many times before, only to find new ways to beat the system. It’s Wall Street’s knack for reinventing itself, as much as anything else, that the CFTC and the SEC will need to watch in coming months.