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Intercontinental Asks SEC to Clear European Sovereign Swaps

November 02, 2012

Intercontinental Exchange Inc., owner of the world’s largest credit-default swaps clearinghouse, requested permission from the Securities and Exchange Commission to back contracts for sovereign debt of five European countries.

The sovereign debt of Ireland, Italy, Greece, Portugal and Spain would be processed by the company’s ICE Clear Europe unit for the first time, rather than the contracts being held between banks and their customers, in a move that’s meant to reduce systemic risk in the financial industry, according to a regulatory filing today. Intercontinental, based in Atlanta, already backs credit swaps on the sovereign debt of Brazil, Mexico, Argentina and Venezuela as well as the Markit CDX Emerging Markets Index of 15 sovereign nations.

Clearing default swaps on Latin American nations was a first step in overcoming one of regulators’ and banks’ biggest hurdles to curbing the risks that the $25 trillion in outstanding contracts pose to the global financial system. While banks have moved many of the contracts linked to corporations into clearinghouses, they’ve struggled to do the same for contracts on themselves and countries in which they’re based without having to require collateral postings that would make the trades uneconomical.

“ICE Clear Europe believes clearance of the new sovereign contracts will facilitate the prompt and accurate settlement of swaps and contribute to the safeguarding of securities and funds associated with swap transactions,” the filing said.

Greece Restructuring

In March, sellers of credit-default swaps on Greece had to pay as much as $2.5 billion to settle contracts triggered by the nation’s debt restructuring while the swaps were still held between banks and their customers and not processed by a clearinghouse. The contracts were settled after investors were forced to exchange their bonds at a loss in the biggest ever debt restructuring that ended more than two years of speculation about whether the derivatives are reliable for insuring sovereign debt after European policy makers sought to prevent payouts on concern they’d worsen the region’s crisis.

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. Clearinghouses, which are capitalized by their members, are meant to reduce systemic risk by sharing responsibility if a member defaults on its payment obligations. They use daily margin calls to keep accounts current and provide regulators with access to prices and positions.

‘Wrong-Way Risk’

The complexity of housing some of the most volatile and correlated credit swaps in a clearinghouse capitalized by the same banks whose debt is protected by the contracts -- such as those on German sovereign debt and on Frankfurt-based Deutsche Bank AG (DBK) -- has prevented their inclusion in the risk-mitigating service. The obstacle extends to contracts linked to countries in which the banks are based. The issue is one of the derivatives industry’s biggest challenges, Jeffrey Sprecher, chief executive officer of Intercontinental Exchange, said last year.

There are at least two risks when clearing sovereign credit swaps. The so-called “wrong-way risk” arises from the default of a country on its debt where a dealer bank has sold protection on that nation’s bonds and thus faces the risk of defaulting because it has large payouts to make. To mitigate this, ICE Clear Europe will denominate its contracts, margin and guaranty fund in U.S. dollars rather than euros, according to the filing.

Dollar Contracts

Self-reference risk is also an issue, where a clearing member bank is an affiliate of the country that the credit swap protection is written against. For instance, any German sovereign debt protection sold by Deutsche Bank wouldn’t be allowed to be cleared by ICE Clear Europe.

“If a clearing member subsequently becomes affiliated with the underlying reference entity, the rules applicable to new sovereign contracts provide for the termination of relevant positions,” the filing said.

The clearinghouse filed the request for approval by the Commission on October 15, according to a federal information and news dispatch released today. The SEC is asking for comments on the proposal and must approve the change.

To contact the reporter on this story: Matthew Leising in New York at

To contact the editor responsible for this story: Alan Goldstein at

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