One of the outcomes of the Dodd Frank act is the need for users of OTC (ISDA) derivatives to clear them using the US Futures Commission Merchant (FCM) model. So far only large dealers who meet the criteria to be a direct clearing member have utilised the service at ICE to clear Credit Default Swaps (CDS). As the CFTC drafts it’s rules to turn Dodd Frank into reality, one of their goals is to open up the market for intermediaries who provide the route for non-direct firms to enter contracts into clearing.

Until now both ICE and LCH had similar criteria for a firm to be an FCM, with the requirement to hold at least $5bn of capital, this is no longer true for ICE who have made a dramatic reduction to only $100m capital, thereby enabling a new class of firm to enter the market place. The CFTC have expressed that they would like this number to be as low as $50m, the decision by ICE has been taken in consultation with the CFTC, as is a first step towards that lower amount.

Whilst this might encourage firms to become FCMs for OTC products, this presents a new challenge to the market infrastructure for CCPs – can they rely upon FCMs to be stable organisations, and is the $100m requirement a useful measure of stability?

The CFTC publish monthly statistics on their FCM population (here) which show that of the 123 total organisations, 50 would meet this requirement, and 73 would not. Of the 50 the majority are registered as FCM Broker Dealers which means they also trade positions in their own name, as well as being registered to clear trades. Whether these firms clear for external organisations is not shown, it is assumed that not all of them are looking to build a business in third party services.

Firms such as State Street and BoNY Mellon easily meet the criteria, and can now enter the market to provide clearing services (in the US for now) for CDS trades. Up until now the $5bn requirement would have excluded all but the top few broker dealers, but from a CCP perspective met the same concept that a highly capitalised firm must therefore be stable.

Under the US FCM framework, with the default of an FCM, it is still unclear what the procedure is to safely transfer client trades to an alternative FCM. The European DCM model (from what I have heard) allows for each client to pre-select one or more backup DCMs, and for the CCP to carry out a procedure of offering the client portfolios to the backup DCMs, who must elect to accept the client. The European model must allow the backups to make a credit decision on each client, as the back-to-back booking model means each client must re-book their trades to face the new DCM, and the DCM must have the bi-lateral credit line capacity to accept the client portfolio.

Given that the European model has a procedural approach which makes sense, the US FCM model at the moment seems to rely on the CFTC to operationally intervene to make decisions on where a client portfolio is transferred to. Quiet puzzling that the regulator (e.g. the referee at the match) decides to become an active player in the game and operationally make decisions which are ultimately risk based. If the outcome of a CFTC decision causes material losses to clients – will they provide an indemnity to the clients to cover this?

Despite the move by ICE, some commentators say the $100m threshold is too high – game on.