An ICE Age of Derivatives

With the global financial system collapsed in late 2008, it became clear that the huge and highly unregulated derivatives market needed to change. The value of derivatives is based on the value of another asset such as a stock or a bond.  When Lehman Brothers went under on September 14, 2008, it had $738 billion of these contracts on its books. Lehman was followed by insurer AIG, which reported as much as $53.5 billion in derivatives losses, which were linked to almost one third of its $182.5 billion federal bailout. The scope of this exposure was beyond investors’ wildest nightmares. Enron’s demise just a few years prior had only $22 billion in derivatives weighing down its financials.

Although Washington has been promising to crack down on derivatives for decades, slow-moving regulators and law makers have made little progress toward taming these wild beasts, even after the financial collapse. Derivatives are the reason for the current debt crisis in Greece, where Goldman Sachs helped the government to use currency swaps to take advantage of exchange rates by making its dollar and yen denominated debt look like cheaper euro-denominated debt. While the Senate stalls on the requirements of financial reform, banks and financial institutions have quietly taken the initiative to self-regulate.

Last year, a group of banks began clearing derivatives on a new entity called ICE Trust US, a clearinghouse owned by Intercontinental Exchange Inc., which operates futures exchanges and over-the-counter markets. Intercontinental has been a major player in creating alternative forms of trading since its inception in 2000, and is currently listed on the NYSE with a market cap of $8 billion. Intercontinental acquired The Clearing Corporation (TCC), which provides services for over-the-counter derivatives trading with nine big banks: BOA, Citi, Goldman Sachs, JPMorgan Chase, UBS, Merrill Lynch, Morgan Stanley, Deutsche Bank and Credit-Suisse. ICE Trust US was then created to clear trades for credit default swaps, a type of derivatives that can be used as insurance against credit defaults and generally focuses on trades between banks and brokers.

Still following? Intercontinental gets half of ICE Trust US revenues, and the nine founding banks split the remaining profits. Recently, Barclays, HSBC, the Royal Bank of Scotland and BNP Paribas have signed on as trading members (although they do not have an ownership stake.) So while Washington stayed tangled in bureaucratic details of creating a clearinghouse, ICE Trust US was making moves. Between March and December 2009, ICE Trust US processed $3.1 billion in trades of credit default swaps and collected $30 million in fees. In English? This is similar to a car dealer saying it sold $200 million in Chevy’s and earned $5 million in profits.

Now, if the Senate ever gets around to passing the clearinghouse requirement ICE Trust US market share could explode. While many agree that putting derivatives trades on a clearinghouse will reduce systemic financial risk. It isn’t a perfect solution. There will still be deals that don’t fit into the system for lack of a price history. At least it’s a step in the right direction.