Clearing the credit default swap

On October 20, the Mitsui & Company invited Dirk Pruis, president of ICE Trust US, to Baruch College to speak to students about credit default swaps, in an event called "Credit Derivatives: Reducing Risks and Enhancing Transparency." Pruis covered the history and practice of ICE credit default swap (CDS) clearing.

ICE Trust is the CDS clearinghouse of IntercontinentalExchange Inc. A clearinghouse is a company that provides settlements services for financial transactions. It serves as a central party, which receives money from the payer and transfers that money to the payee. The CDS is "A single point of contact from a legal perspective," said Pruis. As the president of ICE Trust, Pruis oversees technology operations and financial functions at the clearinghouse.

ICE has three regulated exchanges in different countries and five regulated clearinghouses. "We've become one of the largest exchange and clearinghouse operators in the world," said Pruis.

A CDS offers default insurance on certain types of bonds and loans. "It is the way to strip out the default risk in the bond," said Pruis. The buyer of CDS protection pays a quarterly premium to the seller of protection in return for a payout should the issuer of credit default.

Over-the-counter (OTC) CDS contracts can be traded for speculative investments. In this sense, it is different from insurance. "The key difference between an insurance and a CDS contract has become its regulation and its trade-ability," said Pruis, "there has been tremendous growth in the [CDS] market, particularly over the last three or four years."

A consortium of banks, exchanges, and interdealer brokers, through a company called The Clearing Corporation, started the modern day clearinghouse. The Clearing Corporation was associated with the Chicago Board of Trade, the first futures exchange formed in the United States in the mid-1800s. Futures exchanges allowed people to buy specific quantities of goods or financial instruments at a price sometime in the future.

During the end of 2006, investment banks, inter-dealer brokers, and an exchange started to refocus the clearinghouse function on the CDS market. The banks created a legal framework as a method of dispute resolution. They standardized how a credit event is determined, and what qualified as a default. In 2008, the International Swaps and Derivatives Association (ISDA) adopted this legal framework.

The collapse of Lehman Brothers Inc., a financial services firm, prompted banks and regulators to consider drastic measures to launch a clearing facility. The Clearing Corporation applied to become a limited purpose bank in New York State to enable the Federal Reserve Bank of New York's regulation.

The consortium of banks chose ICE Trust to adopt The Clearing Corporation's operations. ICE Trust was subject to regulatory scrutiny. "There were five agencies that showed up … we had anywhere from half a day to a full day of presentations…on how this clearinghouse was going to work," said Pruis. The company was also under independent review of their risk models by academics from Columbia University and New York University. ICE Trust was approved in March by federal and state banking boards.

ICE Trust is a limited purpose trust bank chartered in the State of New York. It is a member of the Federal Reserve System, and its primary regulators are the Federal Reserve and the New York State Banking Department.

Currently, CME Group is ICE Trust's main competitor in North America, and Eurex is the company's main competitor in Europe. ICE Trust has cleared $2.4 trillion in the United States.