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CME and Citadel will create a market for credit default swaps

by Hollis Templeton
Oct 07, 2008

While credit default swaps may be the riskiest financial product on Wall Street, CME Group Inc. and hedge fund Citadel Investment Group LLC announced Tuesday the launch of a joint venture that will provide the first centralized market for the insurance-like contracts.

Within the next 30 days, the two Chicago-based companies will create the first electronic trading platform for credit default swaps, utilizing CME's clearinghouse and Citadel’s technology for price discovery.

With these resources and an existing over-the-counter swap platform already in place, the operation will cost CME Group very little incrementally, said Morningstar Inc. analyst Michael Wong.

“It’s an upside story for CME Group,” said analyst Patrick O’Shaughnessy of Raymond James Financial Inc. in Chicago. “Technically, they aren’t taking on the risk. They are providing a platform to better manage risk.”

The new venture will operate as an independent organization with its own board of directors and management.

According to the International Swaps and Derivatives Association and the Bank for International Settlements, $62 trillion of credit default swaps currently exist in the marketplace.

Credit default swaps were largely to blame for the collapse of insuror American International Group Inc. in September. AIG was a major seller of credit swaps—financial derivatives that promise payment to investors in mortgage bonds in the event of default.

“Recent market events highlight the urgent need to reduce counterparty credit risks in the CDS market as well as the other over-the counter markets,” stated Craig Donohue, chief executive officer of CME Group, in a Tuesday release. “Our innovative new partnership with Citadel and our invitation to leading market participants to join this first-ever integrated solution, is a key turning point in improving the functioning of these important markets.”

To encourage market participants in the joint venture—especially sellers, who take on the biggest risk—to trade both existing positions and new CDS contracts on the platform, CME Group and Citadel will allocate up to 30 percent of the venture’s equity and offer market-maker privileges to its founding members.

CME Group would not disclose the cost of becoming a founding member.

CME Clearing, as the clearinghouse is called, is the venture’s greatest advantage, Wong said. Because the clearinghouse acts as the middleman between buyers and sellers of CDS contracts, even if a seller goes bankrupt, the buyer will be safe, he stated.

CME Clearing is backed by $7 billion in financial safeguards to guarantee the performance of contracts traded through its platforms. According to the company’s Web site, customer funds have never been lost due to failure by a clearing member.

However, the higher the likelihood of default, the more margin—collateral in the form of treasuries or some other liquid asset—a seller will have to post with CME Clearing. According to Wong, this may actually deter banks and mortgage brokers from using CME Clearing, and instead going with a firm, like a bank, that requires less liquid assets.

Ironically, Citadel is among 12 financial entities that are part of the recently-announced ELX Liquidity Exchange, which, if launched, would compete with CME Group in Treasury futures trading.

CME Group traded more than 56 million Treasury bond contracts in September, and the volume is expected to rise with the government's bailout plan.

“Citadel is just one part of a consortium trying to make that platform exist,” said Wong, who noted that it is still up in the air whether the ELX exchange will ever start up. This will not affect the new venture, he stated.

CME stock dropped to $396, down $7.85 or 2 percent, in Tuesday's broad market retreat.