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June 3, 2013

OTC Credit Lines Not Covered?

By Editorial Staff

Using a clearinghouse to process over-the-counter derivatives transactions can pose credit risks that won't become apparent until after a trade.

That's a warning from officials of trade processor MarkitSERV, which has begun to offer a pre-trade MarkitSERV Credit Centre service. The seemingly good credit of an OTC derivatives party could drag down a buyside firm, which hasn't seen a complete picture of its credit rating until after the trade, they say.

Jeffrey Maron, managing director of MarkitSERV, said that waiting to verify all the credit lines of counterparty until after a trade is too late.

"You may find that some of the counterparties you have done the transaction with won't be able to lose it, because their FCM (futures commission merchants) won't pick it up at the clearinghouse. That is, the FCM refuses to take on that risk," Maron said.

In the wake of the market meltdown of 2008 caused in part by OTC derivatives problems, regulators are requiring the clearing of these contracts, which primarily had been done on a dealer-to-dealer basis before the market disasters.

However, the securities industry has been "struggling to understand how to manage the so-called certainty of execution issue," said Will Rhode, principal at market researcher Tabb Group. That, he added, is the risk of a trade being rejected in a fragmented clearing environment. The credit risk, said MarkitSERV's Maron, can be understood by thinking of two people who split a dinner bill. Both submit their cards to pay the bill. "His card gets declined and yours goes through," said Maron of MarkitSERV, which is owned by the DTCC.

The pre-trade MarkitSERV Credit Centre service will initially cover OTC credit foreign exchange and rates. Later, Maron said, it will cover equity derivatives, futures and options trades. He added that it will also eventually provide the service for OTC derivative trades that are uncleared.

 

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