We’re entering a new era of disclosure which will likely change the landscape for derivative investments for years to come. Tuesday, a group of 15 different Swap dealers including JPMorgan Chase & Co. (JPM) and Goldman Sachs Group, Inc. (GS) agreed to increase the amount of trades they send to clearinghouses. A clearinghouse is simply an intermediary which acts as a guarantor for both parties involved so that the risk of counterparty default is minimized.
For the last decade, the number of unregulated “Over The Counter” contracts between financial institutions has grown and eventually these extensive derivative positions threatened to bring down the nations financial infrastructure. To a large degree, the calamity came as a result of counterparty failure where large players like American International Group, Inc. (AIG) were unable to meet their obligations relating to these complicated agreements.
The news of increased participation by clearinghouses will likely be a strong benefit to companies like IntercontinentalExchange, Inc. (ICE) and CME Group Inc. (CME). Both firms are leaders in facilitating both trade execution and clearing services. The clearing portion of the business represents substantial risk, but also leads to the largest profits. For clearing firms with robust and well monitored risk-management systems, the long-term reward can be substantial and investors can see substantial profits.
Clearance arrangements require both parties to put up a particular amount of capital which is held in order to meet the obligation should one party default. As these positions are held and the value of the gain or loss shifts, the clearinghouse has the right to require additional capital be posted by either party in order to continue to satisfy the potential loss. If a trader is unable to come up with the additional capital needed, the clearinghouse will close out the trade at the market price in order to protect against loss.
Traders pay clearinghouses fees and at the same time, a clearinghouse can often collect interest (only a very modest benefit with today’s rates) on the balances held as collateral. New regulations are requiring a significant increase in cleared trades as agreements that were formally able to bypass the clearance process are now required to be guaranteed by a third party. This new oversight will promote more stability in markets that used to fly under the radar and will instill trust in the system without the government over-regulating or becoming too involved in the actual process of monitoring trades.
Clearance firms should be allowed to set their own limits and trading requirements in order to manage their own risk. If several competitors are involved in the business, it will foster competition where clearance fees and margin requirements are fair, but clearance firms are still able to keep enough capital to offset potential losses and keep stability in trading markets. Regulators should be aware of capital balances and make sure that these balances are sufficient to cover losses, but if the clearance firms are able to set free-market regulations in order to manage risk and create profits, the system will likely be much more healthy than if government agencies set arbitrary rules.
IntercontinentalExchange is currently trading at roughly 17 times expected earnings for 2009. CME Group has a similar multiple closer to 18 times forward earnings. Both stocks look relatively attractive given the potential for significantly higher earnings when swap dealers begin sending more volume through the clearing process. The overall trend of more trades funneled through clearing houses will increase revenue, and both companies have shown an ability to convert new revenue into profitable earnings growth.
There is potential for both stocks to trade lower initially if we see the broad market decline. Investors will likely make the assumption that a declining market means more risk for both companies. However, the potential for more volume in a volatile market should actually increase the value of the stocks, so I would use any weakness as a buying opportunity. Clearing firms are likely the beneficiaries of increased regulatory scrutiny and while OTC trading is here to stay, CME and ICE can play a vital role in ensuring that our financial infrastructure remains sound.
FD: Author has a long position in ICE in the ZachStocks Growth Model
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