ICE tackles ‘hot potato’ of market

You know about NYSE and Nasdaq. How about ICE?

No, it’s not a water or diamond company, or one that will wrestle with future storms here. Atlanta-based ICE, or IntercontinentalExchange (it’s all one word, believe it or not), primarily operates electronic trading exchanges for investors around the world. That means there are no trading floors where people scream out buy and sell orders. Computers, with the help of some pretty smart human beings, handle it all.

Jeff Sprecher

Jeff Sprecher

These days, ICE is handling something quite important — a potential fix for what helped trigger the financial crisis.

First, a little background.

You’ll recall that something few people understood including many on Wall Street — “credit default swaps” — helped undermine global capitalism. The swaps are similar to insurance policies. They allow lenders to buy protection from institutional investors, which agree to cover the risks of loans that may not get repaid, such as subprime mortgages.

Prior to the financial meltdown, the swaps got traded over and over again among investors. But no one was keeping track of all the sales and inter-relationships created from a confusing web of deals. There was no scorekeeper. That compounded the financial mess.

Enter ICE, with an idea for reorganizing the way the credit default swap market works.  It has created a “clearinghouse” in the U.S. and another in Europe. Before the meltdown, there were no clearinghouses, so swaps were bought and sold between two parties. Now, ICE gets in the middle of each transaction after a deal is struck.

“We become the buyer to every seller and the seller to every buyer,” Jeff Sprecher, CEO of ICE, said in a recent interview. That way, the sales become more transparent and the previous game of “hot potato” is no longer being played with swaps, he said.

There are other important changes that ICE has brought to the trading of these risky investments, including:

– A total of $10 billion in collateral has been put up by about 15 big banks and investment houses that are members of these clearinghouses. That reduces risk, although it does not eliminate it.

– ICE knows the current underlying value of the swaps in its clearinghouses — about $1 trillion. That’s no small feat. In fact, Sprecher said, prior to the meltdown there were about 14 or 15 additional trades following an initial swap deal. That created uncertainty among investors because they did not know which institutions were exposed to the riskiest swap sellers or how large their potential losses could be.

– The clearinghouses are not involved in swaps based on  mortgages, which caused the crisis. Instead, they are dealing in swaps protecting the debt of 190 major companies.

Still, ICE’s clearinghouses are not a panacea. For example, credit default swaps are not very liquid. That means they are difficult to sell for cash if investors need to do so quickly. And that becomes much more difficult if a clearinghouse member defaults or goes under.

Also, more institutional investors want access to these clearinghouses. But that will likely mean reducing the collateral and capital required to become members. And that would increase risk.

“I’m not sure we can create perfection,” Sprecher said.

Given the inherent risk, I’d say that’s impossible.

- Henry Unger, The Biz Beat

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One comment Add your comment

Shadow7071

January 18th, 2011
9:47 am

What’s described here is a convolution of financial schemes that in the end we the tax payers end up bailing out.