NOS netting facility to ease fears of FFA market's 'bloody Friday'

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Neville Smith - Wednesday 5 November 2008

OVER-the-counter freight derivatives trades worth $400m have been netted off from the October settlement, potentially saving millions more in counterparty default risk. 
The 11th-hour facility was put together by brokerage Freight Investor Services with Norwegian clearing house NOS in a matter of days to provide a system that will clean up trades multilaterally, protecting credit lines and cashflow. 
Plunging rates in the physical shipping market have threatened to make Friday’s settlement a bloodbath for bilaterally settled OTC trades. Netting will not mean an end to pain for traders who bet on the market rising, but it will allow them to make or receive a single payment net of their market position and so manage their exposure. 
“This does not remove the headache but it relieves some of the pressure,” said FIS’s Michael Gaylard. 
“We saw in global financial markets three weeks ago that everyone was petrified [about counterparty risk]. That virus has moved into the shipping market, now that settlement has come around. This is a way of removing that from the equation.” 
For the October settlement, 41 companies signed up to cover 320 trades with a notional value of $397.7m. 

Counterparts paid a one-off fee to NOS to sign up and have their trades entered for netting. A matrix was used to decide if they were net payers or receivers, based on the positions entered. 
Mr Gaylard said more had expressed interested but could not get sign-off on the contract in time. NOS is redrafting the terms to make them applicable under English law and FIS hopes many more will take part in the November settlement. 
The arrangement does not require traders to sign up to NOS’ clearing services. 
Key to the contract’s acceptance is that only upon receipt of funds from payers does the system pass them on to receivers. 
“That is massively significant and it is why this works, as opposed to bilateral settlement,” said FIS broker Ian Staples. “Everybody has to pay and at the same time.” This lessens the risk of stagnation that seized the credit markets when banks lost trust in each others’ ability to pay. 
Mr Staples said he feared that traders settling bilaterally would not pay each other for similar reasons, increasing the risk of default. 
FIS wrote to market participants two weeks ago, proposing the netting mechanism as a more palatable alternative to a wave of counterparty defaults. 
The system was established in close co-operation with NOS within a week and a half. 
Mr Staples said counterparts had seen a reduction in exposure of between 70% and 90%, with a maximum of 95% in one case. 
Participants in the October netting pool did not know whose trades were included beforehand, but FIS said it hoped that a little more transparency could be brought to the November netting settlement. 
Rather than hunker down and expect the worst, more traders should be open about their participation and so encourage this type of self-regulation, Mr Staples said. 
He said FIS was “impressed by the positive attitude” of players to the proposal and how quickly they had “put aside corporate interest for the good of the market”. 
The October netting still leaves about three-quarters of the OTC market to settle bilaterally Friday, a process that Mr Staples expected to result in defaults. “About a quarter of the [total FFA] market is under pressure, but let’s face it, everybody is under pressure,” he said. “Realistically, we do expect defaults but as a proportion of whole market, fingers crossed it’s manageable.”