There’s an odd little story on the home page of the Financial Times website, odd in three respects.
First, it discusses a development, namely, the launch of a credit derivatives clearinghouse that is important enough that it ought to be reported more broadly, yet several searches on Google News came up empty-handed. Readers no doubt know that credit default swaps, a type of credit derivative, are believed to be the product that led the Fed to sponsor the bail-out of Bear Stearns. Its exposures were large enough to run the risk of creating a cascade of counterparty defaults. A central clearing house would have made that impossible.
Second, the story is remarkably vague as to what kind of “credit derivatives” we are talking about here. The intent of proposals like this is to get the $62 trillion credit default swaps market out of its current, opaque, bi-lateral trading configuration. Many have proposed trading CDS on an exchange (centralized clearing would be part of that structure). But it isn’t clear whether all CDS will be included (many are written on “single names” meaning individual companies) or perhaps a subset, say some of the big baskets. Also noteworthy is that this proposal merely involves clearing, not making prices more transparent to customers.
Third, and the most revealing, is that the FT raises the notion that this move may be cosmetic, designed to forestall regulation.
From the Financial Times:
Efforts to tackle the risk surrounding privately negotiated credit derivatives will take a step forward on Thursday when 11 of the world’s biggest investment banks announce the creation of the first central clearer for the opaque contracts by September.
The absence of a central clearer has made such contracts risky because there is no guarantee that parties will pay out.
This systemic risk has fuelled the global credit crunch, prompting regulators to step up pressure on banks to show they are trying to make the system more dependable.
Credit derivatives allow investors to make bets on the creditworthiness of baskets of corporate debt. Global growth in the notional value of such contracts grew by 81 per cent last year to a value of $62,200bn.
Credit derivatives contracts are predominantly negotiated privately between traders who rely on their assessments of each other’s ability to pay under the terms of the contract. A clearer uses funds contributed by traders to guarantee against default.
“The credit crisis has definitely heightened interest in this kind of solution among the regulators,” said Kevin McClear, chief operating officer of The Clearing Corporation, the Chicago-based institution backed by the banks that will act as the new clearer. “We don’t think there’s a better approach to reducing systemic risk.”
The need to act fast to pre-empt stiffer regulation in the wake of the credit crisis has given impetus to a proposal that has been 18 months in the making. It has also been accelerated by attempts by other clearers, such as LCH.Clearnet, Europe’s largest independent clearer, and the CME Group, the Chicago-based derivatives exchange, to muscle in on the business potential of clearing such over-the-counter derivatives.
Thursday’s proposal is the result of an agreement between The Clearing Corporation (also known as CCorp) and the Depository Trust and Clearing Corporation (DTCC), the New York-based clearing group.
CCorp’s backers – including Goldman Sachs, Citigroup, JPMorgan, Bear Stearns and Morgan Stanley – will establish a guarantee fund to cover losses if any firm should fail.
While Thursday’s announcement is sure to be welcomed, questions remain about whether the proposal will raise industry standards or if it is largely cosmetic.
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Then again, it is common for the investment banks to band together to create exchanges/crossing networks — they have done it many times before.
David,
Agreed but CDS would have to be standardized to be traded. The opaqueness and customization are the big reasons the product is so lucrative. Moving it to an exchange would make it far less profitable.
Why does the financial world need exchange traded credit derivatives?
Richard,
Unless they have a central clearer, the failure of any sizeable participant (and BTW that includes the monolines and AIG) will bring the whole financial system down. This is vastly better than having the taxpayer bear the risk, which is where we are now.
Yvea,
Respectfully, with 60+ trillion outstanding, aren’t we likely to discover that many of the bets were placed with 21st century bucket shops? If so, won’t the counter party defaults bring the system to its knees regardless of Federal Reserve interventon?
Thanks for all the time and effort you put into this blog. Your posts and the comments are consistently the most intelligent and thoughtful I’ve read.
Richard,
Thanks for the kind words,
$60+ trillion in notional amount, the economic exposure is much less. The IMF guesstimates 2%, but in a weak economy, credit risk increases, so the exposure (risk of loss) on existing contracts ought to rise. So what, maybe 4%? 6%? 8% at the worst?
That doesn’t mean all that would come a cropper in a downside scenario, but that is a better indicator of the real exposure.
But to your real point, if we have a real problem, the Fed’s ministrations will be somewhat like asking the audience to applaud so Tinker Bell will live.
Yves,
Let’s hope the 4%,6%,8% loss doesn’t wind up with the commercial banks. Just to be safe, I’ll keep clapping until this is past!
“credit default swaps, a type of credit derivative, are believed to be the product that led the Fed to sponsor the bail-out of Bear Stearns”
The FT actually reported a while back that the repo market was as much a concern as CDS. I find it interesting that the WSJ monograph completely ignores the fact that Bear’s repos were pulled despite the collateral. To Congress Cox made it clear that this dynamic had thrown all the regulators for a loop.
What better way to remove risk from the financial system than by having Citibank, Bear Stearns (???!!!) and others set up a guarantee fund to pay in the event of default.
Gee, doesn’t anyone else what is wrong with this picture?
The Clearing Corporation was recapitalized by the banks back in December of last year. While the press release just came out, this has been worked on for a while now.
There is almost no doubt at least some part of this market will be cleared. Will it ever extend down to individual names is still an open question, but the major indexes will be cleared.
Also, note that this product is unlikly to remain completely OTC. CDS are really corporate bonds in disguise, and corps are regulated by the SEC. I don’t think that the former lassie-faire attitude to new products is in place any longer since the nationalization of Bear, so they will regulate these products. My guess is that a new CFTC regulated market will be approved that allows major players and brokers to trade these in a limited participant marketplace.