In theory, moving credit default swaps from over the counter trading to exchange trading should reduce systemic risk. Exchanges fail far less often than individual institutions, and when they do, the damage has less propensity to propagate into a systemic event.
As keen as the authorities are to get the big, opaque CDS market on a safer platform, obstacles remain. For a host of reasons, outstanding CDS cannot be migrated onto an exchange, but newly written CDS designed to fit certain parameters could be (in theory, old contracts could be “novated” in favor of new ones). CDS suitable for exchange trading would have to be far more standardized. How to simplify the offerings has yet to be sorted out.
The most valuable element of moving CDS to an exchange, as far as lowering systemic risk is concerned, is centralized clearing, since if anyone defaults, the counterparty is the exchange, not an individual firm. Thus regulators have been moving forward as quickly as possible to set up a central clearinghouse. In particular, the CME Group proposed acting as a clearlinghouse, which means that its members would absorb the losses if any counterparty failed. Some rival proposals suggested setting up a new clearinghouse, which is a much sounder design, but would take longer to implement.
However, some savvy and influential and savvy CME members are now objecting to the idea, arguing that the additional risk of CDS clearing on top of their existing CME obligations is more than the members can realistically support. Moreover, they contend that putting together CDS and futures under the same umbrella is too much risk in one venue, and will increase, not reduce systemic risk.
Note that CME Group (along with Citadel) is one of four groups vying to handle the CDS clearing function. However, CME appeared to be the frontrunner. Note that this wrinkle does not imperil the idea, but means there may be more speedbumps down the road.
This development suggests that the rush to get a CDS exchange (or at least a clearinghouse) up and running is being moved forward with such haste that some risks are not being assessed properly.
The article is a bit geeky, but is useful in setting forth some of the risks in CDS trading.
From Bloomberg (hat tip reader Steve):
Electronic trading pioneer Thomas Peterffy says a plan by CME Group Inc. to guarantee credit- default swaps could put his entire $4 billion company at risk.
CME Group’s proposal to use its existing clearinghouse to clear swaps would require exchange members such as Peterffy’s Interactive Brokers Group Inc. to bail out a failed trader. Those companies have put up $101 billion to guarantee the futures and options now cleared by CME.
“It would be a great mistake,” said Peterffy, 64, a Hungarian immigrant whose company executes 14 percent of the world’s equity options. “Mixing the two types of funds will jeopardize the entire financial system” set up to guarantee futures trades, he said.
Peterffy, whose concern is shared by CME Group members including Penson GHCO Chief Executive Officer Chris Hehmeyer, is balking at a plan that CME developed amid pressure from the Federal Reserve to create a safety net for risky credit-default trades, now traded on an over-the-counter basis. Failed investment bank Lehman Brothers Holdings Inc. was among the top 10 dealers in the $55 trillion CDS market.
CME Group announced its CDS clearing plan Oct. 7, saying it would reduce counterparty risk and offer the market a “key turning point.” A rival proposal by Intercontinental Exchange Inc. would avoid the issue raised by Peterffy by creating a separate clearinghouse to segregate its futures and credit-swaps business.
A clearinghouse, capitalized by its members, all but eliminates the risk of trading-partner default by being the buyer for every seller and the seller for every buyer. It employs daily mark-to-market pricing and liquidates positions of traders who can’t pay their margin.
In OTC markets, traders rely on their counterparty to make good on their agreements. A trader with a cleared OTC position could put other CME member firms at risk of making up a shortfall if the trader couldn’t cover the losses. CME’s clearinghouse hasn’t ever suffered a default…
Peterffy said he doubts that the exchange will be able to determine CDS pricing because they trade infrequently.
“There is no assurance once the buyer or seller goes bust you can liquidate those positions near the price” that was settled upon the day before, Peterffy said. Interactive Brokers has as much as $1 billion pledged to equity and derivative exchanges, including CME Group, to fund trader shortfalls.
Credit-default swaps pay buyers face value for the underlying securities or cash equivalent should the company fail to keep to its debt agreements.
“I can see why people would be concerned by the CME’s model,” Penson GHCO’s Hehmeyer said.
CDS pricing will still come from voice and electronically executed over-the-counter trades, said David Rutter, deputy CEO of ICAP Plc’s electronic broking unit. Although most of these swaps trade daily, prices are not always available in all swaps, he said.
“The clearinghouse is potentially compromised if you don’t have really good, independent and reliable mark-to-market information,” Rutter said.
The amount of money traders must have on deposit, known as margin, is the main way clearinghouses insure against losses. CME Group will require higher margin to trade CDS than futures, Taylor said.
To set futures margins, CME Group tallies a trader’s total potential portfolio loss in one day and uses that amount to derive the margin rate. For CDS contracts, CME Group will add up the potential portfolio losses over two to five days, and use that amount to set the margin rate, Taylor said.
Margin calls on CDS contracts could be a greater risk than with futures, said Howard Simons, a strategist at Bianco Research LLC in Glenview, Illinois.
“You have highly correlated systemic risk,” he said. “We have whole industries where if one’s in trouble, all of them are in trouble.”
When Lehman went bankrupt last month, the cost of credit swaps on Morgan Stanley rose almost six-fold.
The CME Group risk committee, composed of the banks and hedge funds that capitalize its clearinghouse, will have to approve any new contracts cleared by the exchange. Taylor declined to comment on the risk committee.
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World’s ‘Dumbest’ Bank Raided By Prosecutors
http://news.hereisthecity.com/news/business_news/8381.cntns
Reuters reports that German authorities raided the Frankfurt offices of state development bank KfW Wednesday, as the probe into how come a $411m swap transaction was executed with Lehman Brothers after the former Wall Street firm had filed for bankrupcty last month.
Prosecutors said in a statement: ‘The aim of the investigation is to determine whether the responsible parties at KfW violated their legal obligations to safeguard assets by failing to block the transfer of funds on September 15, 2008 despite knowledge of signs of liquidity problems at Lehman Brothers, and against the background of an emerging international banking crisis’.
Finally, people are waking up to the problem of clearing single name CDS!
Clearing Houses also depend on the ability of being able to transfer a failed position to someone else.
A trader can’t meet a margin call on a future that he sold at 100 that is now trading at 110. The Clearing House will transfer the short futures positon to another trader and along with the $10.
The Clearing House can even buy futures temporarily to hedge their positon.
How on earth does the Clearing House expect do that with illiquid CDS?
“How on earth does the Clearing House expect do that with illiquid CDS?”
Limit exchange traded CDS to fungible CDS. Make any CDS that is not exchange traded illegal, and writer/buyer punishable by 5 years in prison and 200% of expected profits for each count.
A CDS seller on a single name should deposit 100% initial margin. The only authorized way to post less than that should be to have a diversified portfolio of CDS’s. THe portfolio margin should be determined using market implied correlation on standard tranches CDO’s (that would be cleared on the exchange too).
Anyway, there is no escape
: the exchange margins are going to be way superior to the add-ons of OTC derivatives. That is part of the deleveraging story.
Alas, the payout on the CDS is uncertain. On a $10MM notional the payout could be anwhere from $1.00 to $10MM.
What would then be the intial margin?
This is an opaque financial market that currently threatens the world financial system. In my neighborhood the market for heroin, a derivative of opium, is considered grossly anti-social and those that actively make a market in heroin are considered economic predators. Consequently, the heroin market is actively suppressed. Merely because a “market” exist for a “financial product”, we shouldn’t automatically presume that the product adds social value.
Perhaps, like the market for heroin, Congress should consider whether the market for CDS and similar derivatives is simply a creation of financial speculators and predators, provides no positive social function and may actively undermine our political economy.
Here is a case where a market has not only delivered a grossly inefficient outcome, but it appears to be a product that does not conform to the public interest. This is a market that Congress should consider dismantling.
Yves. You once said that derivatives were like drugs – all have a place – but need to be used appropriately.
The simple solution with CDS is to make it illegal to purchase CDS that exceeds your holding of the underlying bonds issued by the refrence entity.
Further. If your bond holding is very liquid then you just have to accept that full CDS insurance may not be possible. Contracts must have a cancellation clause which takes effect if/when the CDS purchaser has received settlement funds upon sale of underlying bonds. There needs to be a duty to notify CDS writer that contact is now void.
This will cap the value of all CDS to the total issuance of the companies/entities covered. It may even overcome the concerns raised about exchange trading.
There is still a problem with managing transference to 3rd parties. Perhaps that should only be possible for exchanged traded CDS.
With regards to CDS’, has it really been that bad? I know there’s been a lot of hysteria…and this lack of confidence has been troublesome…but past that—I’m just not seeing what the super-charged fuss is all about.
The recent LEH auction was quite orderly.
WM, also appears to be going without a hitch.
After reading blogs like this, I was expecting MUCH worse. It just hasn’t been that bad.
D,
Why do you think AIG needed $85 billion + $38 biliion + another $10 billion of rescue money from the Fed? That was for their CDS exposures. Had they gone under, everyone is agreed it would have constituted a systemic event. And the fact the numbers keep getting bigger says there is serious stress.
Just because the officialdom threw $133 billion at AIG to avert a crisis, and may have succeeded, you now argue that because there were no disastrous outcomes, there was no risk. That is tantamount to saying that because no one died as a result of Three Mile Island, really it was not a big deal at all.
And per the later post citing Roubini, we are not through hedge fund failures. He thinks the worst is yet to come, and some hedge funds were protection writers. Now none of them may big enough players to do much damage individually (protection writing was concentrated in about ten firms), but if there were to be liquidations/failures in close succession, we might see some unravelling.
Yves, you claim “CME appeared to the be frontrunner” to be the CDS exchange and “this wrinkle does not imperil the idea.”
But read the Bloomberg article you posted! The owner of the firm doing 14% of the world’s equity options trades says he prefers a separate exchange from the CME. And “a rival proposal by ICE would avoid the issue raised by [the options trading firm’s owner].”
How can CME still be the frontrunner when this kind of systemic risk worry is raised? If there are going to be kinks in CDS settlement, why do we want to invite contagion into the equity options market or the other CME markets?
Anon of 2:25 AM,
I made quite deliberate use of tenses. The CME “APPEARED” to be the front runner. If they back away from using their clearinghouse due to members refusing to back the idea, they are no longer the head of the pack. It was the supposed willingness to use their current platform that gave them a leg up.