CDS Clearing Houses Could Magnify the Market Disruptions

Last month, the Chicago Mercantile Exchange (CME) teamed up with the Citadel hedge fund group to create a counterparty clearing system for credit default swaps. On Thursday, IntercontinentalExchange (ICE), in collaboration with The Clearing Corporation (a bank-operated clearing house), made its own bid for a slice of the $60 trillion CDS market. The objective of both initiatives is, of course, to avoid market disruptions by guaranteeing payouts in the event of one or other counterparty being unable to comply with settlement obligations. In practice, the very dynamics of a centralized clearing house may cause unprecedented chaos, the type which may result in immediate challenges to the viability of major banks and insurance companies, despite the spate of recent bailouts.

Assuming that the CME and Intercontinental can achieve a consensus in the contractual fundamentals of CDS transactions, including commonality on credit and rating events, in the final analysis no efficient derivatives clearing house can deemed to be credible without a rigid adherence to an acceptable mark-to-market mechanism. Intercontinental has signed memoranda of understanding with Bank of America (BAC), Citi (C), Credit Suisse (CS), Morgan Stanley (MS), Merrill Lynch (MER), JP Morgan (JPM), Goldman Sachs (GS), Deutsche Bank (DB) and UBS (UBS). But, given the outlook for the global economy in 2009 and the injection of government funds, will regulators allow nine of the biggest CDS traders to let the mark-to-market rule influence capital adequacy ratios?

Logically, an integral relationship between mark-to-market and solvency provisions would provide regulators and investors with a picture of the true risk inherent in the balance sheets of CDS market participants on an ongoing basis; and, in many key respects, debacles like Lehman and AIG could have been addressed many months ago if adverse CDS positions had been exposed prior to the sub-prime meltdown.

The problem is that any marking to market of the currently outstanding CDS contracts could well disclose a massive, even shocking, quantum of residual CDS-related losses. It is no secret that default risk spreads have widened right across the CDS spectrum (CDX and iTraxx indices, and sovereign debt) during the month of October, and future price trends depend entirely on the magnitude of the recession, in America and the rest of the world, through the course of next year.

While the clearing houses may well accept highly rated paper as security in lieu of cash margins, and issue margin calls in the event of rating downgrades, they still need to generate ongoing profit and loss statements on CDS positions on a daily basis, if they plan to provide valid indicators of counterparty risk. New contracts will obviously not be subject to concerns relating to the historical shifts in spreads since early this year. But what about existing deals?

In theory, CDS clearing houses are excellent propositions for two reasons. They will establish a semblance of order in a marketplace viewed with deep-rooted suspicion amongst regulators and lawmakers, though much of the suspicion may be attributed to sheer ignorance. At the same time, efficient clearing mechanisms will certainly encourage broader participation in credit default insurance transactions, participation which will assist both sovereigns and corporations to access the CDS and CDO market in order to fine-tune their risk-reward profiles.

In practice, a mark-to-market structure only works when there is minimum threshold-liquidity in underlying contracts. How will the clearing houses balance the lack of liquidity (at least in the initial stages) with the requirement to liquidate positions if pre-determined margins are not maintained?

From an arbitrage perspective, CDS clearing houses are a necessary innovation today, if only to efficiently manage the gap between reference instrument yields, CDS costs, equivalent treasury rates and potential rating adjustments. But the same arbitrage matrix suggests chaos if the mark-to-market challenges are not addressed in a comprehensive manner.

Stock position: None.

Comments

[Bill Herbert:]

I think Ben Stein had it right - just declare all of this nonsense null and void - these are illegal insurance contracts - and move on down the road. If you propose a clearinghouse, I sincerely hope you intend to fund it with private money, i.e. not my money!

Look, if two idiots in a bar bet each other $25,000 on, say, the World Series, and when the loser can't pay, why should the Federal Government step in and pay the winner? That makes no sense.

In the case of the CDS racket (and believe me, that's exactly what it is) the loser is an idiot at Merrill Lynch, and the winner is an idiot at a hedge fund. Or vice versa, it makes no difference. Most of these 'contracts' are just gambling events - negotiated over the phone, often by people like the creep at AIG who was just trying to pump up his bonus, giving no thought to the legality of what he was doing, or how it just might destroy his company.

Many of these so-called "contracts" are just an agreement faxed back and forth, sometimes there is no signature, some of them are now being repudiated by the losers, as in "I never agreed to those terms" or 'Bob left six months ago - we have no idea what you're talking about.'

To ask the U.S. taxpayer to bail out these idiots is beyond any rationality - we are not "saving the financial system", instead we are underwriting crime and extreme recklessness and moral hazard by a bunch of adventurous con men.

2008 Oct 31 07:10 AM

[bonddude:]

The above comment represents the fundamental misunderstanding in popularly advertised thinking about cds derivatives. They are not ALL garbage. Some contracts represent entities with an insurable interest that are actually collateralized. While it is true that the pricing of all of these products is relatively frozen many have actual underlying value. Nevertheless, distinctions and need to be made between the side bet types and collateralized of contracts types by regulators. This will result in a continued and painful selloff in most asset classes until, some have ventured, a 90% contraction in valuation has been effected in the cds markets.

Conclusion, we have not reached the bottom in selling of stocks, gold or oil. The next wave will start when trading in cds contracts begins. JMHO
BG

2008 Oct 31 10:31 AM

[investor88:]

Another wake up call from Rakesh. We so slogan shouting that moving CDS to a public exchange will be the panacea, but it is not so simple getting there.

2008 Nov 02 08:29 AM

[Paul Richards:]

For more on this topic, and somewhat the opposite point of view, please see my article at:

seekingalpha.com/artic...

2008 Nov 02 09:22 AM