Donna Block has an overview of all the different groups jockeying to set up a CDS exchange:
Businesses trying to establish the new market include CME Group Inc.; NYSE Euronext Inc.; IntercontinentalExchange Inc. or ICE; Eurex, the derivatives arm of Deutsche Börse AG; and Knight Capital Group Inc.
But are all these people essentially fighting the last war? Why should CDS, of all non-exchange-traded derivatives, be the ones which are the most dangerous in the future? Neil Roland reports:
"Who's to say the next big crisis won't involve commodity or currency swaps?" said Texas University law professor Henry Hu, who testifies regularly before Congress about derivatives. "If we really care about transparency, we ought to care about all over-the-counter derivatives." ...
University of Houston finance professor Craig Pirrong said a single clearinghouse for the entire $600 trillion derivatives market would do more to address risk and inefficiencies than a guarantor for just one of its sectors.
I do wonder at the way in which credit default swaps, more than any other financial instrument, have become demonized to the point at which people genuinely think that a more-regulated CDS market will pose substantially less systemic risk. But of course the amount of non-CDS OTC derivatives, with all their counterparty risk, dwarfs the CDS market. Which makes me think that all of this is really gesture politics more than it is a serious attempt to reform the financial architecture.
This article has 6 comments:
The reason many derivatives do not already trade on an exchange is that OTC derivatives have higher profit margins -- wider bid / ask spreads at minimum, and usually the market maker knows the price while the buyer has no idea.
From the buyer's viewpoint, OTC derivatives are often off balance sheet. If you are using derivatives to **hedge** (as opposed to speculate), it doesn't necessarily make sense to inflate the balance sheet (both sides) with the business item being hedged and the hedge on the other side. Doing so makes the balance sheet appear much bigger, and can arguably distort various ratio numbers often watched by investors.
Most of the arguments for putting derivatives on an exchange boil down to this: management isn't paying attention to risk management, so the process needs to be outsourced to an exchange...
So rather than fixing the real problem, persons in management that lack the skill set to do their jobs, the markets are saying the function should be outsourced to an exchange.
What you are really arguing with your exchange idea is that we simply don't need banks to be financial intermediaries. They don't have any information advantage, they aren't better at managing risk.
This is clearly a wrong statement, but feel free to come back and provide evidence. Does posting articles in SA mean that you don't have to check facts any more? Is SA the recepticle of fractured journalism?
This is probably the source of Pirrong's $600 trillion #. If you net net down the f/x and ir contracts, you'll have a much lower number. The MV for the classifications will have changed a great deal from the values athered as of 12/31/07.
Good points.
One positive side to making derivatives exchange traded is that the exchange usually backs the contract performance. If you trade a futures contract (an exchange traded derivative) your actual counterparty is the exchange (read the fine print).
You don't have any idea who took the other side of your trade, you only see a bid/ask. The exchange is legally a counterparty to both sides. If you default on payment, the exchange is going to be the one looking to collect, not the other party.
That doesn't fix all the problems, but it does make things more transparent and less likely to blow up in your face. It's always possible to do stupid things and lose all your money as a result. (Think Hunt brothers.) That can't be stopped, but it can be made more unlikely.
Still, I like your idea of eliminating banks altogether. It has some merit.
GOOD.
The problem with CDS contracts is not transparency; it's moral hazard. A CDS on a company in which the holder has no significant stake is, in effect, a life insurance contract on that company, unsupported by an insurable interest. The holder benefits from the collapse of the company, and that's always bad public policy. Since the whole point of an exchange would be to make CDS contracts transferrable from those who need them as hedges to those who want them as speculations (or worse), an exchange for them is a terrible idea.
The law has long prohibited people from taking out life insurance policies on people in whose lives they have no insurable interest. Such a policy gives its buyer a motive for murder and provides no competing social benefit.
Imagine that John Doe wants to borrow $1,000,000 without collateral from XYZ Bank. The bank examines his credit and says "Ok, but you'll need to provide us with a life insurance contract that will pay off your debt to us if you die." Joe, who is in excellent health, easily obtains the contract from CDS Life Insurance Company. Then, unbeknownst to Joe, CDS puts this ad in the newspaper:
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Life Insurance on John Doe
We have recently underwritten the life of John Doe and have found him to be in excellent health (depsite his severe peanut allergy). To amortize the cost of underwriting Joe's policy, we are offering identical policies on Joe's life to anyone who wants one, no questions asked. Joe lives at 10 Maple Lane, Somewhere, USA, and likes to buy his lunch from passing vendors.
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Is that offer any different from what AIG FP proposed with respect to various American corporations? And if not, is there any reason to believe that transparent pricing of this toxic product would do anything to remove the moral hazard it creates?
Naked CDS contracts are a terrible idea, and better price discovery won't make them any less so.