Credit Default Swaps, Counterparty Risk and Free Markets

The recent debate over appropriate credit default swap ("CDS") regulation remains ambivalent. The side in favor of moving credit default swaps onto exchanges argues for less counterparty credit (and systemic) risk. The side in favor of keeping credit default swaps trading over-the-counter ("OTC") argues that current CDS markets operate reliably and efficiently and that current CDS prices reflect counterparty credit risk exposure.

The current structures of exchange-traded futures and OTC forwards markets provide a likely solution for this ongoing problem. Because counterparty credit risk mitigation represents the central goal of new CDS regulation, creating a CDS trading exchange seems appropriate, given sufficient consumer demand for a market. If risk-averse CDS users are willing to pay a price premium for counterparty credit risk mitigation, then let free markets work and allow someone to meet that demand with a supply. Although counterparty credit risk will not completely dissolve, the coexistence of two markets will result in risk mitigation. Less risk and multiple markets should appease both sides of the regulation debate. 

Although the parallel between futures and forwards markets and exchange-traded and OTC CDS markets may seem strong, one key difference remains dangerous. Because futures and forwards involve the trading of countless uncorrelated assets, the probability of an event that will cause significant price fluctuations in most assets (and significant individual default rates) seems remote. The need to cover countless user defaults seems unlikely for exchanges trading futures. CDS markets involve the trading of insurance. The likelihood of an event (such as current market conditions) that could cause a significant number of users to default on seemingly uncorrelated CDS exposures seems less than remote. In this event, exchanges, even with considerable collateral, may not be able to cover all trades. Consequently, hidden counterparty credit risk on exchange-traded derivatives may still exist.

Regardless, the two market solution should still reduce overall counterparty credit (and systemic) risk by spreading it over both exchanges and individuals. As long as no one forces CDS market participants to trade on either market, moving to a two-market structure successfully mitigates risk without compromising free market development. The result is effective legislation.

Disclosure: None

Comments

[dlaw]

Your point makes no sense.

The centralization of counterparty risk through an exchange reduces the threat of netting effects, and therefore reduces overall counterparty risk. Your use of "correlated" and "uncorrelated" is a canard for a specious argument that somehow OTC markets handle risk better. In fact, exchanges create more information and better access to it as an information clearing house. This reduces asymmetry, increases liquidity and does away with unnecessary secrecy and uneconomic profits.

The argument you present for an OTC approach is a non-argument.

2008 Nov 18 07:32 PM

[Samuel Cashiola]

dlaw,

Thanks for the thoughtful comment. Regarding your point(s), I think people can value any new features (some of you which mention above) that an exchange can offer. As long as demand exists for an OTC market, however, people should not be forced to trade on an exchange. If everyone decides that the exchange format is better, then the OTC market will fail with no business. Let natural market forces decide. Why do forward markets still exist?

Thanks

2008 Nov 19 07:46 AM