Would the New Legislation Kill the CDS Market?

New draft legislation in Congress is considering two key changes to the CDS market (see Bloomberg article). First, the bill would require that all trading in the over-the-counter derivatives market would have to be processed by a clearinghouse. Second, the draft legislation would ban CDS (Credit Default Swap) trading unless investors owned the underlying bonds. While the CME group, ICE, and other exchanges would certainly cheer the first move, the second could make any added revenue streams disappear.

Given the size of many of the outstanding bonds, the single-name CDS market would have a difficult time existing. At a time when many markets are frozen, eliminating speculation does not seem to be the best course of action for a market that is currently suffering from liquidity issues. Surely, other measures can be taken to curb speculation (such has been done in the futures market with position limits) without further limiting liquidity and price discovery.

While utilizing a clearinghouse would help to define prices in the OTC market (certainly not welcome news for the investment banks), and seems to make perfect sense, doing so would require some level of standardization. Some worry that a "non-standard CDS" market will still exist, with the proposed legislation simply forcing such trading outside of the US. While this not only forfeits a potential revenue stream for some US exchanges, it may also give up the ability of US regulators to have a say on how this market operates, which also seems counterproductive to the spirit of the draft legislation.

Comments

[ironpants:]

CDS manipulation and trading these where there is no discernible 'insurable interest' have led to wholesale destruction of the market.
Hopefully, Cuomo's hedgefund investigation will shed some light on the cabal of culprits.

Jan 29 11:29 AM

[dieuwer:]

If CDS trading is banned, investor in bonds have no longer a tool to protect against default. I think the result would be an immediate crash of the bond market.

Jan 29 11:33 AM

[ironpants:]

What did bond investors use before CDS?
Surely they must have accepted risk as part of doing business without the carnival of CDS clowns and those who peddle them. Wow, what a novel concept: accepting risk and exercising prudent DD!
At any rate, there should be underlying securities at stake as a minimum.
It's not betting on horses, or is it?

Jan 29 11:46 AM

[Bill Herbert:]

Anyone with any sense knows that the CDS market is a monstrosity, a huge gambling event that has led to off-the-charts speculation, massive losses, and as another poster pointed out, a lack of DD for bond buyers.

Many of the people (such as AIG) playing this market are actually committing fraud, because they do not have the means to pay off on their massive gambling books should the markets crash, just as we have seen.

To pretend that there is some benefit to having this corrupt activity continue is not only an affront to common sense, but it supports the idea of maintaining an illegal insurance market that has done huge damage to our economy.

Jan 29 12:06 PM

[Obama is Bu...:]

Investors do not need a CDS market-- the yield spread above Treasuries already compensates (on average anyway) for expected defaults. If you are going to buy protection, why not just buy the Treasury and be done with it? If the CDS is priced different than the spread, it means the market does not agree with itself on the default probabilities of the bond. Corporate bonds have been trading for decades, so it really doesn't make any sense that this discrepancy exists. If the CDS market were functioning properly, the difference should have been arb'd away years ago.

The problem is one of margins (or lack thereof). Unlike futures contracts, where buyers and sellers must post margins to make sure they will make good on contracts -- CDS traders do not post any margins with the counterparty. The host bank is not required to maintain any reserves against its CDS positions. There is an immediate payment "earned", but no reserve taken against future defaults -- thus the profitability of the trading is vastly overstated. AIG learned this the hard way.

Second problem, CDS pricing models make very dubious assumptions... for starters: default probabilities are clearly not normally distributed. The correlations between issuers is not constant -- during boom times, two issuers might trade inversely to each other (providing a possible hedge); but during a recession, those same two issuer's become positively correlated. This problem makes it very difficult to try to assess a bank's total portfolio risk (across many traders or across the whole desk). I don't know the answer to this.... but it is all too obvious the banks don't either

If CDS are to continue trading, they need to serve an economic purpose. It is not obvious what purpose they serve, other than artificially inflating bank profits in the short term. Further, if CDS serve a purpose, then CDS risk models need serious rethinking

If CDS really serve a need and if the risk can be managed properly, investors will find a way around any legislation. If banks are predicting the end of CDS trading, they are saying CDS really don't serve a true economic need

Jan 29 05:40 PM

[Briggsy:]

The risk is not in holding CDS protection, but in writing it. Issuers like AIG are who have had their balance sheets destroyed. Enforcing sensible reserve requirements will curb the wholesale "minting" of revenues from this type of instrument.

Jan 29 09:54 PM

[Ronald Pires:]

Sensible reserve requirements, Briggsy? But that would make it insurance, and everyone knows that Wall Street doesn't want this stuff considered as insurance. That would lead to all sorts of horrible things like (gulp!) regulation.

Feb 01 08:58 PM