Coming Soon: A Central Clearing House for Credit Derivatives

As reported at the Financial Times and the WSJ, discussions have progressed to the point that larger banks and dealers should have a central clearing house for credit derivatives by later this fall. The market for credit derivatives is currently near $62 trillion in notional value after being less than $5 trillion as little as five years ago.

The goal of the clearinghouse will be to reduce the systemic risk that results from inefficient trading and uncertain counterparty exposure, both of which have increased as the market expanded. Automated trade-matching and electronic processing in other OTC derivatives market was also discussed. Credit derivatives in particular have caused concern as their rapid grown has made it more difficult to both track and measure the exact level of exposure being taken.

Recent credit problems have highlighted the need to better understand counterparty exposure. A central clearing house for credit derivatives should help in this area given that the clearing house will take the risk of a market participant's failure. Any failure would then be absorbed by the clearing house members, reducing the need for the Federal Reserve or Treasury to get involved, and possibly preventing the type of failure that was experienced with Bear Stearns (BSC). Like other clearing houses, trades are also likely to be better scrutinized when made, such as making sure that margin requirements are enforced and trades are verified and recorded.

To date, the levels of electronic derivative trading in the various markets has been mixed. Currently, about 90% of credit derivatives are traded electronically. The interest-rate derivatives market, which is larger and potentially more worrisome, has also increased electronic trading and now sits at about half of all trades. Equity derivatives trading is bringing up the rear with only about one quarter of all trades executed electronically. Depending on the success of the credit derivative clearing house, plans could be expanded to also include the equity and interest rate markets.

One current hitch for the credit derivative clearing house is the need to make sure that the entire CDS market is integrated and electronic. To facilitate the move, dealers have agreed to reduce the total value of outstanding CDS trades, and to help sort out corporate defaults by incorporating a cash settlement mechanism into CDS documentation. Of note is that the market in many cases would still be private, but more centralized.

Although the details of the clearing house are still being worked out, such as what exactly the dealers and exchanges will control, any move is certain to benefit the exchanges as they will now have a direct link to the lucrative CDS market, while the large investment banks that currently control the credit derivative market will need to start sharing some of the billions of dollars of revenue.

For some banks, this line of revenue has been significant. Companies that may be positively impacted include the CME Group (CME) and NYSE Euronext (NYX). Investment banks that may be negatively impacted, at least with regard to losing some of their current credit derivative revenue stream, include Deutsche Bank (DB), Goldman Sachs (GS), and Morgan Stanley (MS).

Comments

[monk:]

Thanks for the update! It would have been nice to wake up and have the BSC ordeal turn out to be bad dream! It's clear the FED wants to wake up without nightmares that cost the U.S. taxpayer.

The recent testimony of many industry participants on the "Hill" = coupled with the FED's mandate that all OTC transactions be totally transparent = Leaves only ONE viable solution. It's self evident that the CME is the only organization with the size and talent to transform an antiquated OTC market into a reliable and quantifiable marketplace:

To sum it up:

CME plays Transparency
Investment Banks play Hide and Seek

CME has clearing for OTC with pricing and daily position netting ready to "Plug and Play"
Investment Banks are unable to balance the books

CME has a strong capital position
Investment Banks are passing around the hat

CME has proven management that lives and breathes the business
Investment Banks have a revolving door, hired hand policy

CME, one of few financials that can and thus is being shorted - Wonder Who?
Investment Banks apply Voodoo Naked Monkey Motion to keep shares up

THE SELLING PRESSURE ON EXCHANGE STOCKS IS AN UNWARRANTED SINISTER ATTEMPT TO MAINTAIN A DESTRUCTIVE "STATUS QUO".

LETTING THE EXCHANGES SET UP AN OTC MARKET THAT IS UNPROVEN AND EXTREMELY IMPORTANT IS LIKE LETTING A FOX GUARD THE HEN HOUSE.

2008 Aug 03 04:00 AM

[Nick Gogerty:]

The netting risk is significant. Let's hope the efforts at compressing exposures in a single netting facility happen soon enough. A major default or cluster of smaller defaults could cause significant liquidity pressures and recursive failures to deliver.

2008 Aug 03 09:45 AM

[quakeguard:]

Monk -your final statement seems to contradict your previous statements...don't you mean the banks would be the foxes not the exchanges????

2008 Aug 03 02:08 PM

[monk:]

Yes THANK YOU! Apologize a late night error
LETTING THE * INVESTMENT BANKS* SET UP AN OTC MARKET THAT IS UNPROVEN (FOR INVESTMENT BANKS) AND EXTREMELY IMPORTANT IS LIKE LETTING A FOX GUARD THE HEN HOUSE.



- The investment banks have proven incapable of policing themselves - Thus any major ownership of an exchange OTC etc would not create a true bona-fide transaction as exhibited by the recent Auction Rate Securities alleged Fraud and BSC's lack of "arms length transactions" between BSAM and BSC - a real sham IMHO (online.wsj.com/public/...) THE LIST GOES ON AND ON.

2008 Aug 03 06:32 PM

[neeb??:]

And who are the investors here?

2008 Aug 03 07:16 PM

[monk:]

need?? Investors:: refer to the group of investment banks that are threatening to start from scratch an operation (exchange) to clear the $ trillions notional amount, OTC transactions (currently not exchange traded - a real mess!) via a 3rd party - arms length "exchange" - thus making OTC trades more transparent (consistent settlement days, pricing monitored by a 3rd party - etc,) Problem is these "investors" (investment banks) have no domain expertise and have proven time and time again that the SRO's responsible for policing investment banking services somehow get in bead with the investment banks and the next thing you know the exchange looks like a fraternity party.

2008 Aug 03 11:23 PM

[monk:]

Very interesting, Mandate OTC to exchanges? Time could not be better!

U.S. Commodity Futures Trading Commission to Hold International Market Surveillance Conference, August 5-7, 2008

CFTC to Host International Regulators at Conference
Washington, DC – The U.S. Commodity Futures Trading Commission (CFTC) will host its first ever market surveillance conference for international regulators August 5-7, 2008 in Washington, DC.

Senior regulatory officials from nine jurisdictions, including leading emerging market jurisdictions such as India and China, will discuss key elements of futures trading oversight, including market and financial surveillance. In addition to highlighting the CFTC’s large trader reporting system, the CFTC will share new surveillance techniques and information about how to design futures contracts that are not susceptible to manipulation.

“This is a critical time for futures regulators around the world,” said CFTC Acting Chairman Walt Lukken. “During this time of volatile and global futures markets it is ever so important that regulators share surveillance approaches, enhance cooperation and coordinate market oversight.”

“This three-day program is designed to share best practices for market monitoring and strengthens partnerships with our overseas counterparts,” said CFTC’s Director of International Affairs Jacqueline Mesa. “Regulators around the world share the same goals to ensure market integrity and customer protections. Building on these shared goals, the CFTC will explain necessary tools and techniques to stop abuses and address them in real-time.”

This conference is for international futures regulators only and is not open to the public.

2008 Aug 04 09:07 PM

[jklondon:]

why not use the DTCC - CCorp tie-up - wont that be the clearing corp of choice??

2008 Sep 26 09:14 AM