Would the New Legislation Kill the CDS Market?

by: David Enke

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.