naked capitalism

In theory, moving credit default swaps from over the counter trading to exchange trading should reduce systemic risk. Exchanges fail far less often than individual institutions, and when they do, the damage has less propensity to propagate into a systemic event.

As keen as the authorities are to get the big, opaque CDS market on a safer platform, obstacles remain. For a host of reasons, outstanding CDS cannot be migrated onto an exchange, but newly written CDS designed to fit certain parameters could be (in theory, old contracts could be “novated” in favor of new ones). CDS suitable for exchange trading would have to be far more standardized. How to simplify the offerings has yet to be sorted out.

The most valuable element of moving CDS to an exchange, as far as lowering systemic risk is concerned, is centralized clearing, since if anyone defaults, the counterparty is the exchange, not an individual firm. Thus regulators have been moving forward as quickly as possible to set up a central clearinghouse. In particular, the CME Group proposed acting as a clearlinghouse, which means that its members would absorb the losses if any counterparty failed. Some rival proposals suggested setting up a new clearinghouse, which is a much sounder design, but would take longer to implement.

However, some savvy and influential and savvy CME members are now objecting to the idea, arguing that the additional risk of CDS clearing on top of their existing CME obligations is more than the members can realistically support. Moreover, they contend that putting together CDS and futures under the same umbrella is too much risk in one venue, and will increase, not reduce systemic risk.

Note that CME Group (along with Citadel) is one of four groups vying to handle the CDS clearing function. However, CME appeared to be the frontrunner. Note that this wrinkle does not imperil the idea, but means there may be more speedbumps down the road.

This development suggests that the rush to get a CDS exchange (or at least a clearinghouse) up and running is being moved forward with such haste that some risks are not being assessed properly.

The article is a bit geeky, but is useful in setting forth some of the risks in CDS trading.

From Bloomberg (hat tip reader Steve):

Electronic trading pioneer Thomas Peterffy says a plan by CME Group Inc. to guarantee credit- default swaps could put his entire $4 billion company at risk.

CME Group’s proposal to use its existing clearinghouse to clear swaps would require exchange members such as Peterffy’s Interactive Brokers Group Inc. to bail out a failed trader. Those companies have put up $101 billion to guarantee the futures and options now cleared by CME.

“It would be a great mistake,” said Peterffy, 64, a Hungarian immigrant whose company executes 14 percent of the world’s equity options. “Mixing the two types of funds will jeopardize the entire financial system” set up to guarantee futures trades, he said.

Peterffy, whose concern is shared by CME Group members including Penson GHCO Chief Executive Officer Chris Hehmeyer, is balking at a plan that CME developed amid pressure from the Federal Reserve to create a safety net for risky credit-default trades, now traded on an over-the-counter basis. Failed investment bank Lehman Brothers Holdings Inc. was among the top 10 dealers in the $55 trillion CDS market.

CME Group announced its CDS clearing plan Oct. 7, saying it would reduce counterparty risk and offer the market a “key turning point.” A rival proposal by Intercontinental Exchange Inc. would avoid the issue raised by Peterffy by creating a separate clearinghouse to segregate its futures and credit-swaps business.

A clearinghouse, capitalized by its members, all but eliminates the risk of trading-partner default by being the buyer for every seller and the seller for every buyer. It employs daily mark-to-market pricing and liquidates positions of traders who can’t pay their margin.

In OTC markets, traders rely on their counterparty to make good on their agreements. A trader with a cleared OTC position could put other CME member firms at risk of making up a shortfall if the trader couldn’t cover the losses. CME’s clearinghouse hasn’t ever suffered a default…

Peterffy said he doubts that the exchange will be able to determine CDS pricing because they trade infrequently.

“There is no assurance once the buyer or seller goes bust you can liquidate those positions near the price” that was settled upon the day before, Peterffy said. Interactive Brokers has as much as $1 billion pledged to equity and derivative exchanges, including CME Group, to fund trader shortfalls.

Credit-default swaps pay buyers face value for the underlying securities or cash equivalent should the company fail to keep to its debt agreements.

“I can see why people would be concerned by the CME’s model,” Penson GHCO’s Hehmeyer said.

CDS pricing will still come from voice and electronically executed over-the-counter trades, said David Rutter, deputy CEO of ICAP Plc’s electronic broking unit. Although most of these swaps trade daily, prices are not always available in all swaps, he said.

“The clearinghouse is potentially compromised if you don’t have really good, independent and reliable mark-to-market information,” Rutter said.

The amount of money traders must have on deposit, known as margin, is the main way clearinghouses insure against losses. CME Group will require higher margin to trade CDS than futures, Taylor said.

To set futures margins, CME Group tallies a trader’s total potential portfolio loss in one day and uses that amount to derive the margin rate. For CDS contracts, CME Group will add up the potential portfolio losses over two to five days, and use that amount to set the margin rate, Taylor said.

Margin calls on CDS contracts could be a greater risk than with futures, said Howard Simons, a strategist at Bianco Research LLC in Glenview, Illinois.

“You have highly correlated systemic risk,” he said. “We have whole industries where if one’s in trouble, all of them are in trouble.”

When Lehman went bankrupt last month, the cost of credit swaps on Morgan Stanley rose almost six-fold.

The CME Group risk committee, composed of the banks and hedge funds that capitalize its clearinghouse, will have to approve any new contracts cleared by the exchange. Taylor declined to comment on the risk committee.