“The Future of CDS: OTC, Exchange-Traded or Clearing House?

Audience questions following the call:

Q: What are the various aspects of the CDS contract that would need to be standardized in order for CDS to be cleared through a central clearing counterparty?

A: Some of the key features of the CDS contract that need to be standardized are Restructuring/Deliverable Obligations, cash settlement and standard fixed coupons. Restructuring – if this is the key Credit Event, the obligation that can be delivered into the contract will depend on the term of the trade. This variation in Deliverable Obligations poses a problem when standardizing all CDS contracts. Cash settlement – currently market participants can opt to cash settle CDS contracts using the ISDA auction process but not all participants elect cash settlement. The option to physically settle the CDS contract outside the auction process needs to be addressed when standardizing CDS contracts. Standard fixed coupons – standardized CDS contracts should trade with a fixed coupon like the index contracts. The question is what this fixed coupon should be for all credits, or what it should be for various categories such as investment grade vs. high yield. All of these aspects are currently being discussed by ISDA. 

Q: What minimum standards need to be achieved for clearing facilities in order for them to be adopted by the market?

A: In particular, there need to be minimum standards around risk management focused on sound margining methodology and back up fund facilities. It is important for clearing counterparties to margin sufficiently to manage their risks, though if there are competing initiatives it is likely that the clearing houses that charge the lowest margin will be the most popular with market participants. Clearing counterparties also need to have adequate facilities for back up funding in case margins are insufficient at any point to cover their counterparty risks. The initiatives that offer practical and user-friendly products are likely to be more successful than others.   

Q: Given the current uncertainties and fears held by clients who may potentially use CDS in their portfolio, could you distinguish between rational client concerns and what may be irrational fears?

A: Rational fears are counterparty risk and systemic risk which could make the entire derivatives market freeze up, so addressing these issues in the form of one or more central counterparties is a positive move for the stability of the market.  Another rational fear is the unknown changes to the regulation of the use of CDS.  Given the public push to “fix” what caused the current economic problems plus a lack of understanding by the public on the actual risks, new regulation needs to be considered and not reactionary.  Irrational concerns are the fear of derivatives and OTC markets in general based on lack of understanding of the real risks.   

Q:  If a CCP becomes a reality and it takes care of only standardized products, what are the issues that hedge funds will face?  

A:  Hedge funds deal in tailored and standardized CDS products and many hedge funds benefit from collateral agreements which allow them to net their exposure from tailored CDS hedged with standardized CDS (e.g. a bespoke tranche delta hedged with single name CDS).  If single name CDS move exclusively to a CCP, then hedge funds could end up posting more margin than they currently do to put on some of their trades. 

Q:  What are the issues that insurance/pension funds should consider around CCP?

A:  These real money investors would mostly benefit from a standardized product and one that reduces counterparty risk. Depending on the structure of the CCP, this could be an exchange or a clearing house. However, to the extent that these investors want to invest in tailored products, they may only have the benefit of the CCP for some of their investments. For the more aggressive investors who invest in tailored and standardized products, they could encounter the same issues that hedge funds face in terms of netting exposures and margin requirements.

Some key terminology around the issues:

  • Credit Default Swaps (CDS) are currently primarily over-the-counter (OTC) derivatives.  Dealers make markets on standard single names, indices and portfolio products.  Standard as well as tailored CDS contracts are entered into between two counterparties.  When entering into a CDS contract, counterparty risk is created; however it is not unique to CDS but exists in all derivative contracts.  Many market participants mitigate their counterparty risk across derivatives by using collateral agreements which are normally documented under a Credit Support Annex “CSA” which forms part of the ISDA Master Agreement.    
  • A clearing house is a financial services company that provides all or part of clearing and settlement services for financial transactions, including matching/confirming trades and automated payment settlements.  Some clearing houses act as central counterparties for derivatives trades thereby acting as the sole counterparty that faces every clearing member who buys or sells.  In this capacity, the clearing house acts as a third party on derivatives contracts collecting and maintaining margins for trades from clearing members.  
  • A number of financial securities trade on centralized financial exchanges.  For example, standard future contracts on short term interest rates, foreign exchange  and  commodities trade on various exchanges.   In addition to providing clearing and settlement services and acting as the central counterparty to all their members, exchanges also provide a central platform for trading and price dissemination.   While exchanges trade various derivative contracts, OTC markets exist along side these exchanges.  

This call was conducted under the Chatham House Rule which states:  “participants are free to use the information received, but neither the identity nor the affiliation of the speaker(s), nor that of any other participant, may be revealed.”

GREAT TO HAVE A MARKET EXPERT SHARE EXPERIENCE AND TEACH – MAKES [MATERIAL] MORE RELEVANT. [HER] ENTHUSIASM IS INFECTIOUS! THANKS VERY MUCH FOR A GREAT COURSE, IN PARTICULAR THE CASE STUDIES – VERY USEFUL TO PUT INTO PRACTICE WHAT WAS TAUGHT.

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