“The Future of CDS: OTC, Exchange-Traded or Clearing House?
A conference call hosted by B&B on Nov 14th 2008, originally attended by over 500 participants. The call was in the form of a panel discussion, where our panel members were all market participants with years of experience in the CDS market and continue to be significant contributors to the ongoing development of the CDS market.
Call Summary:
- CDS has been a useful product that has allowed market participants to transfer their credit risks efficiently. Despite the current credit crisis, the CDS contract has functioned extremely well and the settlement process has been smooth, as evidenced in the Lehman bankruptcy.
- While CDS has been useful, it does have some associated risks. It is instructive to look at the 4 main stages of the CDS trading lifecycle to see where the potential risks lie. These stages are: Execution, Settlement, Clearing and Warehousing. Execution has been smooth from the start, and DTCC’s settlement and warehousing facilities have largely addressed the problems of unmatched confirmations and opacity, respectively. Clearing, however, remains an area that needs further work given concerns around counterparty credit risk.
- Counterparty credit risk, which relates to individual counterparties, could lead to wider systemic risk if many participants are not able to continue transacting in the absence of parties willing to trade with them. There was some evidence of this during the height of concerns around the creditworthiness of bank counterparties. Mitigating counterparty risk by setting up a robust central clearing counterparty should therefore address systemic risk as well.
- There are currently competing initiatives for setting up a central clearing counterparty. Some are based on a clearing house facility, whereas others involve an exchange. The most likely outcome for the future of the CDS market is a combination of:
- One or more central clearing houses in operation as early as Dec 2008 or Jan 2009. The US markets are at the forefront of clearing proposals, though efforts in Europe are gathering strength. A regional solution (one or more clearing houses in the US and one or more clearing houses in Europe) approved by the appropriate regulatory bodies seems more likely than a global solution as there is no single organization applying pressure for the latter. However, this does not rule out a global solution.
- An OTC market that will continue to trade. The OTC market is best designed for tailored transactions and to manage specific risks, and will likely continue for single name CDS transactions.
- Exchange traded products targeted at the institutional investor market. This would also be useful for OTC dealers as hedges could grow and become a larger market similar to Eurodollar futures in the interest rate swap market. Thus far exchanges have not been successful as they have not offered practical or useful products to market participants. However, if exchanges offer good products, they are likely to succeed and will most likely apply to the CDX and iTraxx indices as these are already highly standardized.
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The important point to note about the CDS market is that it is still a young market compared to other derivative markets. As such, it has been evolving and developing since inception. Sometimes it is reactionary and sometimes it is pro-active. Regardless, most market participants see the current developments as positive for the market as a whole. Simply put, change is good in this context.
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.”
For 9-10 hours a day I felt engaged, challenged and focused at all times...I can't remember the last time I've been able to do that for even one-third of the time we spent....and to do that for 4 days straight!