“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.
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.