Tuesday, December 30, 2008

Tug of war over CDS central clearing

From the Financial Times:

In 2008, “credit derivatives” almost became a household phrase. In the past three months alone, the term has been mentioned in the print media nearly as many times as during the whole of 2007.

There is barely a financial regulator – or politician – who has not expressed an opinion on credit default swaps (CDS), the most common type of credit derivative, trading in which ballooned to a peak of more than $60,000bn of contracts by the end of 2007.

Gerald Corrigan – a managing director at Goldman Sachs and the former head of the New York Federal Reserve who has led industry efforts to tackle the systemic risks around the use of over-the-counter derivatives – told a Congressional committee that it was not possible to know whether on balance, CDS contracts had “tempered or amplified the credit crisis”.

“While I believe that we will gravitate toward an informed answer to that question only with the passage of time, based on what we now know I see the CDS as a net plus in a setting in which we must acknowledge that the CDS and other segments of the financial markets have benefited from large scale central bank and governmental interventions,” he said.

Whether regulators believe CDS are at root useful or not, will play a large part on determining the shape of the credit derivatives industry beyond 2008. Already the opaque – but in recent years enormously profitable – part of the markets has been pushed to open up.

Every week, the Depositary Trust & Clearing Corp, the US clearer and settlement system estimated to represent about 90 per cent of the market, publishes the exposures on credit derivatives contracts (although oddly some opacity remains because only the current and previous weeks’ data are ever available publicly, meaning that non-insiders who wish to track developments must record and keep the data themselves).

Market participants are also trying to combat the fear of big numbers by tearing up old, duplicated, or neutralised contracts, reducing the outstanding notional size of the CDS market to $54,000bn by June this year.

But probably the most important and radical change underway is in the attempts to introduce a central clearing house and counterparty. This gained added urgency after the default of Lehman Brothers highlighted to regulators, politicians and bankers themselves the fallibility of important counterparties in the markets.

A central clearing house will dramatically alter the risk profile of the industry by concentrating in one place the market and the biggest dealers, though potentially not the hedge funds and others who make up the buyside. It could also similarly affect the costs and profitability.

“There appears to be a tug of war going on within the world of central clearing solutions,” says Brian Yelvington, analyst at CreditSights. “We thought these would be resolved by year end, but it now seems that these will continue into next year, and some important questions like the cost of the counterparty and margin postings are still not known. These, among others, will affect the profitability of the CDS market going forward.”

There is continued uncertainty about how far the central counterparty will reach, whether it will end up encompassing all credit derivatives or whether it will stop at some indices and individual names.

One issue is how far dealers are willing to go to standardise contracts. Every move to standardisation removes the potential profitability, and there remains some resistance.

Also, there are broader questions about how financial markets will be regulated in the future. In the US, there are discussions about whether various regulators should be merged.

It is also possible that US and European regulators will end up setting different rules, a move which could fragment a market which has so far been global in nature.

“A clearing house in itself does nothing to address the problems which can result from the use of derivatives, which is the leverage that can be created through their use,” says Joel Telpner, partner at Mayer Brown. “The question is whether there will be further legislation to address these concerns, and this will be an important question that will determine the future shape of the market.”

Andrew Feldstein, chief executive of BlueMountain, says the introduction of centralised clearing for credit derivatives on individual entities, like companies or governments, would make trading much more liquid.

“Credit is clearly getting very interesting right now. There is never a guarantee that you will make money, but there will certainly be plenty of incredible opportunities in the credit space and credit derivatives will be one of the most important markets through which to express those views,” he says.

Tuesday, December 23, 2008

U.S. Regulator Approves CME Group Credit Default Swap Clearinghouse Plan

(Bloomberg) -- The U.S. Commodity Futures Trading Commission approved CME Group Inc.’s application to guarantee credit-default swaps with its clearinghouse, potentially generating $400 million in new annual revenue for the company.

“The advent of clearing solutions for the credit default swap market will benefit the financial system significantly,” CFTC Acting Chairman
Walt Lukken said in an e-mailed statement today.

CME Group is competing with
Intercontinental Exchange Inc., NYSE Euronext and Eurex AG to clear credit-default swap trades in the $28 trillion market. A clearinghouse owner could earn between $100 million and $400 million a year in revenue from clearing the trades, according to estimates by Wachovia Capital Markets and Keefe Bruyette & Woods Inc.

A clearinghouse is part of U.S. efforts to oversee credit- default swap market after the contracts contributed to the demise of Bear Stearns Cos. and the government takeover of American International Group Inc. Banks, hedge funds and other investors currently negotiate credit-default swaps privately in the over-the-counter market.

CME Group has still not received licensing approval from Markit Group Ltd., a bank-owned service that provides the most widely used indexes and pricing methods in the credit swap market. The CME Group also needs an exemption from the Securities and Exchange Commission before it can begin clearing contracts.

A clearinghouse, rather than a single bank, would be the counterparty to trades and help absorb losses should another dealer fail, as Lehman Brothers Holdings Inc. did in September. Funded by its members, a clearinghouse is intended to add stability to markets by becoming the buyer to every seller and the seller to every buyer.

European Index
NYSE Euronext began clearing a European CDS index on Dec. 22. Intercontinental Exchange is awaiting regulatory approval from the Federal Reserve Bank of New York. Intercontinental’s clearinghouse, ICE U.S. Trust, was granted a New York state banking license earlier this month. Eurex has said it hopes to begin clearing CDS trades in the first quarter.

Credit-default swaps are contracts that were conceived to protect bondholders against default and are now widely used to speculate on the creditworthiness of companies. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. An increase in the price indicates deterioration in the perception of credit quality; a decline signals the opposite.

The value of the contracts outstanding is determined by weekly data from the Depository Trust Clearing Corp. The market value has come down from over $50 trillion in recent weeks due to netting of trades and counterparties agreeing to exit trades.

The most actively traded contracts in the credit-default swap market are indexes of U.S. and European companies with investment-grade debt ratings. Contracts based on specific companies also trade.

CME in talks with dealers on CDS platform

(Reuters) CME Group Inc (
CME.O) is also in advanced discussions with six dealers to take equity stakes in its credit default swaps (CDS) trading and clearing platform, the Wall Street Journal said. (CME could not be immediately reached for comment by Reuters.)

CME's rival IntercontinentalExchange Inc (
ICE.N) has said it expects to clear CDS by the end of the year.

SEC OKs LCH.Clearnet for U.S. swaps clearinghouse

(Reuters) - The Securities and Exchange Commission gave the go-ahead on Tuesday for LCH.Clearnet Ltd to begin operating as a U.S. central counterparty for credit default swaps.

LCH already acts as a central counterparty in Europe, where it assumes the legal counterparty risk involved when two of its members trade financial instruments.

The SEC approved some temporary exemptions that allow LCH to act as a counterparty, a move which should help add transparency to the unregulated multi-trillion-dollar credit default swaps market, SEC Chairman Christopher Cox said in a statement. "These conditional exemptions will allow a central counterparty to be quickly up and running, while protecting investors through regulatory oversight," Cox said.

The SEC developed the temporary exemptions after consulting with the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the Commodity Futures Trading Commission and the U.K. Financial Services Authority.

The exemptions will let LCH launch a clearinghouse in the U.S. market while giving the SEC time to review their operations and decide if they should be given permanent permission to operate, the agency said.

The virtually-unregulated over-the-counter market in credit default swaps has played a significant role in the credit crisis, including the multi-billion-dollar taxpayer rescue of American International Group (AIG.N).

From the WSJ:

In October, Depository Trust & Clearing Corp. announced plans to take over European-based LCH.Clearnet in a €739 million ($1.03 billion) deal. The deal will result in the formation of the world's largest clearinghouse company owned largely by users.

Monday, December 22, 2008

First group emerges to offer CDS clearing

By Jeremy Grantin in the Financial Times:

Liffe, the futures exchange, and LCH.Clearnet, the London clearer, will on Monday become the first group to offer clearing of credit default swaps, financial instruments that are central to regulatory worries over the risks posed by defaults in the credit derivatives markets.

The development comes as efforts by regulators on both sides of the Atlantic to get such bilaterally negotiated, or over-the-counter (OTC), contracts shifted on to centrally cleared platforms are coming to a head.

Regulators want the CDS market to be centrally cleared because they fear that without such safeguards any future defaults could wreak the same kind of havoc on the financial system as September’s default by Lehman Brothers, which affected about $400bn (£267bn) in credit default swaps linked to the failed bank.

The European Commission last week received commitments from dealers and exchanges to shift CDSs, which are currently not cleared, into a cleared environment by early next year.

US authorities, led by the Federal Reserve Bank of New York, have for months been pushing for a centrally cleared mechanism for CDSs.

Four groups are working on such systems: CME Group, the Chicago derivatives exchange, with hedge fund Citadel; IntercontinentalExchange, another US futures exchange, with The Clearing Corporation and dealer banks; NYSE Euronext; and Eurex, the derivatives unit of Deutsche Börse.

Although some over-the-counter derivatives have been centrally cleared for some time – such as US Treasury bonds, European interest rate swaps and carbon emissions – regulators want CDSs cleared to reduce counterparty risk – that is, the risk that parties to a trade default.

A clearing house acts as the buyer for every seller and as seller for every buyer in a transaction, helping to virtually eliminate counterparty risk.

Liffe, owned by exchange group NYSE Euronext, will launch clearing for three CDS index contracts through Bclear, its trade registration service, prior to sending to LCH.Clearnet for clearing. They will be Markit iTraxx Europe, Market iTraxx Crossover and Markit iTraxx Hi-Vol.

Ade Cordell, head of wholesale services at Liffe, said the exchange expected a slow start so close to Christmas and that the timing was to allow participants to test the system before any meaningful volumes were achieved.

“We are expecting volumes really to come through in the second and third week of January once a critical mass of market participants has done that work,” he said.

Dealers in the CDS market have warned against there being too many clearing solutions, partly because of the cost of posting margin collateral at multiple clearing houses. Some are also uneasy about splitting the market into two pools of liquidity in dollars and euros.

However, last week the governing council of the European Central Bank re­iterated its belief that there was a need for “at least one” European clearing solution, and that “given the potential systemic importance of securities clearing and settlement systems, this infrastructure should be located within the euro area”.

Eurex aims to start offering CDS clearing in March. It is in talks with unnamed entities about setting up a joint venture that would control a separate clearer for CDSs, distinct from Eurex Clearing, its existing clearing operation for exchange-traded derivatives.

Bilateral Counterparty Risk Valuation

Bilateral Counterparty Risk Valuation with Stochastic Dynamical Models and Application to Credit Default Swaps

By Damiano Brigo of Imperial College & FitchSolutions, Agostino Capponi of the California Institute of Technology


We introduce the general arbitrage-free valuation framework for counterparty risk adjustments in presence of bilateral default risk, including default of the investor. We illustrate the symmetry in the valuation and show that the adjustment involves a long position in a put option plus a short position in a call option, both with zero strike and written on the residual net value of the contract at the relevant default times. We allow for correlation between the default times of the investor, counterparty and underlying portfolio risk factors. We use arbitrage-free stochastic dynamical models. We then specialize our analysis to Credit Default Swaps (CDS) as underlying portfolio, generalizing the work of Brigo and Chourdakis (2008) [5] who deal with unilateral and asymmetric counterparty risk. We introduce stochastic intensity models and a trivariate copula function on the default times exponential variables to model default dependence. Similarly to [5], we find that both default correlation and credit spread volatilities have a relevant and structured impact on the adjustment. Differently from [5], the two parties will now agree on the credit valuation adjustment. We study a case involving British Airways, Lehman Brothers and Royal Dutch Shell, illustrating the bilateral adjustments in concrete crisis situations.

Download paper (295K PDF) 26 pages

Friday, December 12, 2008

Fed Refuses Banks Request to Limit Credit-Default Swap Clearing

(Bloomberg) -- U.S. regulators are refusing to allow JPMorgan Chase & Co., Goldman Sachs Group Inc. and seven other banks to dictate what credit-default swap trades will be processed by Intercontinental Exchange Inc.’s proposed clearinghouse, said two people with knowledge of the discussions.

The Federal Reserve Bank of New York denied the request for permission to form a committee that would be able to veto the submission of some contracts, according to the people, who asked not to be named because the discussions are private. The Fed wants ICE U.S. Trust, as the clearinghouse is known, to be governed independently of the banks, the people said.

The clearinghouse is part of efforts to impose oversight of the $31 trillion credit-default swap market after the contracts contributed to this year’s demise of Lehman Brothers Holdings Inc. and the U.S. takeover of American International Group Inc. By keeping certain contracts off the clearinghouse, banks would preserve the trading fees they earn from the privately negotiated contracts.

“This has been a sizeable profit generator for banks, and they’re seeing it go away at a time when they can least afford it,” said Mark Williams, a finance professor at Boston University who estimates banks charge between $25,000 and $50,000 to handle a credit-default swap contract on a company in the Standard & Poor’s 100 index.

An ICE spokeswoman, Kelly Loeffler, JPMorgan’s Brian Marchiony and Michael Duvally of Goldman Sachs declined to comment. A Fed spokesman who didn’t want to be named declined to comment.

Banks, hedge funds and other investors currently negotiate credit-default swaps privately. A clearinghouse, rather than a single bank, would be the counterparty to trades and help absorb losses should another dealer fail as Lehman Brothers did.

Competing Plans

The clearinghouse would be funded by its members and add stability to markets by becoming the buyer to every seller and seller to every buyer.

The New York Fed must approve Intercontinental Exchange’s plan, which includes its corporate governance structure, and would regulate ICE U.S. Trust as a member of the Federal Reserve System. Atlanta-based Intercontinental Exchange, also known as ICE, is the second-largest U.S. futures market.

The ICE proposal is competing with clearinghouse plans by Chicago’s CME Group Inc., the world’s largest futures market, and NYSE Euronext and Eurex AG of Frankfurt. CME Group has partnered with Citadel Investment Group LLC to appeal to derivatives traders at hedge funds.

The banks in the ICE plan will capitalize ICE U.S. Trust with more than $1 billion in a fund to cover potential trading losses, according to ICE General Counsel Jonathan Short. In return for that investment, the banks wanted final say over what contracts will be cleared, the people said.

Other Banks

The seven other banks in the ICE plan aside from New York- based JPMorgan and Goldman Sachs are Citigroup Inc., Bank of America Corp. in Charlotte, North Carolina, Zurich’s Credit Suisse Group AG, Morgan Stanley, Deutsche Bank AG in Frankfurt, Merrill Lynch & Co. and UBS AG in Zurich.

Credit-default swaps are contracts that were conceived to protect bondholders against default and are now widely used to speculate on the creditworthiness of companies. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. An increase in the price indicates deterioration in the perception of credit quality; a decline signals the opposite.

The most actively traded contracts in the credit-default swap market are indexes of U.S. and European companies with investment-grade debt ratings. Contracts based on specific companies also trade.

Fighting Regulation

Investment banks have fought regulation of private markets for more than a decade because the lack of transparency typically allows for greater profitability. As much as 40 percent of the profit for dealers including Goldman Sachs and Morgan Stanley was from private over-the-counter transactions, according to fixed- income research firm CreditSights Inc. of New York.

ICE agreed in October to buy the Chicago-based Clearing Corp., which is owned by Goldman Sachs, Citigroup, JPMorgan and inter-dealer brokers ICAP PLC of London and GFI Group Inc. in New York.

That deal secured commitments by the banks to use ICE U.S. Trust, ICE Chief Executive Officer Jeff Sprecher said on an Oct. 30 conference call.

CME Group and ICE have said they are ready to clear credit- default swap contracts once they receive regulatory approval. NYSE Euronext said it will be ready later this month, and Eurex said it plans to begin clearing in the first quarter.

The Fed, U.S. Securities and Exchange Commission and Commodity Futures Trading Commission signed a memorandum of understanding on Nov. 14 that they said will, for the first time, provide broad oversight of the credit-default swap market.

Thursday, December 4, 2008

Implied Recovery

By Sanjiv R. Das of Santa Clara University, and Paul Hanouna of Villanova University

Abstract: In the absence of forward-looking models for recovery rates, market participants tend to use exogenously assumed constant recovery rates in pricing models. We develop a flexible jump-to-default model that uses observables: the stock price and stock volatility in conjunction with credit spreads to identify implied, endogenous, dynamic functions of the recovery rate and default probability. The model in this paper is parsimonious and requires the calibration of only three parameters, enabling the identification of the risk-neutral term structures of forward default probabilities and recovery rates. Empirical application of the model shows that it is consistent with stylized features of recovery rates in the literature. The model is flexible, i.e., it may be used with different state variables, alternate recovery functional forms, and calibrated to multiple debt tranches of the same issuer. The model is robust, i.e., evidences parameter stability over time, is stable to changes in inputs, and provides similar recovery term structures for different functional specifications. Given that the model is easy to understand and calibrate, it may be used to further the development of credit derivatives indexed to recovery rates, such as recovery swaps and digital default swaps, as well as provide recovery rate inputs for the implementation of Basel II.

Download paper (2,362K PDF) 37 pages

Monday, December 1, 2008

An Overview of Credit Derivatives (Kay Giesecke, Stanford University)

Abstract: Credit risk is the distribution of financial loss due to a broken financial agreement, for example failure to pay interest or principal on a loan or bond. It pervades virtually all financial transactions, and therefore plays a significant role in financial markets. A credit derivative is a security that allows investors to transfer credit risk to other investors who are willing to take it. By facilitating the distribution of risk, these instruments have an important economic function. Yet they have hit the headlines recently. This paper gives an overview of credit derivatives. It discusses the mechanics of standard contracts, describes their application, and highlights the mathematical challenges associated with their analysis.

Download paper (345K PDF) 25 pages

Sunday, September 7, 2008

Credit Derivatives Operational and Settlement Risk

Operational risks have been cited as a possible source of disruption in credit default swap (CDS) markets, largely because of the rapid growth in outstanding contracts. These concerns had manifested themselves in the form of large backlogs of unconfirmed trades. However, banks and dealers, encouraged by the New York Fed and other authorities, have undertaking important infrastructure improvements.

Concerns had also been raised about settlement problems associated with defaults by entities for which the notional value of CDS contracts far exceeds the outstanding amount of underlying deliverable obligations. However, the new cash settlement protocol introduced by the International Swaps and Derivatives Association (ISDA) has successfully smoothed the settlement process in nine credit events since 2005.[1] Dealers have committed to incorporate this protocol into the standard documentation for widely traded credits.[2]

Nevertheless, there remains the potential for market disruption following the simultaneous failure of a major CDS protection seller and an actively traded reference entity, due to the large overhang of redundant bilateral contracts. Such offsetting contracts proliferate because, rather than closing out existing contracts, counterparties often arrange for offsetting contracts. The size of this overhang has been reduced during the last few years among banks and dealers by multilateral terminations (“tearups”) of offsetting contracts. TriOptima’s “TriReduce” service processed $10 trillion tearups in 2007 and $18 trillion in the first half of 2008. In addition, Creditex and Markit are planning to offer a “portfolio compression” service that, instead of tearing up offsetting contracts, replaces them with a smaller number of replacement contracts.

Also, in order to further mitigate these counterparty risks, the major credit derivative banks and dealers are banding together to create a central clearing house, but this will not be fully operational until late 2009 and other market participants (e.g., hedge funds) will not be included.[3] Under this scheme, bilateral contracts will be reassigned so that Chicago-based Clearing Corporation will become the new counterparty for both sides. For any given participant, all of its transactions on the same underlying entity will be netted down to a single position, and a single margin account maintained on its whole portfolio of swaps.[4]

It is also significant that about 90 percent of credit derivatives transactions are now being processed electronically. Although the degree of automated trade processing of other over-the-counter (OTC) derivatives lags that of credit derivatives, the major dealers have made commitments to the authorities to be electronically processing 75 percent of equity derivative trades and 65 percent of interest rate derivatives by January 2009.

However, despite all of these very positive developments, the default of a major CDS derivatives counterparty would likely be a market disruptive event, particularly if it were one of the ten investment banks that stand behind about 90 percent of outstanding contracts according to Fitch's latest survey. Even without a simultaneous failure of one of the more actively-traded underlying entities, the logistics of closing out trades with the failed counterparty would likely be challenging. All surviving counterparties would have to gather together all of their outstanding derivative trades (not just CDS trades) with the defaulting counterparty, and try to replace them with contracts with other counterparties, offset them, or close them out. This could be happening while spreads may be gapping out across the market, since other prospective counterparties are likely going through this same process.


[1] In a physical settlement, the protection buyer delivers obligations to the protection seller in exchange for par value. In a cash settlement, the protection seller pays out the difference between par value and the market value of a deliverable obligation. The new settlement protocol makes cash settlement the standard, but still allows anyone who wants to physically settle to do so, provided the final settlement price is not zero or par. See Bank of America's "Credit Default Swap Primer" (May 5, 2008) for a comprehensive discussion of operational risk issues in CDS markets.

[2] The current cash settlement protocol applies only to bankruptcy and failure-to-pay events, and not restructuring events. This could be problematic versus European and sovereign credits, where restructurings are more common.

[3] The clearing house is scheduled to start up by 2008Q4 with contracts based on standardized index-based credit derivative contracts, but single-name contracts will not come on stream until late 2009. Single-name contracts are hard to handle because they have different premia, although some dealers are pushing to standardize fixed premia.

[4] LIFFE will also be clearing contracts linked to the Markit  iTraxx indices by the end of 2008.