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.