Wednesday, January 6, 2010

Advice to credit-default-swap regulators for 2010

Original posted on Reuters by Richard Beales:

Lawmakers and bank-bashers have pinned blame for the financial crisis — and in particular the collapse of American International Group — on the credit default swap (CDS) market. Changes to and tighter oversight of the giant market are needed. But action should address real, not imaginary, problems. Reuters Breakingviews offers some advice.

1) Don’t ban CDS instruments. They didn’t cause AIG’s downfall — poor risk management did. AIG built up exposure out of all proportion to its ability to cover losses. It was an old trader’s game: selling out-of-the-money options to bring in what looked like risk-free revenue — until the unthinkable happened and losses swamped all previous profits.

The choice of derivative instrument was secondary, but AIG happened to choose credit insurance on dodgy mortgage bonds. The mountain of liabilities should have rung alarm bells, and probably would have done inside any Wall Street bank. That’s an issue that needs separate attention.

Nor can ill-willed CDS traders easily force a company into a death spiral, as some critics claim. Over a short timeframe, it’s just not profitable. Ownership of CDS instruments can affect creditors’ incentives when companies try to restructure outside bankruptcy — but this calls for adjustments to the restructuring process, not a ban on CDS trading.

2) Do tighten collateral and capital requirements. The instruments AIG specialized in lent themselves too readily to the game its financial unit was playing. The insurer didn’t have to post collateral with counterparties as market moves left the company with paper loses. Instead, collateral requirements depended on AIG’s own credit rating. That rating started tumbling as possible losses emerged, and the resulting cash calls made the situation worse.

The standard contracts that make up the bulk of the CDS market — $31 trillion-worth, by the reckoning of the International Swaps and Derivatives Association (ISDA) — work in a safer way. They generally do involve posting collateral as market prices move. Even so, there’s a good case for stiffening and standardizing collateral and related capital requirements for regular CDS instruments.

That would make them less risky and less attractive to speculators. This is one area rightly targeted in reform efforts — and regulators shouldn’t be deflected by the possibility the market could shrink.

3) Don’t force all CDS trading onto exchanges. Exchange trading may be one answer for some instruments, including CDS index products that are highly liquid and less volatile than those referencing single credits such as General Motors or Citigroup. But other markets — for government bonds or currencies, say — manage to be liquid, transparent and reasonably safe without exchanges.

And exchange trades are not always cheaper for users than bilateral or over-the-counter (OTC) transactions. The banking industry makes that point. They may be self-interested, but so are the exchanges which use their powerful lobbies in the United States and elsewhere to fight for the business.

4) Do encourage central clearing. Central clearing is usually associated with exchanges, which muddies the issue. But the two don’t have to go together. With or without an exchange marketplace, central clearing avoids much of the systemic risk associated with one market player going under by sharing losses among many participants — and by providing a single counterparty involved in every relevant trade.

5) Don’t fragment record-keeping in the process. Regulators need to be able to see which market participants are taking risk, and how much. In the CDS market, there’s already a central data warehouse managed by the Depository Trust & Clearing Corporation that records all electronically confirmed trades — more than 98 percent of new trades, according to Markit — as well as some manual trades. This grew out of U.S. Treasury Secretary Tim Geithner’s earlier campaign, while president of the New York Federal Reserve, to automate and improve transparency in the market.

Proposals to force CDS activity onto multiple clearing platforms or exchanges risk fragmenting record-keeping. Ironically, that would make watchdogs’ jobs harder, not easier. Electronic confirmation of trades isn’t yet so widespread in, say, equity derivatives — but in CDS markets, spotting risk hot-spots ought already to be relatively easy.

These suggestions are a good place for policymakers to start. But they should think about all the implications of any new regulations before taking the plunge. Unfortunately, with Washington in a hurry, that isn’t likely to happen — and whatever new rules are enacted may present unintended consequences sooner rather than later.


– Total credit default swap (CDS) contracts outstanding at the end of June 2009, measured by notional (worst-case) exposure, amounted to $31 trillion, according to the International Swaps and Derivatives Association.

– More than 98 percent of CDS trades are confirmed electronically, according to quarterly data from Markit.

– ISDA market survey summary:

– Markit quarterly metrics:

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