Thursday, February 11, 2010

ICE eyes sovereign CDS clearing

Original posted in the Financial Times by Hal Weitzman and Aline van Duyn:

Financial institutions and regulators are in talks about the possibility of clearing sovereign credit derivatives in the wake of the debt crisis in Greece, according to ICE, the US-based electronic futures exchange group.

ICE has emerged as the leading global clearing organisation for credit default swaps – the over-the-counter contracts blamed by many for exacerbating the financial crisis – having cleared CDS contracts with a face value of more than $5,500bn in the past year.

Jeff Sprecher, chief executive, said on Wednesday the company was considering moving into sovereign debt. “Sovereigns present a unique risk and it’s one that we’re debating with the market and with regulators,” he said.

So far, most of the CDS contracts that are cleared are for CDS indices, which represent baskets of corporate credits and which are the most liquid and widely traded types of CDS. Work has started on clearing CDS for individual entities, such as companies or banks, but it is still not apparent how many of these “single name” CDS can be pushed into clearing houses without creating risks for those clearers.

Under centralised clearing, the clearing house absorbs the counterparty risk from financial contracts – a risk that came into focus after the default of Lehman Brothers in 2008. If the bank backing the derivative defaults, the clearing house will ensure that the contract is still honoured. Clearing houses charge margins to put aside to cover any potential defaults, and also often have pools of money set aside for emergencies.

Although sovereign CDS are in strong demand as investors seek to hedge credit risk, liquidity and trading activity can sometimes be extremely low. Clearing houses need to be able to sell positions whenever they require, and illiquid markets could make this difficult. Already, some regulators have expressed concerns that moving too many instruments to clearing houses could make the clearers sources of systemic risk in the future.

Mr Sprecher said sovereign CDS presented a unique set of challenges. “For example, if you have an Italian bank that’s writing protection against the default of the Italian government, what is that risk and is it possible for an Italian bank to survive the collapse of its own government?” he said. “Those are the kind of things that come into clearing sovereigns that the market has never really seen addressed in a holistic way before.”

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