The Federal Reserve Bank of New York has given the 17 banks that are responsible for more than 90% of CDS trading until July 31 to present reform plans, chiefly for creating such a facility, with the objective of reducing operational and counterparty risks. In June, the New York Fed’s chief executive, Timothy Geithner, announced that what is known as the Fed 17 was meeting to "outline a comprehensive set of changes to the derivatives infrastructure". These include the establishment of the central counterparty and the setting of concrete targets for achieving substantially greater automation of trading and settlement. "These changes to the infrastructure will help improve the system’s ability to manage the consequences of failure by a major institution," said Geithner in a statement.
But it is the central counterparty that is at the top of the New York Fed’s priority list. It has been since the near collapse of Bear Stearns, which forced spread levels on the CDS indices to record highs (see chart below) as regulators and participants confronted the possibility of hundreds of thousands of CDS contracts, with Bear involved as either a counterparty or a reference credit, falling into default. But although this might have been a significant factor in the New York Fed’s increased focus on the central counterparty, planned for launch in the third quarter of this year, it was not the reason for the idea’s conception. "This was not so much prompted by Bear Stearns as by the notion that such a large market is exclusively OTC," says Mehernosh Engineer, senior credit strategist at BNP Paribas.
The CDS market has grown rapidly in the past year, and estimates put its size at anywhere between $45 trillion and $62 trillion. This lack of transparency is a profound cause for concern in such a large market, and this concern was merely highlighted by Bear Stearns. "The OTC space is incredibly vast and tremendously complicated, and this needs to be addressed," says John Angelos, director of credit derivatives at Chicago Board Options Exchange. "Bear Stearns showed the imbedded counterparty risk that had not been considered; it was the straw that broke the camel’s back."
The effectiveness of the new system at guarding against bank failures is yet to be seen but the move is certainly in the right direction, and is not the only measure that has been put in place for that purpose. "The Fed has several safeguards that weren’t there before the credit crunch," says Angelos. "The central counterparty is one, the discount window is another. These measures combined will hopefully bolster customer confidence and help keep the banks open."
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Dying Bear shows vulnerability |
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Spread performance on CDS indices |
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Source: Markit |
But, quite apart from the daunting task of designing an adequate computer system and back office to deal with such a high volume of contracts, there are stumbling blocks despite the risk benefits. Most CDS contracts, being OTC traded, are customized, and renegotiating them toward a more standard structure will take time and money. Also, there is a great variation in how much margin has to be posted on current CDS contracts, and those with a favourable arrangement are unlikely to accede to moving those contracts to a central counterparty and so risk having to post higher margins. And the configuration of the central counterparty might mean that it is not adequately equipped to deal with such concerns. "The problem is that the same broker-dealers that are involved in the CDS contracts are creating the central counterparty, and therefore risk remains highly interconnected," says Angelos. "I’d like to see the exchanges getting more involved to further reduce counterparty risk and add transparency. However, broker dealers are needed to support this effort and up until now they have been extremely resistant."
Exchanging times
The move toward a central counterparty can be viewed as a move from the OTC model to a more exchange-like structure and the standardization that that implies. This is arguably happening already. As any product goes through its natural life cycle, it moves towards a standardized model, which generally precipitates a fully fledged exchange model. Looked at in this light, the central counterparty can be viewed as a natural evolution of the CDS market, and a precursor to the arrival of the exchanges.
In June, IntercontinentalExchange (ICE) acquired Creditex for $625 million in a cash-and-stock deal, for the purpose of expanding its credit derivatives offerings. The deal was announced in the days following the central counterparty announcement, and will close at around the same time that the central counterparty begins operations later this year. And ICE is not alone. The Chicago Mercantile Exchange bought London-based Credit Market Analysis, a provider of derivatives market data, for an undisclosed amount at the end of March. The purchase includes two OTC derivatives pricing systems. It is unlikely that the central counterparty will be the only facility of its kind in the CDS market for long.
By moving towards an exchange model, it is hoped that the CDS market will not be so susceptible to such credit events as Bear Stearns, and ape the robustness of other markets, such as equities. "We’ve seen moves of 5% to 10% in a day in the equities market, yet the exchanges kept operating," says Engineer at BNP Paribas. "An unexpected default in credit now would probably stall the market."
The central counterparty will initially support the CDX North America indices, and will be made available to iTraxx contracts in Europe at a later date.