Credit default swaps: Countdown to CDS central counterparty
The announcement of the creation of a central counterparty for over-the-counter credit default swap trades has been described as one of the biggest developments in the history of the market.
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.