Central Clearing House For Credit Derivatives

Posted by Bull Bear Trader | 8/01/2008 07:15:00 AM | , , , , | 0 comments »

As reported at the Financial Times and the WSJ, discussions have progress to the point that larger banks and dealers should have a central clearing house for credit derivatives by later this fall. The market for credit derivatives is currently near $62 trillion in notional value after being less than $5 trillion as little as five years ago. The goal of the clearinghouse will be to reduce the systemic risk that results from inefficient trading and uncertain counterparty exposure, both of which have increased as the market expanded. Automated trade-matching and electronic processing in other OTC derivatives market was also discussed. Credit derivatives in particular have caused concern as their rapid grown has made it more difficult to both track and measure the exact level of exposure being taken.

Recent credit problems have highlighted the need to better understand counterparty exposure. A central clearing house for credit derivatives should help in this area given that the clearing house will take the risk of a market participant's failure. Any failure would then be absorbed by the clearing house members, reducing the need for the Federal Reserve or Treasury to get involved, and possibly preventing the type of failure that was experienced with Bear Stearns. Like other clearing houses, trades are also likely to be better scrutinized when made, such as making sure that margin requirements are enforced and trades are verified and recorded.

To date the levels of electronic derivative trading in the various markets has been mixed. Currently, about 90% of credit derivatives are traded electronically. The interest-rate derivatives market, which is larger and potentially more worrisome, has also increased electronic trading and now sits at about half of all trades. Equity derivatives trading is bringing up the rear with only about one quarter of all trades executed electronically. Depending on the success of the credit derivative clearing house, plans could be expanded to also include the equity and interest rate markets.

One current hitch for the credit derivative clearing house is the need to make sure that the entire CDS market is integrated and electronic. To facilitate the move, dealers have agreed to reduce the total value of outstanding CDS trades, and to help sort out corporate defaults by incorporating a cash settlement mechanism into CDS documentation. Of note is that the market in many cases would still be private, but more centralized.

Although the details of the clearing house are still being worked out, such as what exactly the dealers and exchanges will control, any move is certain to benefit the exchanges as they will now have a direct link to the lucrative CDS market, while the large investment banks that currently control the credit derivative market will need to start sharing some of the billions of dollars of revenue. For some banks, this line of revenue has been significant. Companies that my be positively impacted include the CME Group (CME) and NYSE Euronext (NYX). Investment banks that may be negatively impacted, at least with regard to losing some of their current credit derivative revenue stream, include Deutsche Bank (DB), Goldman Sachs (GS), and Morgan Stanley (MS).