While the effects of government bailouts and spending is still to be determined, Treasury Security Geithner does seem to be responsible for stimulating at least one industry - the exchanges. Since the announcement of his intent to shift more over-the-counter derivative trading onto the exchanges, the share price for the CME Group is up 27 percent, while the share price of Deutsche Borse (owner of the Eurex derivative exchange) is right behind, up 21 percent (see Financial Times article).

CME Group Daily Chart (1 year)
Source: Big Charts

In addition to the exchanges being able to trade more credit derivative products, such as credit default swaps, massive stimulus spending will also make it likely that demand will increase for interest rate products that are traded on the futures exchanges. In particular, the CME should do well given its trading in the popular Eurodollar contract. Yet, all is not rosy, as the introduction of new multilateral trading facilities will also require many of the existing exchanges to modify the way they currently do business, possibly also forcing a cut in fees. The "final" proposed regulations will also have to be carefully examined. For instance, if CDS trading is limited to only those with a direct interest, as opposed to third party speculators, then liquidity will be a fraction of what it is expected, offering less benefit to the exchanges. If, on the other hand, regulations are less restrictive, which seems necessary in order to maintain some type of relatively efficient and liquid market, then the exchanges will certainly benefit from the increased volume, even with a slight reductions in fees. Any rebound in the economy, or continuation of the current new bull / existing bear market rally will also have investors once again dreaming of $700 CME quotes. Let's hope so. After all, an increase in trading and retail participation in the market would certainly be good for more stocks than just the CME Group.

According to a Financial Times article, a European commission examining the credit derivatives industry is asking CDS traders to reduce risk. Ah, if it was only that easy. Kind of like asking someone running a garage sale in the 1980s to sell their old eight-track player for what they paid for it. For one, you are not going to get your original value back, and two, very few people are interested in buying something that may be worthless tomorrow. It is also kind of ironic how we need to reduce risk on the very item we were using to reduce risk in the first place. At some point you cannot just keep passing risk along. Someone has to bear it - which is unfortunately where the government steps in when such exposure is contagious. Fortunately, besides asking for the obvious (and possibly impossible), the commission is forcing its hand a little, stressing how they want a clearinghouse for credit derivatives - otherwise legislation could be introduced. If that is not enough to put the fear in the industry, I am not sure what else is.

As hedge fund investors find it difficult to unload their shares (often due to missing redemption deadlines, or not wanting to wait through their holding period), some are utilizing the secondary market to sell their shares (see WSJ article). Hedgebay Trading Corp., which began business in 1999, operates a secondary market to match buyers and sellers of hedge fund stakes. Initially, when hedge funds were doing well, Hedgebay would have buyers paying a premium in order to take a stake in an attractive fund that may have been closed to new investors. As the market has turned, investors are now offering their shares at a discount, with the average discount recently doubling to 3.5%. Clients include individual investors, funds of funds, pension companies, and endowments. Funds of funds in particular have been aggressively utilizing the site and have actually redeemed more money than they need out of fear that when they do need the money, the individual hedge funds will put up redemption gates. JPMorgan has estimated that there will be up to $100 billion in redemption requests from funds of funds in Q4. The secondary market has even generated new opportunities for Permal Group, which is launching a $500 million fund that buys distressed priced hedge fund stakes, with shares coming from Hedgebay and existing relationships. Just another example of how capitalism does amazing things when it is allowed to operate. Now if only some private entity can do this efficiently with credit default swaps and credit derivatives, investors might actually be able to once again sell attractive hedge fund stakes for a premium.

The drumbeat continues for adopting some type of central clearing house for the complex derivative products that are current causing issues in the marketplace (see Financial Times article). Such a move has been discussed for some time now (see posts here and here), but recent failures are certainly expected to cause the interest in creating such a clearing house to increase. Unfortunately, such an implementation, which I would support, would not be perfect, nor would it cover every existing type of over-the-counter product. Not everything can be perfectly standardized to allow for an efficient clearing. OTC trading will still be necessary for those specialized products that are offered to not only create investment banking fees, but also hedge a specific risk that a company is worried about. The ability to create these products is necessary to encourage both financial innovation, and reasonable risk taking.

So how would you guard against unreasonable risk taking? The same way as before: regulatory capital. The difference this time is that I suspect that the amount of risk capital that companies will be asked to set aside will have as much to do with both the complexity and liquidity levels as it does with the expected default rates and levels of exposure. Products that cannot be traded on exchanges or through a special clearing house will no doubt be too complex and/or too illiquid to make a market. As such, to better insure that these hard to sell and hard to understand assets are properly covered for counterparty risk, required regulatory capital will increase. If excessively complex, the level of regulatory capital may become so extreme that such "self insurance" could prevent such products from even being developed. Hopefully this will not be the case, or the intent. Responsible financial engineers (I know, that sounds like an oxymoron anymore) need to be able to continue to structure products that will allow for the off-loading of risk on both sides of the transaction. Otherwise, financial innovation and reasonable risk taking will slow down, along with the returns the markets desire. Hopefully regulators will find a "reasonable" balance that will still allow for innovation and risk management. While a flat and less volatile market sounds pretty good right now, eventually risk-taking and an expectation of return will come back to the market. Hopefully future regulation and intervention will allow it.

New York is planning to bring parts of the credit derivative market under the control and regulation of insurance supervisors (see Financial Times article). One has to wonder whether this is in fact the proper regulator for credit derivatives, and whether adding another separate oversight agency is the best move. Such a move is being made at a time when plans for a central counterparty clearing house for the credit derivatives market are still being discussed (see Financial Times article). No doubt that such a clearing house would have its own regulator. The problem is that regulatory inconsistencies, which at times even produce regulatory arbitrage, may be contributing to the current problems as much as the lack of regulation. Hopefully a smart, comprehensive, non-complicated, and consistent agency and set of regulations will result. As recently stated by Robert Pickel, from the International Swaps and Derivatives Association: “The state ... should proceed very cautiously and in consultation with federal regulators before acting in a way that may ultimately cause more harm than good.” We can only hope. Unfortunately, time is not on our side for some of the current market problems.

The recent move by the Treasury to place Fannie and Freddie into conservatorship amounts to the equivalent of bankruptcy in the credit derivatives market, generating defaults, and causing dealers in unwind various credit default swaps (see Financial Times article). The move once again highlights some of the problems with the CDS market, as no one really knows the real level of exposure. The notional protection outstanding is expected to be significant, but again, the exact amount is difficult to estimate. Settlement and trading procedures, as well as general transparency, needs to be improved. While the Fannie and Freddie related CDS issues may have less concerns, given that the value of the agency debt is still high and is currently backed by the U.S. government, the next Bear Stearns-like default may not provide as clear an exit plan. The powers to be need to act fast given that the growth of the CDS market is outpacing the current trading infrastructure, while the need for hedging credit risk has never been greater.

As reported at the Financial Times, 60 percent of US and European institutional investors surveyed expect that another big financial firm will collapse within the next 6 months. Another 15 percent think it will happen in 6-12 months. Of interest is that 55 percent of those surveyed have also stopped using one or more financial institutions, other than Bear Stearns, as a counterparty on credit trades due to concerns regarding solvency. This has caused many to cut back their use of credit default swaps and other credit derivatives. US firms in particular were most worried, with 85 percent stating counterparty risk as a serious threat. It appears that many market participants are waiting for another shoe to drop, and at least one more washout and possible testing of the lows before the markets move higher.

Reuters reports that while the failure of Bear Stearns would have likely triggered a series of counterparty failures in the credit default swaps market had the Fed not come to the rescue, CDS securities have actually held up pretty well and remained relatively liquid even while other financial markets have had their challenges. To date, since the market for credit derivatives has come into being, there has not been a default from a major dealer or bank. Ironically, the Bear Stearns issues themselves may have helped bolster the CDS market since not only did the Fed prevent potential counterparty failures associated with Bear, but they also gave the impressions that other major derivative counterparties were too big to fail.

Other markets have not fared as well. Recent credit problems and housing related losses have reduced the flow of capital in the mortgage-backed security, CDO, auction-rate security, corporate bond, and preferred shares markets. On the other hand, liquidity in the CDS market, especially for 5-year duration securities, has been better than other markets, even though it too has experience less dealers, lower liquidity, and wider bid-ask spreads than normal. Yet, it is still functioning and allowing investors with illiquid corporate bond exposure to buy protection with credit derivatives.

Of interest for traders is that in some instances CDS securities have weakened ahead of stock prices, giving traders some clue as to what equities are a cause for concern. As an example, the CDS spreads for Bear Stearns widened by 10 times over two months last summer, significantly under-performing the stock and giving some insight into potential problems. Shortly near the end of the two month period, two Bear Stearns hedge funds collapsed from bad mortgage bets. The traders that were focused on credit risk hedged their exposure in the CDS market long before problems became evident to the equity market. Something worth noting as we hear of new activity in the credit derivative markets going forward.