Central clearing houses have been hailed by regulators as a potential saviour of the much-maligned market for credit default swaps - but a new research paper suggests this optimism might be misplaced.
Treasury secretary Tim Geithner described central clearinghouses as an important element of his (still nebulous) plans to address systemic risks in the financial system.
The received logic behind the move toward a system of central clearing in the largely over-the-counter derivatives market is built around two major points: capital constraints at banks and counterparty risks.
One argument is that banks are likely to be be able to lower the amount of capital they set aside as collateral for trades, because instead of making reserves on an individual basis they would be contributing to a central fund at the clearing house - which would be netting out the multiple positions of member dealers.
As for counterparty risk, a clearing house would reduce the number of counterparties with which banks have to contend (and would, presumably be perceived as less risky than being exposed to Citi, say). In other words, participants will be insulated from the failure of one (or several) dealers.
As analysts at Dresdner noted recently:
This would not be perfect, and in effect it would spread the cost of such a failure across all houses using the clearing facility.But Darrell Duffie, a “distinguished professor of finance” at the Stanford Graduate School of Business and Haoxiang Zhu, a doctoral student there, contend that the clearing houses may actually increase inefficiencies in the market, as well as the amount of collateral banks have to post.
Their argument may be summarised thus (emphasis FT Alphaville’s):
Although the worldwide market for credit default swaps is huge at $27 trillion, it has shrunk by more than 50 percent in the past year, and is too small-and the number of participating institutions is too small-for a clearinghouse that deals only in CDS to efficiently reduce counterparty risk
the clearinghouse should clear a much larger fraction of trades made in the $500 trillion market for over-the-counter (off-exchange) derivatives.
(As an aside, credit default swaps represent just about 11 per cent of the overall market for OTC derivatives, according to data from ISDA and the BIS)
Banks reduce risk by trading across various classes of options, derivatives, and other financial instruments. Ultimately, positions between two counterparties tend to have offsetting exposures; some are of positive market value to a given counterparty, and others are of negative market value. These have a “netting effect,” that is, only the net amount of market value is at risk in a default by one of the counterparties
Duffie and his co-author built a theoretical model to clarify an important tradeoff between two types of netting opportunities, “namely bilateral netting between pairs of dealers across different underlying assets, versus multilateral netting among many dealers across a single class of underlying assets, such as credit default swaps.” The latter of these is the method by which the new clearinghouses will work.
…
clearing only credit default swaps can actually increase the risk to the counterparties because the benefits of bilateral netting across asset classes is reduced in this case.
For instance, if Dealer A is exposed to Dealer B by $100 million on CDS, while at the same time Dealer B is exposed to Dealer A by $150 million on interest-rate swaps, then the introduction of central clearing for only credit default swaps increases the maximum loss between these two dealers, before collateral and after netting, from $50 million to $150 million. Additionally, CDS-only clearing would likely result in demands for additional, expensive, collateral to protect the two parties.
…
a dedicated central clearing counterparty [a clearinghouse] improves netting efficiency for these dealers if and only if the fraction of a typical dealer’s expected exposure attributable to CDS is the majority of the total expected exposures of all remaining bilaterally netted classes of derivatives. In fact, the credit-default swap market is now too small to reach that threshold.
Making matters somewhat worse was the decision to establish multiple clearing houses. Having more than one reduces the netting effect even more…
Current clearinghouse initiatives include CMDX, a joint venture between CME Group and Citadel, ICE Trust and Eurex.
Duffie and Zhu also dismiss the suggestion that clearinghouses will increase transparency in the CDS market:
Actually, the same level of information about CDS trades that would be available to regulators in a clearing house is already available through the Depository Trust and Clearing Corporation (DTCC). With or without a clearing house, there is no plan to reveal trades to the public. So, the stories of improved transparency are a red herring.
There are other, even more obvious critiques of central clearinghouses - for instance, they can clear only standard contracts like indices, and in the post-CDS Big Bang era, North American single-name contracts. But as the authors rightly note, most CDS contracts are not standardized.
Over to you, regulators.
(H/T Research Recap)
Related links:
Banks eye CDS clearinghouse - FT (April 2008)
France calls for eurozone CDS clearinghouse - FT
Japan clearers seek CDS slots - FT
