In essence, the inability to identify the risks and therefore value mortgage- backed securities accurately was at the core of the sub-prime debacle and ensuing credit crunch. The same potential was identified in the CDS market due to its unregulated and fragmented nature.
The event that triggered awareness of the potential danger the market could pose was the cash flight from Bear Stearns. Bear was not allowed to fail due to the volume of CDSs that it had written for other institutional investors. So in effect the decision to keep the brokerage firm from defaulting was driven by the threat a bankruptcy may have posed to Bear’s trading partners, as opposed to the investors and creditors of Bear itself.
The repercussions of further major credit events, such as Lehman Brothers’ collapse and the AIG bailout, have prompted legislators and regulators to consider drastic action. This action ranges from the legislative push within the EU to establish a clearing facility, to the extreme of a bill before the US Congress that would effectively ban most forms of CDS trading.The enormity of this unregulated sector spooked the industry, as unprecedented credit events stressed a market that lacked fully developed clearing and recovery protocols. The figure of $64 trillion at its high point placed added strain on already panicked markets, and the intervention of the International Swaps and Derivatives Association was required to rapidly develop and deploy protocols.
There has been ongoing work to reduce the notional number of outstanding contracts, with the total currently outstanding at $27 trillion. A key milestone of the drive to standardize the market has been the announcement of launch of a single-name contract in the US. Settlement procedures are being developed for inclusion or ‘hard-wiring’ into standard contracts. ISDA has offered the option to settle contracts with cash payments based on an auction instead of requiring that the debt be physically delivered to the protection sellers. Further inclusions cover:
• Auction Settlement provisions that eliminate the need for credit event protocols;
• Resolutions of the Determinations Committees, comprising dealer and buy-side representatives to determine, eg: whether credit events have taken place;
• Credit and Succession Event Backstop Dates that institute a common standard effective date for CDS trades.
ISDA’s aim in combination with the changes in market practice that support standard coupons for CDS is to introduce greater certainty to transactional, operational and risk considerations for treatment of CDS.
The battle between banks and exchanges in the race to set up centralized clearing is over the $34 billion in fees the CDS market generates. What had been an unregulated OTC market, albeit growing exponentially, was primarily a bespoke market with little standardization of contract or capital requirements. CDSs started as a relatively safe means of offloading counterparty risk, in that they functioned as insurance against the risk of a default. The move to centralized clearing will inevitably over time reduce margins in this market; however, as it appears that CDSs are here to stay they will provide a lucrative ongoing fee revenue stream.
Of the four contending central clearing providers, the Intercontinental Exchange, through its purchase of a stake in Chicago Clearing Corp. and its interdealer-broker Creditex and STP technology arm T-Zero, has been the first to clear trades. In its first week it cleared $7.15 billion in contracts. ICE has achieved front runner status by joining with banks such as Goldman Sachs Group Inc. and JP Morgan Chase & Co. amongst others in ownership of the Chicago Clearing Corp. under which they evenly share revenues from the clearinghouse. Futures exchange operator CME Group is working with Citadel Investment Group to create an exchange-like platform to trade and clear CDSs; whilst it has been beaten to the punch by the ICE it has received its regulatory approval to commence clearing, and is waiting for several major CDS dealers to join before launching. NYSE Euronext (through Liffe) and Eurex are emerging as the major players in Europe. In addition, Knight Capital Group has announced NetDelta, a settlement platform that is positioned as an alternative to a CDS clearinghouse. As all of the contenders have experience with clearing, they are providing their own technology, meaning that opportunitiesfor vendors will lie in the linking of dealers to the clearing houses.
It appears that political concerns are now overriding the commercial. Due to the failure of major European dealers to agree on a solution, a centralized European-based CDS clearing system will be legislated for by the European Commission. This move has been prompted by the concern that there is a danger of lack of recourse if one facility in a foreign jurisdiction came to dominate the market. It is envisioned that the resulting European facility will sit alongside a US-based counterpart.
There is still much work to be done in the field of pricing and risk management, as there are many competing tools in the market for determining requisite levels of margins. In a move to steady the hand of regulators, JPMorgan has offered up the source code of its own CDS analytical engine in order to provide a common platform for the fledgling facility. However, as illustrated by the case of the rogue trader at Société Générale which showed that model based risk applications are not enough on their own to stave off disaster – they must be supported by wider processes and an understanding of the nature of the market and risks being taken on.
If the market passively waits for the legislation, there will be a scramble to get the facility up and running. Market data solution providers should follow developments closely as, along with the general shift of OTC products to exchanges, there will be a great need for development and testing while ensuring there are no adverse latency impacts. Key areas of development will be price reporting and the provision of data sufficient for supervision by regulators, and with the establishment of clearing facilities and the standardization of contracts, the logical next step will be the shift to electronic exchange-based trading.
The market is currently undergoing a period of profound rationalization and standardization. The CDS market in its new more transparent form will be an important source of risk management going forward; as such it will be a sizeable and important market. With the continuing development of a multipolar financial environment, including greater coordination between regulators, I would think it inevitable that Asian markets would see the development of a regional clearing house as an important part of their financial architecture.
Whilst the CDS market continues to shrink due to market participants’ efforts to reduce the notional amount of contracts outstanding through the netting out of contracts, there is a steady appetite for credit protection as the recession deepens around the globe. It is our expectation that the CDS market will bottom out in the next six months before resuming a steady more measured rise. Further to, there is an increasing use of CDS contracts to take positions on expected currency movements as the historically low levels of interest rates can no longer reliably indicate future movements.
Damian Shaw-Williams is a Senior Analyst with the Financial Services Technology team at Datamonitor